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U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K


þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		for the fiscal year ended December 31, 2007
		or
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		transition period from to .

Commission file number 000-25425

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)

Registrant’s telephone number, including area code:

(609) 737-0426

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

None

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

Common Stock (no par value)

Title of Each Class:

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes o No þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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


Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company o

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

The aggregate market value of the voting and non-voting common stock held by non-affiliates (computed by reference to the price at which the common stock was last sold) as of the last business day of the Registrant’s most recently completed second fiscal quarter was: $130,578,507.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of March 10, 2008. Common Stock, no par value: 6,569,519 .

Documents Incorporated by Reference

Portions of the definitive Proxy Statement for the 2007 Annual Meeting of Shareholders are incorporated by reference in Part III of this Form 10-K.

PART I


ITEM 1.	*BUSINESS*

THE HOLDING COMPANY

Mercer Insurance Group, Inc. (the “Holding Company” or “MIG”) is a holding company which resulted from the conversion of Mercer Mutual Insurance Company from the mutual to the stock form of organization on December 15, 2003 (the “Conversion”). Prior to the Conversion, and since 1844, Mercer Mutual Insurance Company was engaged in the business of selling property and casualty insurance. Mercer Mutual Insurance Company, a Pennsylvania domiciled company, changed its name to Mercer Insurance Company immediately after the Conversion, and became a subsidiary of the Holding Company.

Mercer Insurance Group, Inc. 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). 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.

OVERVIEW OF THE BUSINESS

MIG, 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.

The Group’s operating subsidiaries are licensed collectively in twenty two states, but are currently focused on doing business in seven states; Arizona, California, Nevada, New Jersey, New York, Pennsylvania and Oregon. MIC and MICNJ recently became licensed to write property and casualty insurance in New York, and initially will write business which supports existing accounts, 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 mail surety is being written in some of these states.

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. FPIC joined the Pool effective January 1, 2006, after receiving regulatory approvals. 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 7 years. An “A” rating is the third highest rating of A.M. Best’s 16 possible rating categories.

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).

We manage our business and report our operating results in three operating segments: commercial lines insurance, 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, surety 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. The Group markets its products through a network of approximately 519 independent agents, of which approximately 280 are located in New Jersey and Pennsylvania, 178 in California with the balance in Arizona, Nevada and Oregon.

ACQUISITION OF FINANCIAL PACIFIC INSURANCE GROUP

On October 1, 2005, the Group acquired all the outstanding stock of FPIG for approximately $41.1 million in cash, including transaction costs. The transaction was effected through a merger of a wholly owned subsidiary of the Group into FPIG. The financial results of FPIG have been included subsequent to the date of the acquisition.

The acquisition was made using funds of the Holding Company, as well as funds advanced to the Holding Company from MIC in the form of both an extraordinary dividend as well as an intercompany loan. The Pennsylvania Insurance Department approved both the extraordinary dividend and the intercompany loan arrangement.

The acquisition has allowed the Group to continue growing its commercial lines segment, to achieve product and geographic diversification, and to achieve greater scale over time in connection with infrastructure costs such as information technology. FPIC currently writes property and casualty insurance for small and medium-sized businesses in the contractor, manufacturing, retail, services and wholesaling sectors in Arizona, California, Nevada and Oregon, and is licensed in another fifteen states outside the Group’s present focus areas. FPIC writes direct mail surety in some of those states.

OUR INSURANCE COMPANIES

Mercer Insurance Company

MIC is a Pennsylvania insurance company originally incorporated under a special act of the legislature of the State of New Jersey in 1844 as a mutual insurance company. On October 16, 1997, it filed Articles of Domestication with Pennsylvania which changed its state of domicile from New Jersey to Pennsylvania, and then subsequently changed its name to Mercer Insurance Company after the Conversion in 2003. MIC owns all of the issued and outstanding capital stock of QHC, which owns all of the issued and outstanding capital stock of MICNJ. MIC also owns 49% of the issued and outstanding stock of FHC, which owns all of the issued and outstanding capital stock of FIC. The remaining 51% of FHC is owned by the MIG.

MIC is a property and casualty insurer of primarily small and medium-sized businesses and property owners located in New Jersey and Pennsylvania. It markets commercial multi-peril and homeowners policies, as well as other liability, workers’ compensation, fire, allied, inland marine and commercial automobile insurance. MIC does not market private passenger automobile insurance in New Jersey. MIC is subject to examination and comprehensive regulation by the Pennsylvania Insurance Department. See “Business — Regulation.”

Mercer Insurance Company of New Jersey, Inc.

MICNJ is a property and casualty insurance company that was incorporated in 1981. It writes the same lines of business as MIC, with its book of business predominantly located in New Jersey. MICNJ is subject to examination and comprehensive regulation by the New Jersey Department of Banking and Insurance. See “Business — Regulation.”

Franklin Insurance Company

FIC is a stock property and casualty insurance company that was incorporated in 1997. MIC acquired 49% of FIC in 2001, with the remaining 51% acquired by MIG as part of the Conversion transaction in 2003. FIC currently offers private passenger automobile and homeowners insurance to individuals located in Pennsylvania. FIC is subject to examination and comprehensive regulation by the Pennsylvania Insurance Department. See “Business — Regulation.”

Financial Pacific Insurance Company

FPIC is a stock property and casualty company that was incorporated in California in 1986 and commenced business in 1987. The Group acquired all of the outstanding stock of FPIG, the holding company for FPIC, on October 1, 2005. FPIC is based in Rocklin, California, and writes primarily commercial package policies for small to medium-sized businesses in targeted classes. It has developed specialized underwriting and claims handling expertise in a number of classes of business, including apartments, restaurants, artisan contractors and ready-mix operators. FPIC’s business is heavily weighted toward the liability lines of business (commercial multi-peril liability, commercial auto) but also includes commercial multi-peril property, commercial auto physical damage and surety for small and medium-sized businesses. FPIC is licensed in nineteen western states, and actively writes insurance in four (Arizona, California, Nevada and Oregon). FPIC is subject to examination and comprehensive regulation by the California Department of Insurance. See “Business — Regulation.”

OUR BUSINESS STRATEGIES

The acquisition of FPIG has moved the Group closer to its goals of a higher proportion of commercial lines premiums as well as product and geographic diversity. As a west coast-based commercial writer, the addition of FPIG resulted in an expansion of our geographic scope and a meaningful line of business diversification. We will continue our efforts to pursue geographic and product line diversification in order to diminish the importance of any one line of business, class of business or territory.

Increase our commercial writings

In recent years, and including the FPIG acquisition, the Group has taken steps to increase commercial premium volume, and we will continue our focus on this goal. Growth in commercial lines reduces our personal lines exposure as a percentage of our overall exposure, which reduces the relative adverse impact that weather-related property losses can have on us. Increased commercial lines business also benefits us because we have greater flexibility in establishing rates for these lines.

In order to attract and retain commercial insurance business, we have developed insurance products and underwriting guidelines specifically tailored to meet the needs of particular types of businesses. These programs are continually refined and, if successful, expanded based on input from our producers and our marketing personnel. We are continually looking for new types of business where we can apply this focus.

We have specialized pricing approaches and/or products designed for religious institutions, contracting, apartment, restaurant, condominium and “main street” accounts as well as various other types of risks. The products, rates and eligibilities vary based on our opinion of the local market opportunities for products in a given area.

We believe that there is an opportunity to increase our volume of commercial business by working with our existing producers of commercial lines business and forming and developing relationships with new producers that focus on commercial business. We believe an increasing share of this market is desirable and attainable given our existing relationships with our producers and our insureds.

Diversify our business geographically

As a result of the FPIG acquisition, we have achieved greater geographic diversification of our business. As of December 31, 2007, 2006 and 2005 our direct written premium was distributed as follows (note that the FPIC premium volume is included in the table beginning October 1, 2005, the date it was acquired):


	Years Ended December 31,						% of Total
	2007		2006		2005		2007			2006			2005
	(In thousands)

California	$	100,202		97,628		23,130		54.7	%		52.5	%		25.1	%
New Jersey		48,750		51,302		49,744		26.7	%		27.6	%		53.9	%
Pennsylvania		13,259		14,274		14,555		7.2	%		7.7	%		15.8	%
Nevada		11,670		14,235		2,450		6.4	%		7.7	%		2.7	%
Arizona		6,134		5,031		1,413		3.4	%		2.7	%		1.5	%
Oregon		2,758		3,107		907		1.5	%		1.7	%		1.0	%
Other States		134		168		41		0.1	%		0.1	%		0.0	%

Total	$	182,907		185,745		92,240		100.0	%		100.0	%		100.0	%

We hold twenty two state licenses, and we are currently focused on doing business in primarily six of these states. These state licenses provide additional opportunity for future growth when market opportunities dictate utilization of those licenses. If market opportunities indicate desirable growth is available through the acquisition of additional state licenses, we will pursue licenses in new states.

Attract and retain high-quality producers with diverse customer bases

We believe our insurance companies have a strong reputation with producers and insureds for personal attention and prompt, efficient service. This reputation has allowed us to grow and foster our relationships with many high volume producers. Several of these producers focus primarily on commercial business and are located in areas we have targeted as growth opportunities within our territories. We intend to focus our marketing efforts on maintaining and improving our relationships with these producers, as well as on attracting new high-quality producers in areas with a substantial potential for growth. We also intend to continue to develop and tailor our commercial programs to enable our products to meet the needs of the customers served by our producers.

Reduce our ratio of expenses to net premiums earned

We are committed to improving our profitability by reducing expenses through the use of enhanced technology, by increasing our net premium revenue through the strategic deployment of our capital and by prudently deploying our workforce to build efficiencies in our processes.

Reduce our reliance on reinsurance

We continue to reduce our reliance on reinsurance by increasing our retention of business written by our insurance companies on individual property and casualty risks. Our capital is best utilized by retaining as much profitable business as practical. We continually evaluate our reinsurance program to reduce the cost and achieve the optimal balance between cost and protection.

We determine the appropriate level of reinsurance based on a number of factors, which include:


	•	the amount of capital the Group is prepared to dedicate to support its underwriting activities;

	•	our evaluation of our ability to absorb multiple losses; and

	•	the terms and limits that we can obtain from our reinsurers.

A decrease in reinsurance would result in a decrease in ceded premiums and a corresponding increase in net premium revenue, but would also increase our potential losses from underwriting. See “Business — Reinsurance” for a description of our reinsurance program.

COMMERCIAL LINES PRODUCTS

The following table sets forth the direct premiums written, net premiums earned, net loss ratios, expense ratios and combined ratios of our commercial lines products on a consolidated basis for the periods indicated. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


	Year Ended December 31,
	2007			2006			2005
	(Dollars in thousands)

Direct Premiums Written:
Commercial multi-peril	$	116,622		$	118,030		$	44,369
Commercial automobile		28,232			25,807			7,955
Other liability		4,251			6,246			7,822
Workers’ compensation		4,959			4,697			4,642
Surety		4,987			5,388			1,924
Fire, allied, inland marine		979			1,424			1,003

Total	$	160,030		$	161,592		$	67,715

Net Premiums Earned:
Commercial multi-peril	$	90,088		$	80,952		$	30,106
Commercial automobile		22,551			17,944			5,862
Other liability		2,387			5,710			8,239
Workers’ compensation		5,501			6,001			6,016
Surety		4,428			4,381			1,197
Fire, allied, inland marine		472			473			859

Total	$	125,427		$	115,461		$	52,279

Net Loss Ratios:
Commercial multi-peril		55.6	%		66.1	%		73.2	%
Commercial automobile		61.2			68.3			48.5
Other liability		315.3			34.0			33.6
Workers’ compensation		51.4			61.8			43.2
Surety		41.5			40.0			15.9
Fire, allied, inland marine		46.9			74.7			6.7

Total		60.8	%		63.7	%		58.3	%

Expense Ratio:
Commercial multi-peril		34.2	%		34.3	%		34.8	%
Commercial automobile		38.5			30.4			30.8
Other liability		36.1			38.2			49.1
Workers’ compensation		19.8			22.3			31.1
Surety		34.4			18.3			(16.9	)
Fire, allied, inland marine		46.7			55.4			50.2

Total		34.4	%		32.8	%		35.2	%

Combined Ratios(1):
Commercial multi-peril		89.8	%		100.4	%		108.0	%
Commercial automobile		99.7			98.7			79.3
Other liability		351.4			72.2			82.7
Workers’ compensation		71.2			84.1			74.3
Surety		75.9			58.3			(1.0	)
Fire, allied, inland marine		93.6			130.1			56.9

Total		95.2	%		96.5	%		93.5	%


(1)		A combined ratio over 100% means that an insurer’s underwriting operations are not profitable.

Commercial Multi-Peril

We write a number of multi-peril policies providing property and liability coverage. Various risk classes are written on this policy.

We offer a business owners policy that provides property and liability coverages to small businesses. This product is marketed to several distinct groups: (i) apartment building owners; (ii) condominium associations; (iii) business owners who lease their buildings to tenants; (iv) mercantile business owners, such as florists, delicatessens, and beauty parlors; and (v) offices with owner and tenant occupancies. We expect to introduce this product in our California territory within the next two years.

We offer in New Jersey and Pennsylvania a specialized multi-peril policy specifically designed for religious institutions. This enhanced product offers directors and officers coverage, religious counseling coverage and equipment breakdown coverage (through a reinsurance arrangement). Coverage for child care centers and schools is also available. We offer versions of this product to individual religious institutions as well as to denomination groups who seek coverage for participating member institutions. This product is also available in New York on a limited basis.

A custom underwritten commercial multi-peril package policy is written in the western states for select contracting classes, as well as small to medium-sized businesses within specified niche markets. This product is focused on commercial accounts primarily in non-urban areas that do not easily fit within a generic business owner policy. The target markets for this product include apartments, artisan and construction contractors, farm labor operations, service contractors, and mercantile (including restaurants) as well as various other risk types.

Commercial Automobile

This product is designed to cover primarily trucks used in business, as well as company-owned private passenger type vehicles. Other specialty classes such as church vans, funeral director vehicles and farm labor buses can also be covered. The policy is marketed as a companion offering to our business owners, commercial multi-peril, religious institution, commercial property or general liability policies.

We also write heavy and extra heavy trucks through our refuse hauler, aggregate hauler and ready-mix programs offered principally in the western states.

Other Liability

We write liability coverage for insureds who do not have property exposure or whose property exposure is insured elsewhere. The majority of these policies are written for contractors such as carpenters, painters or electricians, who often self-insure small property exposures. Coverage for both premises and products liability exposures are regularly provided. Coverage is available for other exposures such as vacant land and habitational risks.

Commercial umbrella coverage and following form excess is available for insureds who insure their primary general liability exposures with us through a business owners, commercial multi-peril, religious institution or commercial general liability policy. This coverage typically has limits of $1 million to $10 million, but higher limits are available if needed. To improve processing efficiencies and maintain underwriting standards, we prefer to offer this coverage as an endorsement to the underlying liability policy rather than as a separate stand-alone policy, but both versions are available.

Workers’ Compensation

We typically write workers’ compensation policies in conjunction with an otherwise eligible business owners, commercial multi-peril, religious institution, commercial property or general liability policy. As of December 31, 2007, most of our workers’ compensation insureds have other policies with us. Workers’ compensation is written principally in New Jersey and Pennsylvania, with availability in New York on a limited basis.

PERSONAL LINES PRODUCTS

The following table sets forth the direct premiums written, net premiums earned, net loss ratios, expense ratios and combined ratios of our personal lines products on a consolidated basis for the periods indicated. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


	Year Ended December 31,
	2007			2006			2005
	(Dollars in thousands)

Direct Premiums Written:
Homeowners	$	14,675		$	15,149		$	14,950
Personal automobile		5,822			6,578			7,057
Fire, allied, inland marine		1,967			1,983			2,037
Other liability		380			409			442
Workers’ compensation		33			34			39

Total	$	22,877		$	24,153		$	24,525

Net Premiums Earned:
Homeowners	$	13,005		$	13,196		$	12,954
Personal automobile		5,797			6,415			6,908
Fire, allied, inland marine		2,049			2,228			2,140
Other liability		369			341			443
Workers’ compensation		28			32			36

Total	$	21,248		$	22,212		$	22,481

Net Loss Ratios:
Homeowners		73.8	%		65.2	%		53.1	%
Personal automobile		69.2			71.6			66.6
Fire, allied, inland marine		44.1			26.0			27.9
Other liability		101.5			109.2			175.4
Workers’ compensation		16.8			60.8			141.0

Total		70.1	%		63.8	%		57.4	%

Expense Ratio:
Homeowners		27.7	%		40.3	%		44.4	%
Personal automobile		34.1			29.3			33.8
Fire, allied, inland marine		22.9			33.4			39.5
Other liability		18.1			44.6			45.4
Workers’ compensation		10.6			22.4			25.3

Total		28.8	%		36.5	%		40.7	%

Combined Ratios(1):
Homeowners		101.5	%		105.5	%		97.5	%
Personal automobile		103.3			100.9			100.4
Fire, allied, inland marine		67.0			59.4			67.4
Other liability		119.6			153.8			220.8
Workers’ compensation		27.4			83.2			166.3

Total		98.9	%		100.3	%		98.1	%


(1)		A combined ratio over 100% means that an insurer’s underwriting operations are not profitable.

Homeowners

Our homeowners policy is a multi-peril policy providing property and liability coverages and optional inland marine coverage. The homeowners policy is sold to provide coverage for an insured’s residence. We market both a standard and a preferred homeowner product. The preferred product is offered at a discount to our standard rates to our customers who have a lower risk of loss. This product is sold only in New Jersey and Pennsylvania.

Personal Automobile

We write comprehensive personal automobile coverage including liability, property damage and all state required insurance minimums for individuals domiciled in Pennsylvania only. This product is multi-tiered with an emphasis placed on individuals with lower than average risk profiles.

Combination Dwelling Policy

Our combination dwelling product is a flexible, multi-line package of insurance coverages. It is targeted to be written on an owner or tenant occupied dwelling of no more than two families. The dwelling policy combines property and liability insurance but also may be written on a monoline basis. The property portion is considered a fire, allied lines and inland marine policy, and the liability portion is considered an other liability policy. This product is available in both New Jersey and Pennsylvania.

Other Liability

We write personal lines excess liability, or “umbrella,” policies covering personal liabilities in excess of amounts covered under our homeowners policies. These policies are available generally with limits of $1 million to $5 million. We do not market excess liability policies to individuals unless we also write an underlying primary liability policy.

Workers’ Compensation

A small portion of our workers’ compensation premiums are considered personal lines insurance because our New Jersey homeowners policy is required to include workers’ compensation coverage for domestic employees.

MARKETING

We market our insurance products exclusively through independent producers, with the exception of a relatively small amount of business within our surety book of business marketed online and by direct mail. All of these producers represent multiple carriers and are established businesses in the communities in which they operate. They generally market and write the full range of our insurance companies’ products. We consider our relationships with our producers to be good. For the year ending December 31, 2007 and 2006, there were no agents in the Group that individually produced greater than 5% of the Group’s direct written premiums. For the year ending December 31, 2005, approximately 17% of the Group’s direct premiums written were produced by two agents.

We emphasize personal contact between our producers and the policyholders. We believe that our producers’ fast and efficient service and name recognition, as well as our policyholders’ loyalty to and satisfaction with producer relationships are the principal sources of new customer referrals, cross-selling of additional insurance products and policyholder retention.

Our insurance companies depend upon their producer force to produce new business, to provide customer service, and to be selective underwriters in their screening of risks for our insurance companies to consider underwriting. The network of independent producers also serves as an important source of information about the needs of the communities served by our insurance companies. We use this information to develop new products and new product features.

Producers are compensated through a fixed base commission often with an opportunity for profit sharing depending on the producer’s aggregate premiums earned and loss experience. Profit sharing opportunities are for a producer’s entire book of business with the Group and not specifically for any individual policy. The Group does not

have any marketing services agreements, placement services agreements, or similar arrangements. By contract, our producers represent one or more of the Group’s carriers. They are monitored and supported by our marketing representatives, who are employees of the Group. These company representatives also have principal responsibility for recruiting and training new producers.

Our insurance companies manage their producers through periodic business reviews (with underwriter and marketing participation) and establishment of benchmarks/goals for premium volume and profitability. Our insurance companies in recent years have terminated a number of underperforming producers.

Our marketing efforts are further supported by our claims philosophy, which is designed to provide prompt and efficient service, resulting in a positive experience for producers and policyholders. We believe that these positive experiences are then conveyed by producers and policyholders to many potential customers.

UNDERWRITING

Our insurance companies write their personal and commercial lines by evaluating each risk with consistently applied standards. We maintain information on all aspects of our business that is regularly reviewed to determine product line profitability. We also employ a staff of underwriters, who specialize in either personal or commercial lines, and have experience as underwriters in their specialized areas. Specific information is monitored with regard to individual insureds to assist us in making decisions about policy renewals or modifications. New property risks are frequently inspected to insure they are as desirable as suggested by the application process.

We plan on introducing, for selected products, an automated process for acceptance and rejection of small accounts through an internet-based rating system. Based on the success of this process, our goal would be to expand the process to other products at some point in the future. Though there will be less direct underwriter involvement, we are confident that underwriting standards will continue to be maintained as risks will continue to be subject to our standardized underwriting verification processes, including physical inspections.

We rely on information provided by our independent producers. Subject to certain guidelines, producers also pre-screen policy applicants. The producers have the authority to sell and bind insurance coverages in accordance with pre-established guidelines in some, but not all cases, provided their historic underwriting performance warrants such authority. Producers’ results are continuously monitored, and continued poor loss ratios often result in agency termination.

CLAIMS

Claims on insurance policies are received directly from the insured or through our independent producers. Claims are then assigned to either an in-house adjuster or an independent adjuster, depending upon the size and complexity of the claim. The adjuster investigates and settles the claim. Our trend is to manage an increasing higher proportion of our claims internally without the use of independent adjusters where scale permits. The Group also has a contingency plan for adjusting and processing claims resulting from a natural catastrophe.

Claims settlement authority levels are established for each claims adjuster based upon his or her level of experience. Multi-line teams exist to handle all claims. The claims department is responsible for reviewing all claims, obtaining necessary documentation, estimating the loss reserves and resolving the claims.

We attempt to minimize claims and related legal costs by encouraging the use of alternative dispute resolution procedures. Litigated claims are assigned to outside counsel for many types of claims, however most litigated claims files handled in our western state operations are managed by in-house attorneys who have specialized training relating to construction liability issues and other casualty risks. We believe this arrangement reduces dramatically the cost of managing these types of claims, as the use of in-house attorneys dramatically reduces the cost of defense work.

TECHNOLOGY

The Group seeks to transact much of its business using technology wherever possible and, in recent years, has made significant investments in information technology platforms, integrated systems and internet-based applications.

The Group is in the process of phasing out legacy systems, primarily those acquired with FPIG, and consolidating onto one core transactional system. As part of this process, the Group is implementing a “data warehouse” to house the Group’s legacy data in one technical platform as well as establish an Executive Dashboard with “drill down” capability. This will streamline and simplify management reporting.

The focus of our ongoing information technology effort is:


	•	to streamline how our producers’ transact business with us;

	•	to continue to evolve our internal processes to allow for more efficient operations;

	•	to enable our producers to efficiently provide their clients with a high level of service;

	•	to enhance agency online inquiry capabilities; and

	•	to provide agencies with on-line reporting.

We believe that our technology initiative may increase revenues by making it easier for our insurance companies and producers to exchange information and do business. Increased ease of use is also an opportunity for us to lower expenses, eliminating the need to operate more than one system once the transition is complete. This will further reduce technology expense and simplify information technology management.

We take reasonable steps to protect information we are entrusted with in the ordinary course of business. As a core part of our disaster recovery planning, we have implemented a secure and reliable off-site disk-to-disk backup and restore capability.

REINSURANCE

Reinsurance Ceded

In accordance with insurance industry practice, our insurance companies reinsure a portion of their exposure and pay to the reinsurers a portion of the premiums received on all policies reinsured. Insurance policies written by our companies are reinsured with other insurance companies principally to:


	•	reduce net liability on individual risks;

	•	mitigate the effect of individual loss occurrences (including catastrophic losses);

	•	stabilize underwriting results;

	•	decrease leverage; and

	•	increase our insurance companies’ underwriting capacity.

Reinsurance can be facultative reinsurance or treaty reinsurance. Under facultative reinsurance, each policy or portion of a policy is reinsured individually. Under treaty reinsurance, an agreed-upon portion of a class of business is automatically reinsured. Reinsurance also can be classified as quota share reinsurance, pro-rata reinsurance or excess of loss reinsurance. Under quota share reinsurance and pro-rata reinsurance, the ceding company cedes a percentage of its insurance liability to the reinsurer in exchange for a like percentage of premiums less a ceding commission. The ceding company in turn recovers from the reinsurer the reinsurer’s share of all losses and loss adjustment expenses incurred on those risks. Under excess reinsurance, an insurer limits its liability to all or a particular portion of the amount in excess of a predetermined deductible or retention. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the ceding company to the extent of the coverage ceded.

The amount and scope of reinsurance coverage we purchase each year is determined based on a number of factors. These factors include the evaluation of the risks accepted, consultations with reinsurance representatives and a review of market conditions, including the availability and pricing of reinsurance. Reinsurance arrangements are placed with non-affiliated reinsurers, and are generally renegotiated annually. For the year ended December 31, 2007, our insurance companies ceded to reinsurers $24.6 million of written premiums, compared to $42.3 million of written premiums for the year ended December 31, 2006, and $19.8 million for the year ended December 31, 2005. The decrease in 2007 from 2006 relates primarily to the increase in underlying retention in 2007 and related decrease in ceding rates. The increase in 2006 from 2005 relates largely to the inclusion of the reinsurance premiums ceded by FPIC, which was acquired by the Group on October 1, 2005.

The largest exposure retained in 2007 on any one individual property risk was $750,000 ($500,000 for 2006 and 2005). Individual property risks in excess of these amounts are covered on an excess of loss basis pursuant to various reinsurance treaties. All property lines of business, including commercial automobile physical damage, are reinsured under the same treaties.

Except for umbrella liability, individual casualty risks that are in excess of $750,000 (excess of $500,000 in 2006 and 2005) are covered on an excess of loss basis up to $1.0 million per occurrence. Casualty losses in excess of $1.0 million arising from workers’ compensation claims are reinsured up to $10.0 million per occurrence per insured. Umbrella liability losses (except for policies issued by FPIC) are reinsured on a 75% quota share basis up to $1.0 million and a 100% quota share basis in excess of $1.0 million. FPIC’s umbrella program is 100% reinsured.

For the surety line of business, written exclusively by FPIC, the Group maintains an excess of loss contract under which it retains the first $500,000 and 10% of the next $3.0 million resulting in a maximum retention of $800,000 per principal.

Catastrophic reinsurance protects the ceding insurer from significant aggregate loss exposure. Catastrophic events include windstorms, hail, tornadoes, hurricanes, earthquakes, riots, blizzards, terrorist activities and freezing temperatures. We purchase layers of excess treaty reinsurance for catastrophic property losses. We reinsure 100% of losses per occurrence in excess of $5.0 million ($2.0 million for 2006 and 2005), up to a maximum of $55.0 million ($32.0 million for 2006 and 2005).

The Group also carries coverage for acts of terrorism of $10.0 million excess of $3.0 million (excess of $2.0 million for 2006 and 2005). This coverage does not apply to nuclear, chemical or biological events.

Prior to 2007, FPIC had a separate reinsurance program from the other insurance companies in the Group, which was largely a continuation of the program it had in place immediately prior to its acquisition by the Group. Commercial multi-peril property and auto physical damage coverage was reinsured, through a $1,650,000 excess of $350,000 excess of loss contract. Excess of $2.0 million, FPIC had a semi-automatic facultative agreement, which provided $8.0 million of coverage. On casualty business FPIC maintained two reinsurance layers, $250,000 excess of $250,000, and $500,000 excess of $500,000, respectively, for commercial multiple peril liability and commercial automobile liability with a syndicate of reinsurers. The maximum exposure on any one casualty risk was $250,000. Excess of $1.0 million, there was a semi-automatic facultative agreement, which provided $5.0 million of coverage.

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 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.

Effective January 1, 2008, the Group renewed its reinsurance coverages with the following changes. The retention on any individual property or casualty risk was increased to $850,000 from $750,000. Pollution coverage written by FPIC will now be fully retained with a standard sub-limit of $150,000 (and up to $300,000 on an exception basis). Prior to 2008, FPIC reinsured 100% of its pollution coverage which in 2007 represented $1.8 million of ceded written premium. The Group also purchased an additional $1.0 million of surety coverage

(subject to a 10% retention) which results in an increased reinsurance coverage to $4.5 million from $3.5 million per principal and a maximum retention of $900,000 per principal as compared to the previous $800,000.

In conjunction with the renewal of the reinsurance program for both 2008 and 2007, the prior year reinsurance treaties were terminated on a run-off basis, which requires that for policies in force as of December 31, 2007 and 2006, respectively, 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 the reinsurers on these prior year treaties as the underlying business runs off.

As of January 1, 2006, FPIC terminated its 2005 property quota share and casualty excess of loss reinsurance contracts on a cut-off basis and restructured its reinsurance program to the structure described above. The restructuring also included the assumption of ceded unearned premium 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 and earned premium for the year ending December 31, 2006.

During the third quarter of 2006, the Group commuted all reinsurance agreements with Alea North America Insurance Company (Alea). These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation the Group received a cash payment of $4.5 million, and recorded a pre-tax net loss on commutation of $160,000.

Prior to 2007, some of the Group’s reinsurance treaties (primarily FPIC treaties) have included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares on a limited basis in the profitability through contingent ceding commissions. Exposure to the loss experience is contractually defined at minimum and maximum levels, and the terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, the net amounts that will ultimately be realized may vary significantly from the estimated amounts presented in the Group’s results of operations.

The insolvency or inability of any reinsurer to meet its obligations to us could have a material adverse effect on our results of operations or financial condition. As of December 31, 2007, the Group’s five largest reinsurers based on percentage of ceded premiums are set forth in the following table:


			Percentage
			of Ceded			A.M. Best
Name			Premiums			Rating

	1.	General Reinsurance Corporation		37	%		A++
	2.	Berkley Insurance Company		27	%		A+
	3.	Munich Reinsurance America, Inc.		8	%		A+
	4.	Greenwich Insurance Company		7	%		A
	5.	Hartford Steam Boiler Inspection and Insurance Company		5	%		A++

The following table sets forth the five largest amounts of loss and loss expenses recoverable from reinsurers on unpaid claims as of December 31, 2007.

Loss and

Loss Expenses

Recoverable on

A.M. Best

Name

Unpaid Claims

Rating

(In thousands)

Berkley Insurance Company

22,030

A+

Partner Reinsurance Company of the U.S.

21,143

A+

QBE Reinsurance Corporation

11,276

Continental Casualty Company

6,535

General Reinsurance Corporation

5,931

A++

The A++, A+ and A ratings are the top three highest of A.M. Best’s 16 ratings. According to A.M. Best, companies with a rating of “A++” or “A+” are rated “Superior”, with “...a superior ability to meet their ongoing

obligations to policyholders.” Companies with a rating of “A” are rated “Excellent”, with “...an excellent ability to meet their ongoing obligations to policyholders.”

Reinsurance Assumed

We generally do not assume risks from other insurance companies. However, we are required by statute to participate in certain residual market pools. This participation requires us to assume business for workers’ compensation and for property exposures that are not insured in the voluntary marketplace. We participate in these residual markets pro rata on a market share basis, and as of December 31, 2007, our participation is not material. For the years ended December 31, 2007, 2006 and 2005, our insurance companies assumed $1.4 million, $2.4 million and $2.9 million of written premiums, respectively.

INTERCOMPANY AGREEMENTS

Our insurance companies are parties to a Reinsurance Pooling Agreement. Under this agreement, all premiums, losses and underwriting expenses of our insurance companies are combined and subsequently shared based on each individual company’s statutory surplus from the most recently filed statutory annual statement. The Pool has no impact on our consolidated results. FPIC joined the Group’s Pool on January 1, 2006. In connection with its participation in the Pool, FPIC transferred approximately $54 million in assets to the other companies in the Pool to recognize their assumption of a portion of its loss and loss adjustment expense and unearned premium reserves.

The Group’s insurance subsidiaries are parties to a Services Allocation Agreement. Pursuant to this agreement, any and all employees of the Group were transferred to, and became employees of, BICUS, a wholly owned subsidiary of MIC. BICUS has agreed to perform all necessary functions and services required by the subsidiaries of the Group in conducting their respective operations. In turn, the subsidiaries of the Group have agreed to reimburse BICUS for its costs and expenses incurred in rendering such functions and services in an amount determined by the parties. The Services Allocation Agreement has no impact on our consolidated results.

The Group and its subsidiaries are parties to a consolidated Tax Allocation Agreement that allocates to each company a pro rata share of the consolidated income tax expense based upon its contribution of taxable income to the consolidated group. The Tax Allocation Agreement has no impact on our consolidated results.

LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

Our insurance companies are required by applicable insurance laws and regulations to maintain reserves for payment of losses and loss adjustment expenses (LAE). These reserves are established for both reported claims and for claims incurred but not reported (IBNR), arising from the policies they have issued. The provision must be made for the ultimate cost of those claims without regard to how long it takes to settle them or the time value of money. The determination of reserves involves actuarial projections of what our insurance companies expect to be the cost of the ultimate settlement and administration of such claims. The reserves are set based on facts and circumstances then known, estimates of future trends in claims severity, and other variable factors such as inflation and changing judicial theories of liability.

In light of such uncertainties, the Group also relies on policy language, developed by the Group and by others, to exclude or limit coverage where not intended. If such language is held by a court to be invalid or unenforceable it could materially adversely affect the Group’s results of operations and financial position. The possibility of expansion of an insurer’s liability, either through new concepts of liability or through a court’s refusal to accept restrictive policy language, adds to the inherent uncertainty of reserving for claims.

When a claim is reported to us, our claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. This estimate reflects an informed judgment based upon general insurance reserving practices and on the experience and knowledge of the estimator. The individual estimating the reserve considers the nature and value of the specific claim, the severity of injury or damage, and the policy provisions relating to the type of loss. Case reserves are adjusted by our claims staff as more information becomes available. It is our policy to settle each claim as expeditiously as possible.

We maintain IBNR reserves to provide for already incurred claims that have not yet been reported and developments on reported claims. The IBNR reserve is determined by estimating our insurance companies’ ultimate net liability for both reported and IBNR claims and then subtracting the case reserves and payments made to date for reported claims.

Because the establishment of loss reserves is an inherently uncertain process, we cannot be certain that ultimate losses will not exceed the established loss reserves and have a material adverse effect on the Group’s results of operations and financial condition. We do not discount our reserves to recognize the time value of money. We do not believe our insurance companies are subject to any material potential asbestos or environmental liability claims.

See additional discussion of loss and loss adjustment expense reserves in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies” under the sections titled “Liabilities for Loss and Loss Adjustment Expenses”, “Methods Used to Estimate Loss and Loss Adjustment Expense Reserves” and “Description of Ultimate Loss Estimation Methods”.

The following table provides a reconciliation of beginning and ending consolidated loss and LAE reserve balances of the Group for the years ended December 31, 2007, 2006 and 2005, prepared in accordance with U.S. generally accepted accounting principles.

RECONCILIATION OF RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES


	2007			2006			2005
	(In thousands)

Reserves for losses and loss adjustment expenses at the beginning of period	$	250,455			211,679			36,028
Less: Reinsurance recoverable and receivables		(85,933	)		(78,744	)		(3,063	)

Net reserves for losses and loss adjustment expenses at beginning of period		164,522			132,935			32,965
Reserves acquired in subsidiary acquisition, net		—			—			91,894

Net balance, as adjusted		164,522			132,935			124,859
Add: Provision for losses and loss adjustment expenses for claims occurring in:
Current year		83,015			79,275			43,921
Prior years		8,171			8,422			(537	)

Total incurred		91,186			87,697			43,384

Less: Loss and loss adjustment expenses payments for claims occurring in:
Current year		22,589			23,284			20,729
Prior years		41,102			32,826			14,579

Total paid		63,691			56,110			35,308

Net balance, December 31		192,017			164,522			132,935
Plus reinsurance recoverable on unpaid losses and loss expenses at end of period		82,382			85,933			78,744

Reserves for losses and loss adjustment expenses at end of period	$	274,399			250,455			211,679

As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses increased by $8.2 million and $8.4 million in 2007 and 2006, respectively, and decreased by $0.5 million in 2005.

The following table presents the increase (decrease) in the liability for unpaid losses and loss adjustment expenses attributable to insured events of prior years incurred in the year ended December 31, 2007 by line of business. Amounts shown in the 2005 column of the table include all 2005 and prior accident year development for FPIC, which was acquired on October 1, 2005, and accounted for as a purchase business combination.


				Year Ended December 31,
										2004
	Total			2006			2005			and Prior
				(In thousands)

Commercial multi-peril	$	5,911		$	(1,792	)	$	7,655		$	48
Commercial automobile		(2,504	)		(1,786	)		(749	)		31
Other liability		4,388			1,068			1,155			2,165
Workers’ compensation		(787	)		153			(184	)		(756	)
Homeowners		1,220			377			270			573
Personal automobile		101			(197	)		212			86
Other lines		(158	)		(33	)		27			(152	)

Net prior year development	$	8,171		$	(2,210	)	$	8,386		$	1,995

Each quarter, we compute our estimated ultimate liability using actuarial principles and procedures applicable to the lines of business written. The establishment of loss and loss adjustment expense reserves is an inherently uncertain process and reserve uncertainty stems from a variety of sources. 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. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustment is made. A discussion of factors contributing to an increase (decrease) in the liability for unpaid losses and loss adjustment expenses for the Group’s three major lines of business, representing 88% of net loss and loss adjustment reserves at December 31, 2007, follows:

Commercial multi-peril

With $140.0 million of recorded reserves, net of reinsurance, at December 31, 2007, commercial multi-peril is the line of business that carries the largest net loss and loss adjustment expense reserves, representing 73% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for prior year losses and loss adjustment expenses for the commercial multi-peril line of business increased by $5.9 million in 2007. The majority of this development relates to loss adjustment reserves for 2005 and prior accident years of our West coast operations.

The strengthening of net loss and loss adjustment expense reserves in the commercial multi-peril line reflects refinement in the assumptions and techniques supporting the reserve estimates, primarily on the contractor liability book of business. Contractor liability claims, particularly construction defect claims, are long-tailed in nature and develop over a period of ten to twelve years, based on the related statute of limitations. The increase in our estimates of insured events of prior years relates primarily to a higher than expected level of claims being reported in 2007 for such prior years. Actuarial methods are used to predict future development which is assumed to follow an expected pattern that is supported by historical data and industry trends. This line of business and related reserving assumptions are inherently uncertain and several factors, including newly observed trends, taken into consideration in the actuarial analysis can cause volatility in the determination of net ultimate losses.

Commercial automobile

With $16.6 million of recorded reserves, net of reinsurance, at December 31, 2007, commercial automobile is the Group’s second largest reserved line of business, representing 9% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the commercial automobile line of business decreased by $2.5 million in 2007. The development of net ultimate losses on the commercial automobile line of

business was better than expected in 2007 for the more recent accident years, primarily as a result of a reduction in claims frequency and a lower than expected incurred losses in the West coast business.

Other liability

With $12.4 million of recorded reserves, net of reinsurance, at December 31, 2007, other liability is the Group’s third largest reserved line of business, representing 6% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the other liability line of business increased by $4.4 million in 2007. The development of net ultimate losses on the other liability line of business was primarily the result of increases in loss reserves and litigation expense on larger East coast claims in the process of settlement.

The following tables show the development of our consolidated reserves for unpaid losses and LAE from 1997 through 2007 determined under U.S. generally accepted accounting principles (GAAP). The top line of each table shows the liabilities, net of reinsurance, at the balance sheet date, including losses incurred but not yet reported. The upper portion of each table shows the cumulative amounts subsequently paid as of successive years with respect to the liability. The lower portion of each table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as more information becomes known about the frequency and severity of claims for individual years. A redundancy exists when the re-estimated liability at each December 31 is less than the prior liability estimate. Similarly, a deficiency exists when the re-estimated liability at each December 31 is greater than the prior liability estimate. The “cumulative redundancy” depicted in the tables, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.

Amounts shown in the 2005 column of the table include all 2005 and prior accident year development for FPIC, which was acquired on October 1, 2005, and accounted for as a purchase business combination.


	Year Ended December 31,
	1997		1998		1999		2000		2001		2002
	(In thousands)

Liability for unpaid losses and LAE net of reinsurance recoverable	$	19,851	$	22,565	$	23,643	$	24,091	$	25,634	$	27,198
Cumulative amount of liability paid through:
One year later		4,536		5,525		5,842		5,726		7,376		8,840
Two years later		7,537		8,655		8,627		9,428		11,850		15,442
Three years later		9,738		10,605		11,237		12,142		15,610		19,947
Four years later		10,975		11,893		12,726		14,139		18,493		23,126
Five years later		11,550		12,554		13,613		15,750		20,123		24,156
Six years later		11,816		13,034		14,865		16,628		20,726
Seven years later		12,118		13,888		15,702		17,210
Eight years later		12,610		14,600		16,254
Nine years later		12,939		15,003
Ten years later		13,229
Liability estimated as of:
One year later		17,874		19,909		19,689		20,810		23,490		26,601
Two years later		16,440		17,478		18,506		19,539		22,084		26,924
Three years later		14,711		16,625		17,484		17,745		22,522		26,681
Four years later		14,204		15,826		16,167		18,050		22,047		26,507
Five years later		13,913		14,762		16,200		17,751		21,817		26,458
Six years later		13,273		14,955		16,604		17,934		22,014
Seven years later		13,462		15,329		16,791		18,153
Eight years later		13,463		15,523		16,919
Nine years later		13,703		15,560
Ten years later		13,719

Cumulative total redundancy (deficiency), net	$	6,132	$	7,005	$	6,724	$	5,938	$	3,620	$	740

Gross liability — end of year		31,872		30,948		29,471		28,766		31,059		31,348
Reinsurance recoverable — end of year		12,021		8,383		5,828		4,675		5,425		4,150

Net liability — end of year	$	19,851	$	22,565	$	23,643	$	24,091	$	25,634	$	27,198

Gross re-estimated liability — latest		21,889		20,973		21,868		22,585		27,062		31,359
Re-estimated reinsurance recoverable — latest		8,170		5,413		4,949		4,432		5,048		4,901

Net re-estimated liability — latest	$	13,719	$	15,560	$	16,919	$	18,153	$	22,014	$	26,458

Cumulative total redundancy (deficiency), gross	$	9,983	$	9,975	$	7,603	$	6,181	$	3,997	$	(11	)


	Year Ended December 31,
	2003			2004			2005			2006			2007
	(In thousands)

Liability for unpaid losses and LAE net of reinsurance recoverable	$	32,225		$	32,965		$	132,935		$	164,522		$	192,017
Cumulative amount of liability paid through:
One year later		12,772			14,580			32,826			41,102			—
Two years later		20,624			23,011			62,178
Three years later		26,610			29,177
Four years later		29,309
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Liability estimated as of:
One year later		31,339			32,427			141,357			172,693			—
Two years later		32,392			35,323			151,741
Three years later		32,763			37,330
Four years later		33,228
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later

Cumulative total redundancy (deficiency), net	$	(1,003	)	$	(4,365	)	$	(18,806	)	$	(8,171	)	$	—

Gross liability — end of year		37,261			36,028			211,679			250,455			274,399
Reinsurance recoverable — end of year		5,036			3,063			78,744			85,933			82,382

Net liability — end of year	$	32,225		$	32,965		$	132,935		$	164,522		$	192,017

Gross re-estimated liability — latest		39,488			44,295			235,663			258,828
Re-estimated reinsurance recoverable — latest		6,260			6,965			83,922			86,135

Net re-estimated liability — latest	$	33,228		$	37,330		$	151,741		$	172,693

Cumulative total redundancy (deficiency), gross	$	(2,227	)	$	(8,267	)	$	(23,984	)	$	(8,373	)

INVESTMENTS

On a consolidated basis, all of our investments in fixed income and equity securities are classified as available for sale and are carried at fair value.

An important component of our consolidated operating results has been the return on invested assets. Our investment objectives are to: (i) maximize current yield, (ii) maintain safety of capital through a balance of high quality, diversified investments that minimize risk, (iii) maintain adequate liquidity for our insurance operations, (iv) meet regulatory requirements, and (v) increase surplus through appreciation. However, in order to enhance the yield on our fixed income securities, our investments generally have a longer average maturity than the life of our

liabilities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”

Our investment policy requires that investments be made in a portfolio consisting of bonds, equity securities, and short-term money market instruments. Our equity investments are concentrated in companies with larger capitalizations. The investment policy does not permit investment in unincorporated businesses, private placements or direct mortgages, foreign denominated securities, financial guarantees or commodities. The Board of Directors of the Group has developed this investment policy and reviews it periodically.

The following table sets forth consolidated information concerning our investments.


	At December 31, 2007				At December 31, 2006				At December 31, 2005
	Cost(2)		Fair Value		Cost(2)		Fair Value		Cost(2)		Fair Value
	(In thousands)

Fixed income securities(1):
United States government and government agencies(3)	$	83,016	$	83,715	$	75,683	$	74,981	$	75,864	$	75,001
Obligations of states and political subdivisions		142,873		144,026		116,361		116,298		80,728		80,278
Industrial and miscellaneous		65,109		65,208		53,298		52,717		55,326		54,732
Mortgage-backed securities		30,980		31,289		29,427		29,458		19,273		19,118

Total fixed income securities		321,978		324,238		274,769		273,454		231,191		229,129
Equity securities		12,500		17,930		10,940		16,522		8,599		14,981
Short-term investments		—		—		7,692		7,692		4,289		4,289

Total	$	334,478	$	342,168	$	293,401	$	297,668	$	244,079	$	248,399


(1)		In our consolidated financial statements, investments are carried at fair value.

(2)		Original cost of equity securities; original cost of fixed income securities adjusted for amortization of premium and accretion of discount.

(3)		Includes approximately $56,142, $48,840 and $24,796 (cost) and $56,637, $48,548 and $24,446 (estimated fair value) of mortgage-backed securities backed by the U.S. government and government agencies as of December 31, 2007, 2006 and 2005, respectively.

The table below contains consolidated information concerning the investment ratings of our fixed maturity investments at December 31, 2007.


	Amortized
Type/Ratings of Investment(1)(2)	Cost		Fair Value		Percentages(3)
	(Dollars in thousands)

U.S. government and agencies	$	83,016	$	83,715		25.8	%
AAA		155,041		156,466		48.3	%
AA		35,969		36,043		11.1	%
A		46,508		46,576		14.4	%
BBB		1,055		1,057		0.3	%
BB		389		381		0.1	%

Total	$	321,978	$	324,238		100.0	%


(1)		The ratings set forth in this table are based on the ratings assigned by Standard & Poor’s Corporation (S&P). If S&P’s ratings were unavailable, the equivalent ratings supplied by Moody’s Investors Services, Inc., Fitch Investors Service, Inc. or the NAIC were used where available.


(2)		The ratings shown above include, where applicable, credit enhancement by monoline bond insurers (see Item 7A for discussion of credit enhancement)

(3)		Represents the fair value of the classification as a percentage of the total fair value of the portfolio.

The table below sets forth the maturity profile of our consolidated fixed maturity investments as of December 31, 2007 (note that mortgage-backed securities in the below table include securities backed by the U.S. government and agencies):


	Amortized
Maturity	Cost(1)		Fair Value		Percentages(2)
	(Dollars in thousands)

1 year or less	$	13,210	$	13,217		4.1	%
More than 1 year through 5 years		83,197		83,572		25.8	%
More than 5 years through 10 years		88,870		89,551		27.6	%
More than 10 years		49,579		49,972		15.4	%
Mortgage-backed securities		87,122		87,926		27.1	%

Total	$	321,978	$	324,238		100.0	%


(1)		Fixed maturities are carried at fair value in our consolidated financial statements.

(2)		Represents the fair value of the classification as a percentage of the total fair value of the portfolio.

As of December 31, 2007, the average maturity of our fixed income investment portfolio (excluding mortgage-backed securities) was 5.9 years and the average duration was 3.5 years. Our fixed maturity investments include U.S. government bonds, securities issued by government agencies, obligations of state and local governments and governmental authorities, corporate bonds and mortgage-backed securities, most of which are exposed to changes in prevailing interest rates. We carry these investments as available for sale. This allows us to manage our exposure to risks associated with interest rate fluctuations through active review of our investment portfolio by our management and board of directors and consultation with our financial advisor.

Our consolidated average cash and invested assets, net investment income and return on average cash and invested assets for the years ended December 31, 2007, 2006 and 2005 were as follows:


	Year Ended December 31,
	2007(1)			2006			2005
	(Dollars in thousands)

Average cash and invested assets	$	332,580		$	294,358		$	155,800
Net investment income(1)		13,053			10,070			4,467
Return on average cash and invested assets		3.9	%		3.4	%		2.9	%


(1)		Net investment income for 2007 includes $720,000 non-recurring investment income from the retaliatory tax refund.

We have one non-traded equity security, a non-voting common stock in Excess Reinsurance Company, which is carried at $0.8 million and $0.9 million as of December 31, 2007 and 2006, respectively. Excess Reinsurance Company paid a special dividend to the Group in 2007, 2006 and 2005 in the amount of $1,000, $228,000 and $183,000, respectively. Its fair value is based on the estimated selling price of the company based on current offers, which is lower than statutory book value. Other non-traded securities, which are not material in the aggregate, are carried at cost.

A.M. BEST RATING

A.M. Best rates insurance companies based on factors of concern to policyholders. All companies in the Group, including FPIC effective January 1, 2006, participate in the intercompany pooling agreement (see “Intercompany Agreements” above) and have been assigned a group rating of “A” (Excellent) by A.M. Best.

The Group has been assigned that rating for the past 7 years. An “A” rating is the third highest of A.M. Best’s 16 possible rating categories.

According to the A.M. Best guidelines, A.M. Best assigns “A” ratings to companies that have, on balance, excellent balance sheet strength, operating performance and business profiles. Companies rated “A” are considered by A.M. Best to have “an excellent ability to meet their ongoing obligations to policyholders.” In evaluating a company’s financial and operating performance, A.M. Best reviews:


	•	the company’s profitability, leverage and liquidity;

	•	its book of business;

	•	the adequacy and soundness of its reinsurance;

	•	the quality and estimated market value of its assets;

	•	the adequacy of its reserves and surplus;

	•	its capital structure;

	•	the experience and competence of its management; and

	•	its marketing presence.

COMPETITION

The property and casualty insurance market is very highly competitive. Our insurance companies compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Some of these competitors have substantially greater financial, technical and operating resources than our insurance companies. Within our producer’s offices we compete to be a preferred market for desirable business, as well as competing with other carriers to attract and retain the best producers. Our ability to compete successfully in our principal markets is dependent upon a number of factors, many of which are outside our control. These factors include market and competitive conditions. Many of our lines of insurance are subject to significant price competition. Some companies may offer insurance at lower premium rates through the use of salaried personnel or other distribution methods, rather than through independent producers paid on a commission basis (as our insurance companies do). In addition to price, competition in our lines of insurance is based on quality of the products, quality and speed of service, financial strength, ratings, distribution systems and technical expertise.

Pricing in the property and casualty insurance industry historically has been and remains cyclical. During a soft market cycle, price competition becomes prevalent, which makes it difficult to write and retain properly priced personal and commercial lines business. In response to what management believes is driven by the current soft market, the marketplace is populated with some competitors who are significantly reducing their prices and/or offering coverage terms that are generous in relation to the premium charges being made. We believe that in some instances, the prices and terms being offered, if matched by us, would not provide us with an adequate rate of return, if any.

Our policy is to maintain disciplined underwriting during soft markets, declining business which is inadequately priced for its level of risk. The market has become very highly competitive, with increasing competition being seen in virtually all classes of commercial and personal accounts. This affects our new business opportunities for us, creates more challenging renewals, which can adversely impact premium revenue levels for the Group. We continue to focus on long-term profitability rather than short-term revenue. We also continue to work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institutions risks, contracting risks, small business risks and property risks.

Many of our competitors offer internet-based quoting and/or policy issuance systems to their producers. In response to this improvement in marketplace technology, we are developing information system applications to create an automated process for acceptance and rejection of accounts through an internet-based rating system.

REGULATION

General

Insurance companies are subject to supervision and regulation in the states in which they do business. State insurance authorities have broad administrative powers to administer statutes and regulations with respect to all aspects of our insurance business including:


	•	approval of policy forms and premium rates;

	•	standards of solvency, including establishing statutory and risk-based capital requirements for statutory surplus;

	•	classifying assets as admissible for purposes of determining statutory surplus;

	•	licensing of insurers and their producers;

	•	advertising and marketing practices;

	•	restrictions on the nature, quality and concentration of investments;

	•	assessments by guaranty associations;

	•	restrictions on the ability of our insurance company subsidiaries to pay dividends to us;

	•	restrictions on transactions between our insurance company subsidiaries and their affiliates;

	•	restrictions on the size of risks insurable under a single policy;

	•	requiring deposits for the benefit of policyholders;

	•	requiring certain methods of accounting;

	•	periodic examinations of our operations and finances;

	•	claims practices;

	•	prescribing the form and content of records of financial condition required to be filed; and

	•	requiring reserves for unearned premium, losses and other purposes.

State insurance laws and regulations require our insurance companies to file financial statements with insurance departments everywhere they do business, and the operations of our insurance companies and accounts are subject to examination by those departments at any time. Our insurance companies prepare statutory financial statements in accordance with accounting practices and procedures prescribed or permitted by these departments.

Financial Examinations

Financial examinations are conducted by the Pennsylvania Insurance Department, the California Department of Insurance, and the New Jersey Department of Banking and Insurance every three to five years. The Pennsylvania Insurance Department’s last examination of MIC was as of December 31, 2004. Their last examination of FIC was as of December 31, 2004. The New Jersey Department of Banking and Insurance’s last examination of MICNJ was as of December 31, 2004. The last examination of FPIC by the California Department of Insurance was as of December 31, 2003.

These examinations did not result in any adjustments to the financial position of any of our insurance companies. In addition, there were no substantive qualitative matters indicated in the examination reports that had a material adverse impact on the operations of our insurance companies.

NAIC Risk-Based Capital Requirements

In 1990, the NAIC began an accreditation program to ensure that states have adequate procedures in place for effective insurance regulation, especially with respect to financial solvency. The accreditation program requires that a state meet specific minimum standards in over five regulatory areas to be considered for accreditation. The accreditation program is an ongoing process and once accredited, a state must enact any new or modified standards approved by the NAIC within two years following adoption. As of December 31, 2007, Pennsylvania, New Jersey, and California, the states in which our insurance company subsidiaries are domiciled, were accredited.

Pennsylvania, New Jersey and California impose the NAIC’s risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula. These risk-based capital requirements attempt to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. Under the formula, a company first determines its “authorized control level” risk-based capital. This authorized control level takes into account (i) the risk with respect to the insurer’s assets; (ii) the risk of adverse insurance experience with respect to the insurer’s liabilities and obligations, (iii) the interest rate risk with respect to the insurer’s business; and (iv) all other business risks and such other relevant risks as are set forth in the RBC instructions. A company’s “total adjusted capital” is the sum of statutory capital and surplus and such other items as the risk-based capital instructions may provide. The formula is designed to allow state insurance regulators to identify weakly capitalized companies.

The requirements provide for four different levels of regulatory attention. The “company action level” is triggered if a company’s total adjusted capital is less than 2.0 times its authorized control level but greater than or equal to 1.5 times its authorized control level. At the company action level, the company must submit a comprehensive plan to the regulatory authority that discusses proposed corrective actions to improve the capital position. The “regulatory action level” is triggered if a company’s total adjusted capital is less than 1.5 times but greater than or equal to 1.0 times its authorized control level. At the regulatory action level, the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed. The “authorized control level” is triggered if a company’s total adjusted capital is less than 1.0 times but greater than or equal to 0.7 times its authorized control level; at this level the regulatory authority may take action it deems necessary, including placing the company under regulatory control. The “mandatory control level” is triggered if a company’s total adjusted capital is less than 0.7 times its authorized control level; at this level the regulatory authority is mandated to place the company under its control. The capital levels of our insurance companies have never triggered any of these regulatory capital levels. We cannot assure you, however, that the capital requirements applicable to the business of our insurance companies will not increase in the future.

Market Conduct Regulation

State insurance laws and regulations include numerous provisions governing trade practices and the marketplace activities of insurers, including provisions governing the form and content of disclosure to consumers, illustrations, advertising, sales practices and complaint handling. State regulatory authorities generally enforce these provisions through periodic market conduct examinations, which the Group is subject to from time to time. No material issues have been raised in the market conduct exams performed on the Group’s insurance subsidiaries.

Property and Casualty Regulation

Our property and casualty operations are subject to rate and policy form approval. All of the rates and policy forms that we use that require regulatory approval have been filed with and approved by the appropriate insurance regulator. Our operations are also subject to laws and regulations covering a range of trade and claim settlement practices. To our knowledge, we are currently in compliance with these laws and regulations. State insurance regulatory authorities have broad discretion in approving an insurer’s proposed rates. The extent to which a state restricts underwriting and pricing of a line of business may adversely affect an insurer’s ability to operate that business profitably in that state on a consistent basis.

State insurance laws and regulations require us to participate in mandatory property-liability “shared market,” “pooling” or similar arrangements that provide certain types of insurance coverage to individuals or others who otherwise are unable to purchase coverage voluntarily provided by private insurers. Shared market mechanisms

include assigned risk plans; fair access to insurance requirements or “FAIR” plans; and reinsurance facilities, such as the New Jersey Unsatisfied Claim and Judgment Fund. In addition, some states require insurers to participate in reinsurance pools for claims that exceed specified amounts. Our participation in these mandatory shared market or pooling mechanisms generally is related to the amounts of our direct writings for the type of coverage written by the specific arrangement in the applicable state. For the three years ended December 31, 2007, 2006 and 2005, we received earned premium from these arrangements in the amounts of $1,801,000, $2,539,000, and $2,696,000, respectively, and incurred losses and loss adjustment expenses from these arrangements in the amounts of $1,185,000, $3,908,000, and $2,249,000, respectively. Because we do not have a significant amount of direct writings in the coverages written under these arrangements, we do not anticipate that these arrangements will have a material effect on us in the future. However, we cannot predict the financial impact of our participation in any shared market or pooling mechanisms that may be implemented in the future by the states in which we do business.

Guaranty Fund Laws

All states have guaranty fund laws under which insurers doing business in the state can be assessed to fund policyholder liabilities of insolvent insurance companies. The states in which our insurance companies do business have such laws. Under these laws, an insurer is subject to assessment depending upon its market share in the state of a given line of business. For the years ended December 31, 2007, 2006 and 2005, we incurred approximately $(180,000), $105,000, and $168,000, respectively, in assessments pursuant to state insurance guaranty association laws. We establish reserves relating to insurance companies that are subject to insolvency proceedings when we are notified of assessments by the guaranty associations. We cannot predict the amount and timing of any future assessments on our insurance companies under these laws.

Terrorism Risk Insurance Act

The Terrorism Risk Insurance Act of 2002 (TRIA) established a program that provides a backstop for insurance-related losses resulting from any act of terrorism as defined. Under this law, coverage provided by an insurer for losses caused by certified acts of terrorism is partially reimbursed by the United States under a formula under which the government pays 85% (in 2007) of covered terrorism losses, exceeding a prescribed deductible. Therefore, the act limits an insurer’s exposure to certified terrorist acts (as defined by the act) to the deductible formula. The deductible is based upon a percentage of direct earned premium for commercial property and casualty policies. Coverage under the act must be offered to all property, casualty and surety insureds. On December 26, 2007, the President of the United States signed into law the Terrorism Risk Insurance Program Reauthorization Act of 2007 which extends TRIA through December 31, 2014. The law extends the temporary federal program that provides for a transparent system of shared public and private compensation for insured losses resulting from acts of terrorism.

We are currently charging a premium for terrorism coverage on our businessowners, commercial automobile, commercial workers’ compensation, tenant-occupied dwelling, special contractors, special multi-peril, monoline commercial fire, monoline general liability and religious institution policies. Insureds that are charged a terrorism premium have the option (except workers’ compensation) of deleting terrorism coverage to reduce their premium costs; however many do not do so. Insureds under commercial workers’ compensation policies do not have the option to delete the terrorism coverage. Most other policies include terrorism coverage at no additional cost. Where allowed, we exclude coverage for losses that are from events not certified as terrorism events, with no buyback option available to the policyholder.

We are unable to predict the extent to which this legislation may affect the demand for our products or the risks that will be available for us to consider underwriting. We do not know the extent to which insureds will elect to purchase this coverage when available.

New and Proposed Legislation and Regulations

The property and casualty insurance industry continues to receive a considerable amount of publicity related to pricing, coverage terms, the lack of availability of insurance, and the issue of paying profit-sharing commissions to agents. Regulations and legislation are being proposed to limit damage awards, to control plaintiffs’ counsel fees, to

bring the industry under regulation by the federal government and to control premiums, policy terminations and other policy terms. We are unable to predict whether, in what form, or in what jurisdictions, any regulatory proposals might be adopted or their effect, if any, on our insurance companies.

Dividends

Our insurance companies are restricted by the insurance laws of their respective states of domicile regarding the amount of dividends or other distributions they may pay without notice to or the prior approval of the state regulatory authority.

All dividends from MIC to MIG require prior notice to the Pennsylvania Insurance Department. All “extraordinary” dividends require advance approval. 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, 2007, the amount available for payment of dividends from MIC in 2008, without the prior approval, is approximately $6.2 million. In 2005, MIC applied for, and received, approval to pay an extraordinary dividend of $10 million, which was used in connection with the acquisition of FPIG.

All dividends from FPIC to FPIG (wholly owned by MIG) require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval. 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, 2007, the amount available for payment of dividends from FPIC in 2008, without the prior approval, is approximately $6.0 million.

Holding Company Laws

Most states have enacted legislation that regulates insurance holding company systems. Each insurance company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish certain information. This includes information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Pursuant to these laws, the respective insurance departments may examine our insurance companies and their holding companies at any time, require disclosure of material transactions by our insurance companies and their holding companies and require prior notice of approval of certain transactions, such as “extraordinary dividends” distributed by our insurance companies.

All transactions within the holding company system affecting our insurance companies and their holding companies must be fair and equitable. Notice of certain material transactions between our insurance companies and any person or entity in our holding company system will be required to be given to the applicable insurance commissioner. In some states, certain transactions cannot be completed without the prior approval of the insurance commissioner.

EMPLOYEES

All of our employees are employed directly by BICUS, a wholly owned subsidiary of MIC. Our insurance companies do not have any employees. BICUS provides management services to all of our insurance companies. As of December 31, 2007, the total number of full-time equivalent employees of BICUS was 223. None of these employees are covered by a collective bargaining agreement and BICUS believes that its employee relations are good.

AVAILABLE INFORMATION

The Company maintains a website at www.mercerins.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available free of charge on our website as soon as practicable after electronic filing of such material with, or furnishing it to, the Securities and Exchange Commission.


ITEM 1A.	*RISK FACTORS*

Risks Relating to Our Business and Industry

Catastrophic Events

As a property and casualty insurer, we are subject to claims from catastrophes that may have a significant negative impact on operating and financial results. We have experienced catastrophe losses, and can be expected to experience catastrophe losses in the future. Catastrophe losses can be caused by various events, including coastal storms, snow storms, ice storms, freezing, hurricanes, earthquakes, tornadoes, wind, hail, fires, and other natural or man-made disasters. We also face exposure to losses resulting from acts of war, acts of terrorism and political instability. The frequency, number and severity of these losses are unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event.

We attempt to mitigate catastrophe risk by reinsuring a portion of our exposure. However, reinsurance may prove inadequate if:


	•	A major catastrophic loss exceeds the reinsurance limit;

	•	A number of small catastrophic losses occur which individually fall below the reinsurance retention level.

In addition, because accounting regulations do not permit insurers to reserve for catastrophic events until they occur, claims from catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could have a material adverse affect on our financial condition or results of operations. Our ability to write new business also could be adversely affected.

Loss Reserves

We maintain reserves to cover amounts we estimate will be needed to pay for insured losses and for the expenses necessary to settle claims. Estimating loss and loss expense reserves is a difficult and complex process involving many variables and subjective judgments. Estimates are based on management assessment of the known facts and circumstances, prediction of future events, claims severity and frequency and other subjective factors. We regularly review our reserving techniques and our overall amount of reserves. We review historical data and consider the impact of various factors such as:


	•	trends in claim frequency and severity;

	•	our loss history and the industry’s loss history;

	•	information regarding each claim for losses;

	•	legislative enactments, judicial decisions and legal developments regarding damages;

	•	changes in political attitudes; and

	•	trends in general economic conditions, including inflation.

Our estimated loss reserves could be incorrect and potentially inadequate. If we determine that our loss reserves are inadequate, we will have to increase them. This adjustment would reduce income during the period in which the adjustment is made, which could have a material adverse impact on our financial condition and results of operation. There is no precise way to determine the ultimate liability for losses and loss settlements prior to final settlement of the claim.

Terrorism

The threat of terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, as well as loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations of the Group as well as a decrease in our

stockholders’ equity, net income and/or revenue. The Terrorism Risk Insurance Reauthorization and Extension Act of 2007 requires that some coverage for terrorist loss be offered by primary property insurers and provides Federal assistance for recovery of claims. In addition, some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures.

We cannot predict at this time whether and the extent to which industry sectors in which we maintain investments may suffer losses as a result of potential decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected. We can offer no assurances that the threats of future terrorist-like events in the United States and abroad or military actions by the United States will not have a material adverse effect on our business, financial condition or results of operations.

Reinsurance

Our ability to manage our exposure to underwriting risks depends on the availability and cost of reinsurance coverage. Reinsurance is the practice of transferring part of an insurance company’s liability and premium under an insurance policy to another insurance company. We use reinsurance arrangements to limit and manage the amount of risk we retain, to stabilize our underwriting results and to increase our underwriting capacity. The availability and cost of reinsurance are subject to current market conditions and may vary significantly over time.

Significant variation in reinsurance availability and cost could result in us being unable to maintain our desired reinsurance coverage or to obtain other reinsurance coverage in adequate amounts and at favorable rates. If we are unable to renew our expiring coverage or obtain new coverage, it will be difficult for us to manage our underwriting risks and operate our business profitably.

It is also possible that the losses we experience on risks we have reinsured will exceed the coverage limits on the reinsurance. If the amount of our reinsurance coverage is insufficient, our insurance losses could increase substantially.

If our reinsurers do not pay our claims in a timely manner, we may incur losses. We are subject to loss and credit risk with respect to the reinsurers with whom we deal because buying reinsurance does not relieve us of our liability to policyholders. If our reinsurers are not capable of fulfilling their financial obligations to us, our insurance losses would increase.

Investments

Our investment portfolio contains a significant amount of fixed-income securities, including at different times bonds, mortgage-backed securities (MBSs) and other securities. The market values of all of our investments fluctuate depending on economic conditions and other factors. The market values of our fixed-income securities are particularly sensitive to changes in interest rates.

We may not be able to prevent or minimize the negative impact of interest rate changes. Additionally, we may, from time to time, for business, regulatory or other reasons, elect or be required to sell certain of our invested assets at a time when their market values are less than their original cost, resulting in realized capital losses, which would reduce net income.

Regulation

If we fail to comply with insurance industry regulations, or if those regulations become more burdensome, we may not be able to operate profitably.

Our insurance companies are regulated by government agencies in the states in which we do business, as well as by the federal government. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. These regulations are generally administered by a department of insurance in each state in which we do business.

State insurance departments conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.

In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations or practices that we believe may be generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect our ability to operate our business. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business.

We are also subject to various accounting and financial requirements established by the NAIC. If we fail to comply with these laws, regulations and requirements, it could result in consequences ranging from a regulatory examination to a regulatory takeover of one or more of our insurance companies. This would make our business less profitable. In addition, state regulators and the NAIC continually re-examine existing laws and regulations, with an emphasis on insurance company solvency issues and fair treatment of policyholders. Insurance laws and regulations could change or additional restrictions could be imposed that are more burdensome and make our business less profitable.

We are subject to the application of U.S. generally accepted accounting principles (GAAP), which is periodically revised and/or expanded. As such, we are periodically required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board. It is possible that future changes required to be adopted could change the current accounting treatment that we apply and such changes could result in a material adverse impact on our results of operations and financial condition.

Geographic

Due to the geographic concentration of our business (principally, Arizona, California, Nevada, New Jersey, Oregon and Pennsylvania) catastrophe and natural peril losses may have a greater adverse effect on us than they would on a more geographically diverse property and casualty insurer.

We could be significantly affected by legislative, judicial, economic, regulatory, demographic and other events and conditions in these states. In addition, we have significant exposure to property losses caused by severe weather that affects any of these states. Those losses could adversely affect our results.

Additionally, a significant portion of our direct premium writings are written in the construction contractor markets, primarily in California. A significant downturn in the United States or California construction industry could adversely affect our direct written premium.

Competition

The property and casualty insurance market in which we operate is very highly competitive. Competition in the property and casualty insurance business is based on many factors. These factors include the perceived financial strength of the insurer, premiums charged, policy terms and conditions, services provided, reputation, financial ratings assigned by independent rating agencies and the experience of the insurer in the line of insurance to be written. We compete with stock insurance companies, mutual companies, local cooperatives and other underwriting organizations. Many of these competitors have substantially greater financial, technical and operating resources than we have.

We pay producers on a commission basis to produce business. Some of our competitors may offer higher commissions or insurance at lower premium rates through the use of salaried personnel or other distribution methods that do not rely on independent producers. Increased competition could adversely affect our ability to attract and retain business and thereby reduce our profits from operations.

We believe that our current marketplace is experiencing significant pressure to reduce prices and/or increase coverage that is generous in relation to the premium being charged. This pricing pressure could result in fewer new business opportunities for us and possibly fewer renewals retained which could lead to reduced direct written premium levels.

Many of our competitors offer internet-based quoting and/or policy issuance systems to their agents. The Group’s ability to compete with marketplace technology advances could adversely affect its ability to write business and service accounts with the agency force, and could adversely impact its results of operations and financial condition.

A new form of competition may enter the marketplace as reinsurers attempt to diversify their insurance risk by writing business in the primary marketplace. The Group also faces competition, primarily in the commercial insurance market, from entities that may desire to self-insure their own risks. The Group’s ability to compete with reinsurers and self-insurers could adversely impact its results of operations and financial condition.

Rating

A reduction in our A.M. Best rating could affect our ability to write new business or renew our existing business. Ratings assigned by the A.M. Best Company, Inc. are an important factor influencing the competitive position of insurance companies. A.M. Best ratings represent independent opinions of financial strength and ability to meet obligations to policyholders and are not directed toward the protection of investors. If our financial position deteriorates, we may not maintain our favorable financial strength rating from A.M. Best. A downgrade of our rating could severely limit or prevent us from writing desirable business or from renewing our existing business.

Key Producers

Our results of operations may be adversely affected by any loss of business from key producers. Our products are marketed by independent producers. Other insurance companies compete with us for the services and allegiance of these producers. These producers may choose to direct business to our competitors, or may direct less desirable risks to us which could have a material adverse effect on us.

Dividends

Subsidiaries of the Group may declare and pay dividends to the Holding Company only if they are permitted to do so under the insurance regulations of their respective state of domicile. If our insurance subsidiaries are unable to pay adequate dividends through their respective holding companies to the Holding Company, our ability to pay shareholder dividends would be affected. All of the states in which the Group’s subsidiaries are domiciled regulate the payment of dividends. States, including New Jersey, Pennsylvania, and California require that the Group give notice to the relevant state insurance commissioner prior to its subsidiaries declaring any dividends and distributions payable to the parent. During the notice period, the

state insurance commissioner may disallow all or part of the proposed dividend upon determination that: (i) the insurer’s surplus is not reasonable in relation to its liabilities and adequate to its financial needs and those of the policyholders, or (ii) in the case of New Jersey, the insurer is otherwise in a hazardous financial condition. In addition, insurance regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval upon determination that, because of the financial condition of the insurance subsidiary or otherwise, payment of a dividend or any other payment to an affiliate would be detrimental to an insurance subsidiary’s policyholders or creditors.

The Group began paying a quarterly dividend in the second quarter of 2006. However, future cash dividends will depend upon our results of operations, financial condition, cash requirements and other factors, including the ability of our subsidiaries to make distributions to us, which ability is restricted in the manner previously discussed in this section. Also, there can be no assurance that we will continue to pay dividends even if the necessary financial conditions are met and if sufficient cash is available for distribution.

Technology

The Group’s business is increasingly dependent on computer and Internet-enabled technology. The Group’s ability to anticipate or manage problems with technology associated with scalability, security, functionality or reliability could adversely affect its ability to write business and service accounts, and could adversely impact its results of operations and financial condition.

Acquisitions

The Group made an acquisition in 2005 and intends to grow its business in part through acquisitions in the future as part of its long term business strategy. These type of transactions involve significant challenges and risks that the business transactions do not advance our business strategy, that we don’t realize a satisfactory return on the investment we make, or that we may experience difficulty in the integration of new employees, business systems, and technology or diversion of management’s attention from our other businesses. These factors could adversely affect our operating results and financial condition.

Key Personnel

We could be adversely affected by the loss of our key personnel. The success of our business is dependent, to a large extent, on the efforts of certain key management personnel, and the loss of key personnel could prevent us from executing our business strategy and could significantly and negatively affect our financial condition and results of operations. As we continue to grow, we will need to recruit and retain additional qualified management personnel, and our ability to do so will depend upon a number of factors, such as our results of operations and prospects and the level of competition then prevailing in the market for qualified personnel. Presently, competition to attract and retain key personnel is intense.


ITEM 1B.	*UNRESOLVED STAFF COMMENTS*

None.


ITEM 2.	*PROPERTIES*

Our main office and corporate headquarters is located at 10 North Highway 31, Pennington, New Jersey in a facility of approximately 25,000 square feet owned by MIC. We also own a tract of land adjacent to our main office property.

MIC also owns a 32,000 square foot office facility in Lock Haven, Pennsylvania. MIC sub-leases a portion of this facility.

FPIC leases approximately 25,000 square feet for the Group’s west coast operations in Rocklin, California. FPIC owns 2.9 acres of land adjacent to its office building, carried at $1.3 million. FPIC also owns a townhouse, used for corporate purposes, in Rocklin, California carried at $0.4 million.


ITEM 3.	*LEGAL PROCEEDINGS*

Our insurance companies are parties to litigation in the normal course of business. Based upon information presently available to us, we do not consider any litigation to be material. However, given the uncertainties attendant to litigation, we cannot be sure that our results of operations and financial condition will not be materially adversely affected by any litigation.


ITEM 4.	*SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS*

None.

PART II


ITEM 5.	*MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.*

The common stock trades on the NASDAQ National Market under the symbol “MIGP”. As of February 28, 2008, the Group had 309 shareholders holding approximately 0.8 million shares in their own name, with the balance of the outstanding shares held in street name.

The payment of shareholder dividends is subject to the discretion of the MIG’s Board of Directors which considers, among other factors, the Group’s operating results, overall financial condition, capital requirements and general business conditions. On March 29, 2007, June 29, 2007, September 28, 2007 and December 28, 2007, MIG paid a quarterly dividend of $0.05 per common share. The amount of dividends paid out on these four dates totaled $1.3 million, which amount was funded by dividends from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators. We currently expect that the present quarterly dividend of $0.05 per common share will continue during 2008.

The Group’s ability to receive dividends, loans or advances from its insurance subsidiaries is subject to the approval and/or review of the insurance regulators in the respective domiciliary states of the insurance subsidiaries. Such approval and review is made under the respective domiciliary states’ insurance holding company act, which generally requires that any transaction between currently related companies be fair and equitable to the insurance company and its policyholders. The Group does not believe that such restrictions limit the ability of the insurance subsidiaries to pay dividends to the Group now or in the foreseeable future.

Information regarding restrictions and limitations on the payment of cash dividends can be found in Item 1, “Business — Regulation” in the “Dividends” section.

The range of closing prices of the Group’s stock, traded on the NASDAQ National Market, during 2007 was between $17.38 and $21.59 per share. The range of closing prices during each of the quarters in 2007 and 2006 is shown below:


	4th Quarter				3rd Quarter				2nd Quarter				1st Quarter
	2007		2006		2007		2006		2007		2006		2007		2006

Share price range:
High	$	18.90	$	26.61	$	21.59	$	26.87	$	20.07	$	19.45	$	20.56	$	18.95
Low	$	17.40	$	18.93	$	17.38	$	18.21	$	17.94	$	18.61	$	17.70	$	14.81

As of December 31, 2007, the Group had no outstanding authorization or program for the repurchase of its common stock.

Performance Graph

Set forth below is a line graph comparing the cumulative total shareholder return on the Group’s Common Stock to the cumulative total return of the Nasdaq Stock Market (U.S. Companies) and the Nasdaq Insurance Index for the period commencing December 16, 2003 (the day the Group’s Common Stock began trading on Nasdaq) and ended December 31, 2007.


	December 16,		December 31,		December 31,		December 31,		December 31,		December 31,
	2003		2003		2004		2005		2006		2007
Mercer Insurance Group, Inc.		100.00		103.29		110.53		123.46		166.34		147.74
Nasdaq Companies Index		100.00		104.03		113.21		115.61		127.04		137.72
Nasdaq Insurance Index		100.00		103.10		125.17		140.29		158.62		150.06

The graph assumes $100 was invested on December 16, 2003, in the Group’s Common Stock and each of the indices, and that dividends were reinvested. The comparisons in the graph are required by the Securities and Exchange Commission and are not intended to forecast or be indicative of possible future performance of our common stock.


ITEM 6.	*SELECTED FINANCIAL DATA*

The following table sets forth selected consolidated financial data for MIG at and for each of the years in the five year period ended December 31, 2007. You should read this data in conjunction with the Group’s consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this report.


	Years Ended December 31,
	2007			2006			2005			2004			2003
	(Shares and dollars in thousands, except per share amounts)

Revenue Data:
Direct premiums written	$	182,907		$	185,745		$	92,240		$	65,790		$	61,152
Net premiums written		159,667			145,791			75,266			59,504			52,802
Statement of Earnings Data:
Net premiums earned		146,675			137,673			74,760			55,784			47,864
Investment income, net of expenses		13,053			10,070			4,467			2,841			1,707
Net realized investment gains		24			151			1,267			484			703
Total revenue		161,681			149,929			81,266			59,467			50,660
Conversion expense(1)		—			—			—			—			66
Minority interest in income of subsidiary(2)		—			—			—			—			(131	)
Net income(10)		14,235			10,635			7,020			3,264			583
Comprehensive income(3)(10)		16,316			10,599			4,685			3,972			2,073
Balance Sheet Data (End of Period):
Total assets		546,435			506,967			446,698			181,560			175,875
Total investments and cash		363,748			315,286			269,076			141,393			138,679
Stockholders’ equity		133,406			115,839			103,399			100,408			98,326
Ratios:
GAAP combined ratio(4)(10)		95.8	%		97.0	%		94.9	%		98.8	%		103.8	%
Statutory combined ratio(5)(10)		94.4	%		95.2	%		94.1	%		95.4	%		102.2	%
Statutory premiums to-surplus ratio(6)		1.30	x		1.27	x		1.15	x		0.96	x		1.72	x
Yield on investment, before tax(7)		3.6	%		3.4	%		2.9	%		2.0	%		2.0	%
Return on average equity		11.4	%		9.7	%		6.9	%		3.3	%		0.9	%
Per-share data: (8)
Net income (loss):
Basic(10)		2.32			1.77			1.18			0.52			(0.08	)
Diluted(10)		2.25			1.71			1.14			0.51			(0.08	)
Dividends to stockholders		0.20			0.15			—			—			—
Stockholders’ equity		21.48			19.06			17.34			16.49			15.65
Weighted average shares:(9)
Basic		6,144			6,023			5,943			6,236			6,253
Diluted		6,325			6,222			6,160			6,354			6,253


(1)		Costs and expenses related to the stock conversion incurred in the year ended December 31, 2003. Stock conversion expenses consist primarily of the costs of engaging independent accounting, valuation, legal and other consultants to advise us and our insurance regulators as to the stock conversion process and related matters, as well as printing and postage costs relating to our communications with our policyholders. These costs and expenses are reported in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 00-3, “Accounting by Insurance Enterprises for Demutualizations and Formations of Mutual Insurance Holding Companies and for Certain Long-Duration Participating Contracts.”


		SOP 00-3 addresses financial statement presentation and accounting for stock conversion expenses and accounting for retained earnings and other comprehensive income at the date of the stock conversion.

(2)		Income of the Group attributable to the minority interest in FHC, which interest was acquired by the Group immediately after the Conversion for shares of the Group.

(3)		Includes Net Income and the change in Unrealized Gains and Losses of the investment portfolio.

(4)		The sum of losses, loss adjustment expenses, underwriting expenses and dividends to policyholders divided by net premiums earned. A combined ratio of less than 100% means a company is making an underwriting profit.

(5)		The sum of the ratio of underwriting expenses divided by net premiums written, and the ratio of losses, loss adjustment expenses, and dividends to policyholders divided by net premiums earned.

(6)		The ratio of net premiums written divided by ending statutory surplus, except for 2003, where a weighted average of statutory surplus is used.

(7)		The ratio of net investment income divided by total cash and investments.

(8)		Earnings per share data reflect only net loss for the period from December 16, 2003, the date of the Conversion, through December 31, 2003. Net loss during this period was ($477,000).

(9)		Unallocated ESOP shares at December 31 of each year are not reflected in weighted average shares.

(10)		The 2007 results include a non-recurring refund of state premium retaliatory taxes, plus interest, in the after-tax amounts of $2.8 million, or $0.44 per diluted share. See footnote 15 to the consolidated financial statements.


ITEM 7.	*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, and the “Description of Business” contained in Item 1 of this report. This discussion contains forward-looking information that involves risks and uncertainties. Actual results could differ significantly from these forward-looking statements.

OVERVIEW

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

The Group’s net income is primarily determined by four elements:


	•	net premium income;

	•	underwriting cost and agent commissions;

	•	investment income;

	•	amounts paid or reserved to settle insured claims.

Variations in premium income are subject to a number of factors, including:


	•	limitations on rates arising from competitive market place conditions or regulation;

	•	limitation on available business arising from a need to maintain the pricing and quality of underwritten risks;

	•	the Group’s ability to maintain it’s A (“Excellent”) rating by A.M. Best;


	•	the ability of the Group to maintain a reputation for efficiency and fairness in claims administration;

	•	the availability, cost and terms of reinsurance.

Variations on investment income are subject to a number of factors, including:


	•	general interest rate levels;

	•	specific adverse events affecting the issuers of debt obligations held by the Group;

	•	changes in prices of equity securities generally and those held by the Group specifically.

Loss and loss adjustment expenses are affected by a number of factors, including:


	•	the quality of the risks underwritten by the Group;

	•	the nature and severity of catastrophic losses;

	•	weather-related patterns in areas where we insured property risks;

	•	the availability, cost and terms of reinsurance;

	•	underlying settlement costs, including medical and legal costs.

The Group seeks to manage each of the foregoing to the extent within its control. Many of the foregoing factors are partially, or entirely, outside the control of the Group.

CRITICAL ACCOUNTING POLICIES

General

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 operation 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 actuarial techniques. Specifically, on a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Some of our business relates to coverage for short-term risks, and for these risks loss development is comparatively rapid and historical paid losses, adjusted for known variables, have been a reliable predictive measure of future losses for purposes of our reserving. Some of our business relates to longer-term risks, where the claims are slower to emerge and the estimate of damage is more

difficult to predict. For these lines of business, more sophisticated actuarial methods, such as the Bornhuetter-Ferguson loss development methods (see “Methods” below) are employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses. A substantial portion of the business written by FPIC is this type of longer-tailed casualty business.

Methods Used to Estimate Loss & Loss Adjustment Expense Reserves

We apply the following general methods in projecting loss and loss adjustment expense reserves for the Group:

1. Paid loss development;

2. Paid Bornhuetter-Ferguson loss development;

3. Reported loss development;

4. Reported Bornhuetter-Ferguson loss development; and

5. Separate developments of claims frequency and severity.

In addition, we apply several diagnostic ratio tests of the reserves for long-tailed liability lines of business, including but not limited to:

1. Retrospective tests of the ratios of IBNR reserves to earned premiums and to estimated ultimate incurred losses;

2. Retrospective tests of the ratios of the loss reserves to earned premiums and to estimated ultimate incurred losses;

3. Ratios of cumulative and incremental incurred and paid losses to earned premiums and to estimated ultimate incurred losses;

4. Ratios of cumulative and incremental paid losses to cumulative incurred losses and ratios of incremental paid losses to prior case loss and LAE reserves;

5. Ratios of cumulative average incurred loss per claim and cumulative average incurred loss per reported claim; and

6. Ratios of cumulative average paid loss per claim closed with payment and of average case reserve per pending claim.

Description of Ultimate Loss Estimation Methods

The reported loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at comparable stages of maturity. Historical “age-to-age” loss development factors are calculated to measure the relative development of an

accident year from one maturity point to the next. We then selected appropriate age-to-age loss development factors based on these historical factors and use the selected factors to project the ultimate losses.

The paid loss development method is mechanically identical to the incurred loss development method described above with the exception that paid losses replace reported losses. The paid method does not rely on case reserves or their adequacy in making projections.

The validity of the results from using a loss development approach can be affected by many conditions, such as internal claim department processing changes, a shift between single and multiple claim payments, legal changes, or variations in a company’s mix of business from year to year. Also, since the percentage of losses paid for immature years is often low, development factors are volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimates. Therefore, ultimate values for immature accident years are often based on alternative estimation techniques.

The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected losses rather than a function of currently reported losses. The expected losses used in this analysis are selected judgmentally based upon the historical relationship between premiums and losses for more mature accident years, adjusted to reflect changes in average rates and expected changes in claims frequency and severity. The expected losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected incurred loss development factors. Finally, the expected unreported losses are added to the current reported losses to produce ultimate losses.

The calculations underlying the Bornhuetter-Ferguson expected loss projection method based on paid loss data are similar to the incurred Bornhuetter-Ferguson calculations with the exception that paid losses and unpaid percentages replace reported losses and unreported percentages.

The Bornhuetter-Ferguson method is most useful as an alternative to other models for immature accident years. For these immature years, the amounts reported or paid may be small and unstable and therefore not predictive of future development. Therefore, future development is assumed to follow an expected pattern that is supported by more stable historical data or by emerging trends. This method is also useful when changing reporting patterns or payment patterns distort the historical development of losses.

For the property lines of business (special property, personal auto physical damage, and commercial auto physical damage) the results of the reserve calculations were similar and we generally rely on an averaging of the methods utilized.

For the homeowners and commercial multi-peril lines of business (excluding California CMP business for policy years 1996 and prior) we generally rely on the incurred loss development and incurred Bornhuetter-Ferguson methods in estimating loss reserves. These two methods yield more consistent results although the two paid methods yielded reserves that were similar in total to the incurred methods.

In July of 1995, the California Supreme Court rendered its Opinion of Admiral Insurance Company vs. Montrose Chemical Corporation (the Montrose Decision). In that decision, the Supreme Court ruled that in the case of a continuous and progressively deteriorating loss, such as pollution liability (or construction defect liability), an insurance company has a definitive duty to defend the policyholder until all uncertainty related to the severity and cause of the loss is extinguished.

After the Montrose Decision, FPIC (a subsidiary of the Group since October 1, 2005) experienced a significant increase in construction defect liability cases impacting our West Coast commercial multi-peril liability lines of business, to which it would not have been subject under the old interpretation of the law. In response, FPIC (prior to its acquisition by the Group) implemented a series of underwriting measures to limit the prospective exposure to Montrose and construction defect liability claims. These changes to coverage and risk selection resulted in an improvement in the post-Montrose underwriting results.

FPIC evaluates commercial multi-peril liability reserves by segregating pre- and post-Montrose activity as well as segregating contractor versus non-contractor experience. An inception to date ground-up incurred loss database was created as the basis for this new analysis. The pre-Montrose activity is evaluated on a report year basis

which eliminates the accident year development distortions caused by the effects of the Montrose Decision. For policy years 1997 and later, the reserves are analyzed using the more traditional accident year analysis.

For the casualty lines (commercial multi-peril liability, other liability, personal auto liability, commercial auto liability, workers’ compensation) the paid loss development method yielded less than reliable results for the immature years and we did not use the method in selecting ultimate losses and reserves. For these lines we primarily relied on the incurred Bornhuetter-Ferguson method for the most recent accident years and both of the incurred loss development methods for the remaining years.

The property and casualty industry has incurred substantial aggregate losses from claims related to asbestos-related illnesses, environmental remediation, product and mold, and other uncertain or environmental exposures. We have not experienced significant losses from these types of claims.

We compute our estimated ultimate liability using these principles and procedures applicable to the lines of business written. However, because the establishment of loss reserves is an inherently uncertain process, we cannot be certain that ultimate losses will not exceed the established loss reserves and have a material adverse effect on the Group’s results of operations and financial condition. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustments are made.

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 December 31, 2007.

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


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			December 31,		December 31,			December 31,		December 31,
Reinsurance			2007		2007(1)			2006		2006(1)
			(Dollars in thousands)

	(10.0	)%	$	172,815		9.5	%	$	148,070		9.4	%
	(7.5	)%		177,616		7.1	%		152,183		7.0	%
	(5.0	)%		182,416		4.7	%		156,296		4.7	%
	(2.5	)%		187,217		2.4	%		160,409		2.3	%
	Base			192,017		—			164,522		—
	2.5	%		196,817		(2.4	)%		168,635		(2.3	)%
	5.0	%		201,618		(4.7	)%		172,748		(4.7	)%
	7.5	%		206,418		(7.1	)%		176,861		(7.0	)%
	10.0	%		211,219		(9.5	)%		180,974		(9.4	)%


(1)		Net of Tax

The Group’s consulting actuaries’ determined range of loss and loss adjustment expense reserves on a net basis range from a low of $153.5 million to a high of $200.3 million as of December 31, 2007. The Group’s net loss and loss adjustment expense reserves are carried at $192.0 million as of December 31, 2007. Management’s point estimate of reserves is at the higher end of its actuarially determined range in recognition of the inherent uncertainty in assessing the potential ultimate liabilities given legal developments as well as the evolution in its operations. The evolution in its operations include such things as changes in coverage and pricing in response to market opportunity as well as higher reinsurance retentions and geographic and product diversification all of which affect management’s reserve estimates.

The chart below displays case and IBNR reserves for the Group as of December 31, 2007 and 2006 by line of business:

As of December 31, 2007


									Reinsurance
									Recoverable
							IBNR		on Unpaid
							Reserves		Losses and
	Case Loss		Case LAE		Total Case		(including		Loss			Net
	Reserves		Reserves		Reserves		LAE)		Expenses			Reserves
	(In thousands)

Homeowners	$	5,071		—		5,071		2,095		684			6,482
Workers’ compensation		3,936		—		3,936		4,389		742			7,583
Commercial multi-peril		28,560		4,997		33,557		165,359		58,891			140,025
Other liability		5,395		—		5,395		7,556		546			12,405
Other lines		280		—		280		205		111			374
Commercial auto liability		10,950		387		11,337		23,369		18,094			16,612
Commercial auto physical damage		319		8		327		2,467		1,081			1,713
Products liability		15		—		15		30		197			(152	)
Personal auto liability		1,103		—		1,103		714		60			1,757
Personal auto physical damage		282		—		282		93		(18	)		393
Surety		1,384		9		1,393		5,426		1,994			4,825

Total Loss & LAE Reserves	$	57,295		5,401		62,696		211,703		82,382			192,017

As of December 31, 2006


									Reinsurance
									Recoverable
							IBNR		on Unpaid
							Reserves		Losses and
	Case Loss		Case LAE		Total Case		(including		Loss		Net
	Reserves		Reserves		Reserves		LAE)		Expenses		Reserves
	(In thousands)

Homeowners	$	4,987		—		4,987		1,732		529		6,190
Workers’ compensation		3,943		—		3,943		4,210		892		7,261
Commercial multi-peril		33,984		4,470		38,454		143,071		61,430		120,095
Other liability		4,448		—		4,448		4,973		142		9,279
Other lines		221		—		221		334		110		445
Commercial auto liability		12,350		389		12,739		20,689		20,077		13,351
Commercial auto physical damage		549		18		567		2,652		1,040		2,179
Products liability		45		—		45		75		—		120
Personal auto liability		1,050		—		1,050		737		43		1,744
Personal auto physical damage		332		—		332		92		—		424
Surety		965		19		984		4,120		1,670		3,434

Total Loss & LAE Reserves	$	62,874		4,896		67,770		182,685		85,933		164,522

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 accumulated other 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. In the years ended December 31, 2007, 2006 and 2005, we recorded a pre-tax charge to earnings of $138,000, $121,000 and $517,000, respectively, for write-downs of other than temporarily impaired securities. In 2007, these charges related to common stocks, in 2006 these charges related to fixed income securities, and in 2005 these charges related to preferred stocks and fixed income securities. Adverse investment market conditions, poor operating performance, or other adversity encountered by companies whose stock or fixed maturity securities we own 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 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.

Policy Acquisition Costs

We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are primarily related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premiums.

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 related 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.

Many of the reinsurance treaties participated in by the Group prior to 2007 and primarily FPIC treaties have included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares on a limited basis in the profitability of our reinsurance treaties through contingent ceding commissions. The Group’s exposure in the loss experience is contractually defined at minimum and

maximum levels. The terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, the net amounts that will ultimately be realized may vary significantly from the estimated amounts presented in the Group’s results of operations.

Income Taxes

We use the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. 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.

Contingencies

Besides claims related to its insurance products, the Group is subject to proceedings, lawsuits and claims in the normal course of business. The Group assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses. There can be no assurance that actual outcomes will be consistent with those assessments.

RESULTS OF OPERATIONS

Revenue and income by segment is as follows for the years ended December 31, 2007, 2006 and 2005. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


	December 31
	2007		2006			2005
	(In thousands)

Revenues:
Net premiums earned:
Commercial lines	$	125,427	$	115,461		$	52,279
Personal lines		21,248		22,212			22,481

Total net premiums earned		146,675		137,673			74,760

Net investment income		13,053		10,070			4,467
Realized investment gains		24		151			1,267
Other		1,929		2,035			772

Total revenues		161,681		149,929			81,266

Income before income taxes:
Underwriting income (loss):
Commercial lines		5,964		4,246			3,383
Personal lines		234		(60	)		431

Total underwriting income		6,198		4,186			3,814
Net investment income		13,053		10,070			4,467
Realized investment gains		24		151			1,267
Other		714		677			413

Income before income taxes	$	19,989	$	15,084		$	9,961

The key elements of the Group’s business model are the sales of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in influencing the success of the business model. These factors are affected by the factors impacting the insurance industry in general and factors unique to the Group as described in the following discussion.

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, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.

Our growth in premiums, underwriting results and investment income have been, and continue to be, influenced by market conditions, as well as the acquisition of FPIG on October 1, 2005. The Group’s financial statements include FPIG and its results of operations for the entire year of 2007 and 2006 and for the period of October 1, 2005 through December 31, 2005.

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, and 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 2007, as compared to 2006, due in part to increased competition and reduced audit premium on expired business, among other factors discussed more in detail below in the 2007 vs. 2006 Revenue discussion.

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.

YEAR ENDED DECEMBER 31, 2007 COMPARED TO YEAR ENDED DECEMBER 31, 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. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines

of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


2007 vs. 2006 Income	2007			2006			Change			% Change
	(Dollars in thousands)

Commercial lines underwriting income	$	5,964		$	4,246		$	1,718			40.5	%
Personal lines underwriting income (loss)		234			(60	)		294			490.0	%
Total underwriting income		6,198			4,186			2,012			48.1	%
Net investment income		13,053			10,070			2,983			29.6	%
Net realized investment gains		24			151			(127	)		(84.1	)%
Other		1,929			1,889			40			2.1	%
Interest expense		(1,215	)		(1,212	)		(3	)		0.2	%
Income before income taxes		19,989			15,084			4,905			32.5	%
Income taxes		5,754			4,449			1,305			29.3	%
Net Income	$	14,235		$	10,635		$	3,600			33.9	%
Loss/ LAE ratio (GAAP)		62.2	%		63.7	%		(1.5	)%
Underwriting expense ratio (GAAP)		33.6	%		33.3	%		0.3	%
Combined ratio (GAAP)		95.8	%		97.0	%		(1.2	)%
Loss/ LAE ratio (Statutory)		62.2	%		61.5	%		0.7	%
Underwriting expense ratio (Statutory)		32.2	%		33.7	%		(1.5	)%
Combined ratio (Statutory)		94.4	%		95.2	%		(0.8	)%

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.

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 ended 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 for the year ended December 31, 2007, and related performance metrics such as the combined ratio.

The Group’s GAAP combined ratio for 2007 was 95.8%, as compared to a combined ratio for the prior year of 97.0%. On a pro-forma basis, after removing the effect of the non-recurring retaliatory tax refund described above, the GAAP combined ratio for 2007 was 98.3%. The statutory combined ratio for 2007 and 2006 was 94.4% and 95.2%, respectively. See discussion below relating to commercial and personal lines performance.

Net investment income increased $3.0 million or 29.6% to $13.1 million in 2007 as compared to $10.1 million in 2006. Included in this increase is $720,000 attributable to the non-recurring impact of the 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.

Realized investment gains amounted to $24,000 in 2007 as compared to $151,000 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 of

$1.9 million in 2007 and 2006 represents service charges recorded on insurance premiums. Interest expense of $1.2 million in 2007 and 2006 represents interest charges on the trust preferred obligations of FPIG.

Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investment segment) follow with further discussion below. Changes have been made to the 2006 presentation of the commercial and personal lines segments to conform to the allocation methodology used for the 2007 commercial and personal lines results.


2007 vs. 2006 Revenue	2007		2006		Change			% Change
	(In thousands)

Direct premiums written	$	182,907	$	185,745	$	(2,838	)		(1.5	)%
Net premiums written		159,667		145,791		13,876			9.5	%
Net premiums earned		146,675		137,673		9,002			6.5	%
Net investment income		13,053		10,070		2,983			29.6	%
Net realized investment gains		24		151		(127	)		(84.1	)%
Other revenue		1,929		2,035		(106	)		(5.2	)%
Total revenue	$	161,681	$	149,929	$	11,752			7.8	%

Total revenues for 2007 increased $11.8 million or 7.8% to $161.7 million as compared to $149.9 million in 2006. This increase was due primarily to an increase in net premiums earned and net investment income. Net premiums earned totaled $146.7 million in 2007 as compared to $137.7 million in 2006, representing a 6.5% or $9.0 million increase. Net premiums written increased $13.9 million or 9.5% to $159.7 million as compared to $145.8 million in 2006. Net premiums written and net premiums earned were impacted in 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 $13.1 million in 2007, as compared to $10.1 million in 2006, representing a 29.6% or $3.0 million increase. The increase in net investment income in 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 $24,000 in 2007 as compared to $151,000 in 2006. Net realized gains in 2007 and 2006 include the mark-to-market fair value adjustment on the interest rate swaps related to the floating-rate trust preferred securities. The mark-to-market on the swaps resulted in a realized loss of $774,000 and $94,000 in 2007 and 2006, respectively. See the investment income discussion below for further information.

In 2007, direct premiums written decreased $2.8 million or 1.5% to $182.9 million in 2007 as compared to $185.7 million in 2006. The 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 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 related exposures) and the related audit premium on expiring policies. Audits, primarily of construction related policies, generated $3.1 million of premium in 2007, representing a decline of $8.9 million as compared to $12.0 million of premium that was generated in 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, 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 and earned premium for 2006. There was no similar impact in 2007 relating to this restructuring.

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 2007.

Growth in Net Investment Income is discussed below.


2007 vs. 2006 Investment Income and Realized Gains	2007			2006			Change			% Change
	(In thousands)

Fixed income securities	$	13,356		$	11,044		$	2,312			20.9	%
Dividends		319			514			(195	)		(37.9	)%
Cash, cash equivalents & other		1,442			859			583			67.9	%
Gross investment income		15,117			12,417			2,700			21.7	%
Investment expenses		2,064			2,347			(283	)		(12.1	)%
Net investment income	$	13,053		$	10,070		$	2,983			29.6	%
Realized losses — fixed income securities	$	—		$	(402	)	$	402			N/M
Realized gains — equity securities		798			638			160			N/M
Mark-to-market valuation for interest rate swaps		(774	)		(94	)		(680	)		N/M
Net realized gains — other		—			9			(9	)		N/M
Net realized gains	$	24		$	151		$	(127	)		(84.1	)%

(N/M means “not meaningful”)

In 2007, net investment income increased $3.0 million, or 29.6% to $13.1 million, as compared to $10.1 million in 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. Net investment income also benefited from the $720,000 non-recurring impact of the retaliatory tax refund.

In 2007, investment income on fixed income securities increased $2.3 million, or 20.9% to $13.4 million, as compared to $11.0 million 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 5.22% in 2007, as compared to 5.14% in 2006.

Dividend income declined $0.2 million or 37.9% to $0.3 million in 2007, from $0.5 million in 2006. The decline in dividend income is primarily attributable to a decline in dividends received relating to an equity security held in a reinsurance company. Excess Reinsurance Company paid a special dividend to the Group in 2007 and 2006 in the amount of $1,000 and $228,000, respectively. Interest income on cash and cash equivalents increased $0.6 million or 67.9% to $1.4 million in 2007, as compared to $0.9 million in 2006, primarily as a result of the

$720,000 of non-recurring interest received on the retaliatory tax refund. Investment expenses decreased $0.3 million or 12.1% to $2.1 million in 2007, from $2.3 million in 2006.

Net realized gains for 2007 were $24,000, as compared to $151,000 in 2006. In 2007, net realized gains of $24,000 included a loss on the mark-to-market valuation on the interest rate swaps of $774,000, write-down of securities determined to be other than-temporarily impaired of $138,000, and gains of $936,000 on the sale of equity investments. 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 four 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 corporate security held with a market value of $0.4 million. As of December 31, 2007, the fixed income portfolio had an average rating of AA, an average effective maturity of 5.9 years, and an average tax equivalent yield of 5.22%.

Among its portfolio holdings, the Group’s only subprime exposure consists of asset-backed securities within the home equity subsector. The ABS home equity subsector totaled $1.7 million (book value) on December 31, 2007, representing 10.4% of the ABS holdings, 2.0% of the total structured product holdings, and 0.5% of total fixed income holdings. The subprime related exposure consists of five individual securities, two of which have a 100% credit enhancement, based on insurance against default as to principal and interest. In the case that the monoline insurance companies were to be downgraded, the ratings on the ABS securities would receive the equivalent rating. Among the three securities without credit enhancement, two are rated Aaa/AAA and one is rated Aa2/AA by Moody’s and S&P. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”

The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2007 are as follows:


	Less than 12 Months				12 Months or Longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
	(In thousands)

U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	6,242	$	24	$	12,089	$	91	$	18,331	$	115
Obligations of states and political subdivisions		4,535		9		12,386		68		16,921		77
Corporate securities		5,586		108		22,842		345		28,428		453
Mortgage-backed securities		484		16		7,679		87		8,163		103

Total fixed maturities		16,847		157		54,996		591		71,843		748

Total equity securities		4,155		276		84		20		4,239		296

Total securities in a temporary unrealized loss position	$	21,002	$	433	$	55,080	$	611	$	76,082	$	1,044

Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2007 the Group has 74 fixed maturity securities with unrealized losses for more than twelve months. Of the 74 securities with unrealized losses for more than twelve months, 72 of them have fair values of no less than 94% or more of cost, and the other 2 securities have a fair value greater than 89% of cost. The fixed income portfolio is invested 100% in investment grade securities, with the exception of one corporate security held with a market value of $0.4 million, and these unrealized losses primarily reflect the current interest rate environment. The Group does not believe theses declines are other than temporary due to the credit quality of the holdings. The Group currently has the ability and intent to hold these securities until recovery.

There are 16 common stock securities that are in an unrealized loss position at December 31, 2007. All of these securities have been in an unrealized loss position for less than six months. There are 7 preferred stock securities that are in an unrealized loss position at December 31, 2007. Five preferred stock securities have been in an unrealized loss position for less than six months. One preferred stock security has been in an unrealized loss position for more than six months but less than twelve months and one preferred stock security has been in an unrealized loss position for more than twelve months. The Group believes these declines are not other than temporary as a result of reviewing the circumstances of each such security in an unrealized position. The Group currently has the ability and intent to hold these securities until recovery.

The following table summarizes the period of time that equity securities sold at a loss during 2007 had been in a continuous unrealized loss position:


	Fair
	Value on		Realized
Period of Time in an Unrealized Loss Position	Sale Date		Loss
	(In thousands)

0-6 months	$	1,051	$	93
7-12 months		63		2
More than 12 months		—		—

Total	$	1,114	$	95

The equity securities sold at a loss had been expected to appreciate in value but after reevaluation were sold so that sale proceeds could be reinvested. Securities were sold due to a desire to reduce exposure to certain issuers and industries or in light of changing economic conditions.

Results of our Commercial Lines segment were as follows. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


2007 vs. 2006 Commercial Lines (CL)	2007			2006			Change			% Change
	(Dollars in thousands)

CL Direct premiums written	$	160,030		$	161,592		$	(1,562	)		(1.0	)%
CL Net premiums written	$	139,359		$	123,829		$	15,530			12.5	%
CL Net premiums earned	$	125,427		$	115,461		$	9,966			8.6	%
CL Loss/ LAE expense ratio (GAAP)		60.8	%		63.7	%		(2.9	)%
CL Expense ratio (GAAP)		34.4	%		32.8	%		1.6	%
CL Combined ratio (GAAP)		95.2	%		96.5	%		(1.3	)%

In 2007, our commercial lines direct premiums written decreased by $1.6 million or 1.0% to $160.0 million as compared to direct written premium in 2006 of $161.6 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 2007, our commercial lines net premiums written increased by $15.5 million, or 12.5%, to $139.4 million as compared to net premiums written in 2006 of $123.8 million. Net premiums earned in 2007 increased 8.6%, or $10.0 million, to $125.4 million from $115.5 million in 2006. See additional discussion above in the 2007 vs. 2006 Revenue discussion.

In the commercial lines segment for 2007, we had underwriting income of $6.0 million, a GAAP combined ratio of 95.2%, a GAAP loss and loss adjustment expense ratio of 60.8% and a GAAP underwriting expense ratio of 34.4%, compared to underwriting income of $4.2 million, a GAAP combined ratio of 96.5%, a GAAP loss and loss

adjustment expense ratio of 63.7% and a GAAP underwriting expense ratio of 32.8% in 2006. Our commercial lines loss ratio for 2007 reflects a frequency of losses reported and severity within a normal range of our expectations. The performance of the commercial lines in 2007 was impacted favorably by the non-recurring retaliatory tax refund.

Results of our Personal Lines segment were as follows. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


2007 vs. 2006 Personal Lines (PL)	2007			2006			Change			% Change
	(Dollars in thousands)

PL Direct premiums written	$	22,877		$	24,153		$	(1,276	)		(5.3	)%
PL Net premiums written	$	20,308		$	21,962		$	(1,654	)		(7.5	)%
PL Net premiums earned	$	21,248		$	22,212		$	(964	)		(4.3	)%
PL Loss/ LAE expense ratio (GAAP)		70.1	%		63.8	%		6.3	%
PL Expense ratio (GAAP)		28.8	%		36.5	%		(7.7	)%
PL Combined ratio (GAAP)		98.9	%		100.3	%		(1.4	)%

In 2007, personal lines direct premiums written declined to $22.9 million, representing a decline of $1.3 million or 5.3% from $24.2 million in 2006. Our personal lines have been impacted by increased competition, similar to our commercial lines. Net premiums written also declined to $20.3 million in 2007, as compared to $22.0 million in 2006, representing a decline of $1.7 million or 7.5%. Personal lines net premiums earned in 2007 declined 4.3% or $1.0 million to $21.2 million from $22.2 million in 2006.

In the personal lines segment for 2007, we had underwriting income of $0.2 million, a GAAP combined ratio of 98.9%, a GAAP loss and loss adjustment expense ratio of 70.1% and a GAAP underwriting expense ratio of 28.8%, compared to an underwriting loss of $0.1 million, a GAAP combined ratio of 100.3%, a GAAP loss and loss adjustment expense ratio of 63.8% and a GAAP underwriting expense ratio of 36.5% in 2006. Our personal lines loss ratio for 2007 reflects a frequency and severity of losses reported which falls generally within a normal range of our expectations.

Underwriting Expenses and the Expense Ratio is discussed below.


2007 vs. 2006 Expenses and Expense Ratio	2007			2006			Change			% Change
	(Dollars in thousands)

Amortization of Deferred Acquisition Costs	$	38,763		$	32,694		$	6,069			18.6	%
As a % of net premiums earned		26.4	%		23.7	%		2.7	%
Other underwriting expenses		10,528			13,242			(2,714	)		(20.5	)%
Total expenses excluding losses/ LAE	$	49,291		$	45,936		$	3,355			7.3	%
Underwriting expense ratio		33.6	%		33.3	%		0.3	%

Underwriting expenses increased by $3.4 million, or 7.3%, to $49.3 million in 2007, as compared to $45.9 million in 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 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 most of the treaties effective January 1, 2007 do not provide for ceding commission, which increases underwriting expenses and net acquisition costs.


2007 vs. 2006 Income Taxes	2007			2006			Change			% Change
	(Dollars in thousands)

Income before income taxes	$	19,989		$	15,084		$	4,905			32.5	%
Income taxes		5,754			4,449			1,305			29.3	%
Net income	$	14,235		$	10,635		$	3,600			33.9	%
Effective tax rate		28.8	%		29.5	%		(0.7	)%

Federal income tax expense was $5.8 million and $4.4 million for 2007 and 2006, respectively. The effective tax rate was 28.8% and 29.5% for 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).

YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005

The components of income for 2006 and 2005, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


2006 vs. 2005 Income	2006			2005			Change			% Change
	(Dollars in thousands)

Commercial lines underwriting income	$	4,246		$	3,383		$	863			25.5	%
Personal lines underwriting loss		(60	)		431			(491	)		113.9	%
Total underwriting income		4,186			3,814			372			9.8	%
Net investment income		10,070			4,467			5,603			125.4	%
Net realized investment gains		151			1,267			(1,116	)		(88.1	)%
Other		1,889			719			1,170			162.7	%
Interest expense		(1,212	)		(306	)		(906	)		296.1	%
Income before income taxes		15,084			9,961			5,123			51.4	%
Income taxes		4,449			2,941			1,508			51.3	%
Net Income	$	10,635		$	7,020		$	3,615			51.5	%
Loss/LAE ratio (GAAP)		63.7	%		58.0	%		5.7	%
Underwriting expense ratio (GAAP)		33.3	%		36.9	%		(3.6	)%
Combined ratio (GAAP)		97.0	%		94.9	%		2.1	%
Loss/LAE ratio (Statutory)		61.5	%		55.4	%		6.1	%
Underwriting expense ratio (Statutory)		33.7	%		38.7	%		(5.0	)%
Combined ratio (Statutory)		95.2	%		94.1	%		1.1	%

Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investment segment) follow with further discussion below. Changes have been made to the 2005 presentation of the commercial and personal lines segments to conform to the allocation methodology used for the 2006 commercial and personal lines results.

The Group’s GAAP combined ratio for 2006 was 97.0%, as compared to a combined ratio for the prior year of 94.9%. The statutory combined ratio for 2006 and 2005 was 95.2% and 94.1%, respectively. Our commercial lines underwriting income benefited from the contribution of FPIC, which was acquired on October 1, 2005. The personal lines performance, while benefiting from rate increases initiated in 2005 on our homeowners line of business and a redirection of our Pennsylvania personal auto book to better performing tiers of business, underperformed the prior year. Frequency and severity of claims on personal lines was within the normal range of expectations during 2006. Frequency of losses reported on our commercial lines was also within a normal range of our expectations and we experienced a slight increase in severity during 2006 as compared to 2005.

Net investment income increased $5.6 million or 125.4% to $10.1 million in 2006 as compared to $4.5 million in 2005, primarily as a result of the acquisition of FPIG in addition to higher short-term and long-term interest rates in 2006. Realized investment gains amounted to $151,000 in 2006 as compared to $1.3 million in 2005. The higher level of realized gains in 2005 was attributable to the disposition of securities in anticipation of funding the acquisition of FPIG on October 1, 2005 for $41.1 million (including acquisition costs). Other revenue, which is primarily service charges recorded on insurance premiums, increased $1.2 million or 162.7% to $1.9 million in 2006 as compared to $0.7 million in 2005, reflecting the impact of the acquisition of FPIG. Interest expense of $1.2 million in 2006 and $0.3 million in 2005 represents the inclusion of the trust preferred obligations of FPIG and their related interest charges for the year ending December 31, 2006 and the quarter ending December 31, 2005.


2006 vs. 2005 Revenue	2006		2005		Change			% Change
	(In thousands)

Direct premiums written	$	185,745	$	92,240	$	93,505			101.4	%
Net premiums written		145,791		75,266		70,525			93.7	%
Net premiums earned		137,673		74,760		62,913			84.2	%
Net investment income		10,070		4,467		5,603			125.4	%
Net realized investment gains		151		1,267		(1,116	)		(88.1	%
Other revenue		2,035		772		1,263			163.6	%
Total revenue	$	149,929	$	81,266	$	68,663			84.5	%

Total revenues for 2006 increased $68.7 million or 84.5% to $149.9 million as compared to $81.3 million in 2005. This increase was due primarily to inclusion of the revenue of FPIG for the entire year of 2006 compared to inclusion of revenue of FPIG for only the fourth quarter in 2005. FPIG contributed $84.9 million and $15.9 million in revenue for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Net premiums earned totaled $137.7 million in 2006 as compared to $74.8 million in 2005, representing an 84.2% or $62.9 million increase. This increase was due to the FPIG acquisition which contributed $77.3 million and $13.9 million in net premiums earned for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Realized investment gains amounted to $151,000 in 2006 as compared to $1.3 million in 2005. The gains in 2005 were the result of sales of mostly equity securities to fund the FPIG acquisition. Net realized gains in 2006 and 2005 also include the mark-to-market fair value adjustment on the interest rate swaps related to the floating-rate trust preferred securities. The mark-to-market on the swaps resulted in a realized (loss)/gain of $(94,000) and $122,000 in 2006 and 2005, respectively.

In 2006, direct premiums written increased $93.5 million or 101.4% to $185.7 million in 2006 as compared to $92.2 million in 2005. FPIC contributed $120.1 million and $27.9 million in direct written premium for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.

Growth in Net Investment Income is discussed below.


2006 vs. 2005 Investment Income and Realized Gains	2006			2005			Change			% Change
	(In thousands)

Fixed income securities	$	11,044		$	5,195		$	5,849			112.6	%
Dividends		514			559			(45	)		(8.1	)%
Cash, cash equivalents & other		859			748			111			14.8	%
Gross investment income		12,417			6,502			5,915			91.0	%
Investment expenses		2,347			2,035			312			15.3	%
Net investment income	$	10,070		$	4,467		$	5,603			125.4	%
Realized losses — fixed income securities	$	(402	)	$	(608	)	$	206			N/M
Realized gains — equity securities		638			1,751			(1,113	)		N/M
Mark-to-market valuation for interest rate swaps		(94	)		122			(216	)		N/M
Realized gains — other		9			2			7			N/M
Net realized gains	$	151		$	1,267		$	(1,116	)		(88.1	)%

(N/M means “not meaningful”)

In 2006, net investment income increased $5.6 million or 125.4% to $10.1 million in 2006 as compared to $4.5 million in 2005. Our investment income benefited in 2006 from higher short-term and long-term interest rates, an increase in average cash and invested assets to $294.4 million in 2006 from $155.8 million in 2005, and increased largely due to the inclusion of the net investment income of FPIG for the entire year of 2006 compared to inclusion of net investment income of FPIG for only the fourth quarter in 2005. FPIG contributed $6.3 million and $1.4 million in net investment income for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.

In 2006, investment income on fixed income securities increased $5.8 million or 112.6% to $11.0 million in 2006 as compared to $5.2 million in 2005. This was driven by an increase in long-term interest rates, an increase in the average invested assets and the inclusion of FPIG for the entire year of 2006. The Group’s tax equivalent yield (yield adjusted for tax-benefit received on tax-exempt securities) on fixed income securities increased to 5.14% in 2006 compared to 4.57% in 2005. Since the acquisition of FPIG, a much larger proportion of the Group’s premium writings relate to casualty, or longer-tail, business. By its nature, longer-tail business requires more time for losses to manifest themselves, with the result that claims tend to be paid later on casualty claims than on other types of claims. The later payment of claims associated with casualty reserves provides a company with the opportunity to use the funds, which will ultimately be paid out as claims, for a longer period of time, thus generating a larger relative portfolio of fixed income securities and higher investment income.

Dividend income and interest income on cash and cash equivalents was stable in 2006 at $0.5 million and $0.9 million, respectively, as compared to 2005 at $0.6 million and $0.7 million, respectively.

Investment expenses increased 15.3%, or $0.3 million, to $2.3 million in 2006 from $2.0 million in 2005. Although a full year of expenses are included for FPIG as compared to only a quarter in 2005, investment expenses increased by only 15.3% in 2006 as compared to a 91.0% increase in gross investment income. This reflects cost savings achieved by the Group in consolidating investment strategies, policies and external advisors. As of January 1, 2006, the Group consolidated investment managers and uses only one manager/advisor for all insurance subsidiaries in the Group.

Net realized gains for 2006 were $0.2 million, as compared to $1.3 million in 2005. As noted above, the 2005 gains were taken as part of the process of funding the acquisition of FPIG. In 2006, net realized investment gains of $0.2 million included gains on securities sales of $1.0 million, offset by losses on securities sales of $0.6 million, $0.1 million from the write-down of a fixed-income security determined to be other-than-temporarily impaired and a loss of $0.1 million relating to the mark-to-market valuation on the interest rate swaps. Securities determined to be other-than-temporarily impaired are written down to our estimate of fair market value. 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 swap 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, with, as of December 31, 2006, an average rating of AAA, an average maturity of 5.4 years (excluding mortgage-backed securities), and an average tax equivalent yield of 5.14%. In order to enhance the yield on our fixed income securities, our investments generally have a longer average maturity than the life of our liabilities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”

The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2006 are as follows:


	Less than 12 Months				12 Months or Longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
	(In thousands)

U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	4,834	$	24	$	50,353	$	869	$	55,187	$	893
Obligations of states and political subdivisions		24,948		90		40,918		552		65,866		642
Corporate securities		4,211		17		41,850		767		46,061		784
Mortgage-backed securities		4,481		24		13,266		159		17,747		183

Total fixed maturities		38,474		155		146,387		2,347		184,861		2,502

Total equity securities		1,991		100		—		—		1,991		100

Total securities in a temporary unrealized loss position	$	40,465	$	255	$	146,387	$	2,347	$	186,852	$	2,602

Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2006 the Group has 198 fixed maturity securities with unrealized losses for more than twelve months. Of the 198 securities with unrealized losses for more than twelve months, 192 of them have fair values of no less than 96% or more of cost and the other 6 securities have a fair value greater than 93% 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 December 31, 2006, and these unrealized losses primarily reflect the current interest rate environment. The Group does not believe theses declines are other than temporary due to the credit quality of the holdings. The Group currently has the ability and intent to hold these securities until recovery.

There are 12 equity securities that are in an unrealized loss position at December 31, 2006. All of these securities have been in an unrealized loss position for less than six months. The Group believes these declines are not other than temporary as a result of reviewing the circumstances of each such security in an unrealized position. The Group currently has the ability and intent to hold these securities until recovery.

The following table summarizes the period of time that equity securities sold at a loss during 2006 had been in a continuous unrealized loss position:


	Fair
	Value on		Realized
Period of Time in an Unrealized Loss Position	Sale Date		Loss
	(In thousands)

0-6 months	$	1,832	$	368
7-12 months		—		—
More than 12 months		—		—

Total	$	1,832	$	368


2006 vs. 2005 Commercial Lines (CL)	2006			2005			Change			% Change
	(Dollars in thousands)

CL Direct premiums written	$	161,592		$	67,715		$	93,877			138.6	%
CL Net premiums written	$	123,829		$	52,634		$	71,195			135.3	%
CL Net premiums earned	$	115,461		$	52,279		$	63,182			120.9	%
CL Loss/LAE expense ratio (GAAP)		63.7	%		58.3	%		5.4	%
CL Expense ratio (GAAP)		32.8	%		35.2	%		(2.4	)%
CL Combined ratio (GAAP)		96.5	%		93.5	%		3.0	%

In 2006, our commercial lines direct premiums written increased by $93.9 million or 138.6% to $161.6 million as compared to direct written premium in 2005 of $67.7 million. This increase was due primarily to inclusion of the direct premiums written of FPIC for the entire year of 2006 compared to inclusion of direct premiums written of FPIC for only the fourth quarter in 2005. FPIC contributed $120.1 million and $27.9 million in direct premiums written for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Net premiums earned increased $63.2 million or 120.9% to $115.5 million in 2006 from $52.3 million in 2005, of which FPIC contributed $77.3 million and $13.9 million of net premiums earned for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.

Effective January 1, 2006, FPIC restructured its property reinsurance agreement covering the first $2,000,000 of loss from an 80% quota share to a $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s 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 and earned premium for the year ending December 31, 2006.

During the third quarter of 2006, the Group commuted all reinsurance agreements with Alea. These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation, the Group received a cash payment of $4.5 million, and recorded a pre-tax net loss on commutation of $160,000.

In the commercial lines segment for 2006, we had underwriting income of $4.2 million, a GAAP combined ratio of 96.5%, a GAAP loss and loss adjustment expense ratio of 63.7% and a GAAP underwriting expense ratio of 32.8%, compared to underwriting income of $3.4 million, a GAAP combined ratio of 93.5%, a GAAP loss and loss adjustment expense ratio of 58.3% and a GAAP underwriting expense ratio of 35.2% in 2005. Our commercial lines loss ratio for 2006 reflects a frequency of losses reported within a normal range of our expectations, and includes a slight increase in severity compared to 2005.

lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:


2006 vs. 2005 Personal Lines (PL)	2006			2005			Change			% Change
	(Dollars in thousands)

PL Direct premiums written	$	24,153		$	24,525		$	(372	)		(1.5	)%
PL Net premiums written	$	21,962		$	22,632		$	(670	)		(3.0	)%
PL Net premiums earned	$	22,212		$	22,481		$	(269	)		(1.2	)%
PL Loss/LAE expense ratio (GAAP)		63.8	%		57.4	%		6.4	%
PL Expense ratio (GAAP)		36.5	%		40.7	%		(4.2	)%
PL Combined ratio (GAAP)		100.3	%		98.1	%		2.2	%

Personal lines direct premiums written remained stable at $24.2 million and $24.5 million in 2006 and 2005, respectively. Net premiums written and earned also remained stable at $22.0 million and $22.2 million, respectively in 2006 compared to $22.6 million and $22.5 million, respectively in 2005.

In the personal lines segment for 2006, we had an underwriting loss of $0.1 million, a GAAP combined ratio of 100.3%, a GAAP loss and loss adjustment expense ratio of 63.8% and a GAAP underwriting expense ratio of 36.5%, compared to underwriting income of $0.4 million, a GAAP combined ratio of 98.1%, a GAAP loss and loss adjustment expense ratio of 57.4% and a GAAP underwriting expense ratio of 40.7% in 2005. The frequency and severity of losses in the personal lines book in 2006 was within the range of our normal expectations.

Underwriting Expenses and the Expense Ratio is discussed below.


2006 vs. 2005 Expenses and Expense Ratio	2006			2005			Change			% Change
	(Dollars in thousands)

Amortization of Deferred Acquisition Costs	$	32,694		$	16,849		$	15,845			94.0	%
As a % of net premiums earned		23.7	%		22.5	%		1.2	%
Other underwriting expenses		13,242			10,766			2,476			23.0	%
Total expenses excluding losses/LAE	$	45,936		$	27,615		$	18,321			66.3	%
Underwriting expense ratio		33.3	%		36.9	%		(3.6	)%

Underwriting expenses increased by $18.3 million, or 66.3%, to $45.9 million in 2006, as compared to $27.6 million in 2005. The 66.3% increase in underwriting expenses primarily reflects the 84.2% increase in net premiums earned, offset by the inclusion of FPIC which operates at a lower expense ratio than that of the balance of the Group.

FPIG was included in the Group’s operating results from October 1, 2005. FPIC’s book of business tends to operate with higher loss ratios and lower expense ratios than the Group’s business prior to the acquisition. In addition, due to FPIC’s higher usage of reinsurance, it also records higher levels of ceded commission and contingent ceded commission. In the year ended December 31, 2006, the Group, based on FPIC’s reinsurance participations, recognized ceded commissions and net contingent ceded commissions on reinsurance contracts of $9.7 million and $1.2 million, respectively as compared to the year ended December 31, 2005, where the Group recognized ceded commissions and net contingent ceded commissions on reinsurance contracts relating to FPIC of $4.2 million and $1.5 million, respectively.

Effective January 1, 2006, the Group adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123R “Share-Based Payment” (SFAS 123R), using the modified-prospective-transition method. As a result of adopting SFAS 123R on January 1, 2006, the Group’s 2006 underwriting expenses included a pre-tax charge of $711,000 to recognize the compensation cost of unvested stock options granted under the Group’s plan and the impact of SFAS 123R on the computation of expense relating to grants of restricted stock. In addition to the charge relating to the transition to SFAS 123R, the Group’s 2006 underwriting expenses included a pre-tax

charge of $687,000 associated with grants of restricted stock. During 2005, underwriting expenses included a pre-tax charge of $693,000 associated with grants of restricted stock.


2006 vs. 2005 Income Taxes	2006			2005			Change			% Change
	(Dollars in thousands)

Income before income taxes	$	15,084		$	9,961		$	5,123			51.4	%
Income taxes		4,449			2,941			1,508			51.3	%
Net income	$	10,635		$	7,020		$	3,615			51.5	%
Effective tax rate		29.5	%		29.5	%		—	%

Federal income tax expense was $4.4 million and $2.9 million for 2006 and 2005, respectively. The effective tax rate was 29.5% for both 2006 and 2005. The 2006 effective tax rate was impacted by an increase in the tax rate on current taxable income of 1% (due to the graduated tax rate structure), offset by higher tax-advantaged income (municipal bond interest and dividend income, which reduce the effective tax rate).

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.

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. See discussion of restrictions on dividends and distributions in the section “Business — Regulation”.

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.

As part of the funding of the acquisition of FPIG, MIC entered into a loan agreement with MIG, by which it advanced 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, September 28, 2007 and December 28, 2007, MIG paid a quarterly shareholder dividend of $0.05 per common share. The amount of dividends paid out on these dates totaled $1.3 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, the 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 December 31, 2007, the shares authorized under the plan have been increased under this provision to 1,075,870 shares. During 2007, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options. A total of 3,000 shares of restricted stock and 19,400 incentive stock options were forfeited during 2007. A total of 14,100 incentive stock options granted under the Plan were exercised during 2007. Upon exercise, new shares were issued to the option holder.

On October 20, 2004, the Group’s Board of Directors authorized the repurchase of up to 250,000 additional shares of its common stock (in addition to the 250,000 share repurchase authorized June 16, 2004 and previously completed). The repurchase of the additional 250,000 shares was completed on March 2, 2005. The repurchased shares will be held as treasury shares available for issuance in connection with the Group’s 2004 Stock Incentive Plan. In the aggregate, 500,000 shares have been repurchased in the open market since the Conversion, at an aggregate cost of $6.3 million, or $12.53 per share, with 2005 purchases totaling $3.2 million, or $13.18 per share. In addition, 2,301 and 1,950 shares of stock were repurchased from employees in 2007 and 2006, respectively, in order to pay the required tax withholdings on the vesting of restricted stock under the stock incentive plan.

Total assets increased 8%, or $39.5 million, to $546.4 million, at December 31, 2007, from $507.0 million at December 31, 2006. The Group’s total investments increased $44.5 million or 15%, primarily due to net cash provided by operating activities. Prepaid reinsurance premiums decreased $6.9 million or 42%, primarily due to a change in certain of the Group’s reinsurance contracts for 2007, whereby fewer unearned premium reserves are ceded. Deferred policy acquisition costs increased $3.8 million or 23%, reflecting the increase to net unearned premium reserves.

Total liabilities increased 6%, or $21.9 million, to $413.0 million, at December 31, 2007, from $391.1 million at December 31, 2006, primarily a result of the increase in loss and loss adjustment expense reserves of $23.9 million or 10% and the increase in unearned premiums of $6.1 million, or 7%. Other reinsurance balances decreased $9.9 million or 40%, primarily due to a change in certain of the Group’s reinsurance contracts for 2007, whereby less premium is ceded.

Total stockholders’ equity increased 15%, or $17.6 million, to $133.4 million, at December 31, 2007, from $115.8 million at December 31, 2006, primarily due to net income of $14.2 million, unrealized gains on investment securities of $2.3 million, stock compensation plan amortization of $1.0 million and ESOP shares committed of $1.2 million, issuance of common stock of $0.2 million, offset by stockholder dividends of $1.3 million.

IMPACT OF INFLATION

Inflation increases consumers’ needs for property and casualty insurance coverage. Inflation also increases 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. 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.

RECENT ACCOUNTING PRONOUNCEMENTS

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 does not expect that the adoption of SFAS No. 157 will have a significant effect on operations, financial condition or liquidity.

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 does not expect that the adoption of SFAS No. 159 will have a significant effect on operations, financial condition or liquidity.

In June 2006, the 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.

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 December 31, 2007 which would give rise to previously undisclosed market, credit or financing risk.

The Group and its subsidiaries have no significant contractual obligations at December 31, 2007, other than their insurance obligations under their policies of insurance, trust preferred securities, a line of credit obligation, and

operating lease obligations. Projected cash disbursements pertaining to these obligations at December 31, 2007, are as follows:


	Jan. 1, 2008		Jan. 1, 2009		Jan. 1, 2011		After
	to Dec. 31,		to Dec. 31,		to Dec. 31,		Dec. 31,
	2008		2010		2012		2012		Total
	(In thousands)

Gross property and casualty insurance reserves	$	59,735		75,697		43,902		95,065	$	274,399
Trust preferred securities, net principal outstanding		—		—		—		15,559		15,559
Interest expense relating to trust preferred securities		1,290		2,780		2,783		28,332		35,185
Line of credit		3,000		—		—		—		3,000
Operating leases		411		818		749		2,976		4,954

Total contractual obligations	$	64,436		79,295		47,434		141,932	$	333,097

The timing of the amounts for gross property and casualty insurance reserves are an estimate based on historical experience and expectations of future payment patterns. However, the timing of these payments may vary significantly from the amounts state above.


ITEM 7A.	*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 FPIG acquisition on October 1, 2005.

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 on the balance sheet.

The average duration of our fixed maturity investments, excluding mortgage-backed securities that are subject to prepayment, was approximately 3.5 years as of December 31, 2007. As a result, the market value of our investments may fluctuate in response to changes in interest rates. In addition, we may experience investment losses to the extent our liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate environments.

Fluctuations in near-term interest rates could have an impact on the results of operations and cash flows. Certain of these fixed income securities have call features. In a declining interest rate environment, these securities may be called by their issuer and replaced with securities bearing lower interest rates. In a rising interest rate environment, we may sell these securities (rather than holding to maturity) and receive less than we paid for them.

As a general matter, we do not attempt to match the durations of our assets with the durations of our liabilities. Our goal is to maximize the total return on all of our investments. An important strategy that we employ to achieve this goal is to try to hold enough in cash and short-term investments in order to avoid liquidating longer-term investments to pay claims.

The table below shows the interest rate sensitivity of our fixed income financial instruments measured in terms of market value (which is equal to the carrying value for all our securities).


	As of December 31, 2007
	Market Value
	−100 Basis		No Rate		+100 Basis
	Point Change		Change		Point Change
	(In thousands)

Bonds and preferred stocks	$	340,660	$	326,414	$	311,332
Cash and cash equivalents		21,580		21,580		21,580

Total	$	362,240	$	347,994	$	332,912

Credit Risk

The quality of our interest-bearing investments is generally good. The fixed income portfolio is invested 100% in investment grade securities, with the exception of one corporate security held with a market value of $0.4 million. For the year ended December 31, 2007, we incurred no impairment charges for other than temporarily impaired fixed-income securities.

Municipal Bond Holding Exposure

The overall credit quality, based on weighted average Standard & Poor’s (S&P) ratings or equivalent when the S&P rating is not available, of our $144.0 million municipal fixed income portfolio is:


	•	“AAA” including insurance enhancement

	•	“AA” excluding insurance enhancement


	•	99% of the underlying ratings are “A−” or better

	•	80% of the underlying ratings are “AA−” or better

The municipal fixed income portfolio with insurance enhancement represents $103.2 million, or 72% of the total municipal fixed income portfolio.


	•	The average credit quality with insurance enhancement is “AAA”

	•	The average credit quality without insurance enhancement is “AA”

	•	Each municipal fixed income investment is evaluated based on its underlying credit fundamentals, irrespective of credit enhancement provided by bond insurers

The municipal fixed income portfolio without insurance enhancement represents $40.8 million, or 28% of the total municipal fixed income portfolio.


	•	Average credit quality is “AAA−”

The following represents the Group’s municipal fixed income portfolio as of December 31, 2007:


	Average Credit		Market		% of Total			Unrealized
	Rating		Value		Muni			Gain
	(Dollars in thousands)

Uninsured Securities		AAA−	$	40,855		28	%	$	294
Securities with Insurance Enhancement*		AAA		103,171		72	%		859
Without Insurance Enhancement		AA−

Total				144,026		100	%		1,153


	Market
Credit Enhancement	Value		% of Total
	(Dollars in thousands)

AMBAC		11,317		8	%
FGIC		32,149		22	%
FSA		31,268		22	%
MBIA		28,436		20	%
No Enhancement		33,941		24	%
Other Enhancement		6,915		5	%

Grand Total		144,026		100	%

The following represents the Group’s ratings on the municipal fixed income portfolio as of December 31, 2007:


																Total Municipal					Total Municipal
																Fixed Income					Fixed Income
											Underlying Rating					Portfolio					Portfolio
						Insurance					of Insurance					(with Insurance					(without Insurance
	Uninsured					Enhanced					Enhanced					Enhancement)					Enhancement)
S&P or	Securities(1)					Securities(2)					Securities(3)					(1) + (2)					(1) + (3)
equivalent	Market		% of			Market		% of			Market		% of			Market		% of			Market		% of
ratings	Value		Total			Value		Total			Value		Total			Value		Total			Value		Total
	(Dollars in thousands)

AAA	$	22,416		55	%	$	103,171		100	%	$	9,225		9	%	$	125,587		87	%	$	31,640		22	%
AA+		6,045		15	%							21,847		21	%		6,045		4	%		27,891		19	%
AA		11,345		28	%							29,772		29	%		11,345		8	%		41,117		29	%
AA−		1,049		3	%							21,472		21	%		1,049		1	%		22,521		16	%
A+												8,732		8	%							8,732		6	%
A												7,994		8	%							7,994		6	%
A−												3,049		3	%							3,049		2	%
BBB−												1,081		1	%							1,081		1	%

Total	$	40,855		100	%	$	103,171		100	%	$	103,171		100	%	$	144,026		100	%	$	144,026		100	%

Average Rating		AAA−					AAA					AA					AAA					AA

Structured Product Exposure

The Group’s structured product exposure includes commercial mortgage backed securities (CMBS), residential mortgage backed securities (MBS) and asset backed securities (ABS). The total book value, as of December 31, 2007, was $87.4 million and represented 27% of the total fixed income portfolio.

As of December 31, 2007, CMBS holdings totaled $10.0 million (book value), representing 11% of the total structured product holdings. All CMBS securities are rated Aaa/AAA by either Moody’s, S&P, or Fitch.

As of December 31, 2007, MBS holdings totaled $61.0 million (book value), representing 70% of the total structured product holdings. The MBS securities consist of both pass-through and collateralized mortgage obligation (CMO) structures. The pass-throughs are all agency sponsored securities and have a Aaa/AAA rating. Among the CMO’s, a majority are agency sponsored and as a result, also have a Aaa/AAA rating. The non-agency backed securities represent 20% of the CMO holdings and 8% of total MBS holdings; five of six of such securities have a Aaa/AAA rating by Moody’s or S&P and one security is rated A by S&P.

As of December 31, 2007, ABS holdings totaled $16.4 million (book value), representing 19% of the total structured product holdings . The ABS securities consist of a diversified blend of subsectors including, automobile loan and credit card receivables, equipment financing, home equity, rate reduction bonds, among other ABS. Outside of a single holding of $500,000 par of home equity (sub-prime), all ABS securities are rated Aaa/AAA by Moody’s and S&P.

The ABS home equity subsector (holding sub-prime home equity loans) totaled $1.7 million (book value) on December 31, 2007, representing 10.4% of the ABS holdings and 2.0% of the total structured product holdings. This subsector exposure consists of five individual securities, of which two have a 100% credit enhancement. In the case that the monoline insurance companies were to be downgraded, the ratings on the ABS securities would receive the equivalent rating. Among the three securities without credit enhancement, two are rated Aaa/AAA and one is rated Aa2/AA by Moody’s and S&P.

There are two sectors where the Group has indirect exposure to subprime securities. These are the U.S. Agency and investment grade corporate sectors. As of December 31, 2007, The Group held $21.1 million (book value) of agency debt, consisting predominately of Freddie Mac and Fannie Mae.

The second sector of the market in which the Group has indirect exposure to subprime securities is the investment grade corporate market. As of December 31, 2007 the Group’s portfolio held $65.1 million (book value) of corporate bonds. Of these holdings, $6.0 million were in the banking sector, $3.8 million were in the brokerage sector, and $2.8 million were in the finance sector. The banking, brokerage, and finance sectors of the investment grade corporate market continue to face stresses and challenges. Although these issuers will continue to need to strengthen their reserves and write-off bad debts which will impact their earnings, it is expected that these issuers will continue to pay principal and interest when due.

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. Portfolio characteristics are analyzed regularly and market risk is actively managed through a variety of techniques. In accordance with accounting principles generally accepted in the United States of America, when an equity security becomes other than temporarily impaired, we record this impairment as a charge against earnings. For the year ended December 31, 2007, we recorded a pre-tax charge to earnings of $138,000 for write-downs of other than temporarily impaired equity securities.

Group and industry concentrations are monitored by the Board of Directors. At December 31, 2007, our equity portfolio made up 5.2% of the Group’s total investment portfolio. At December 31, 2007, the top ten equity holdings represented $7.5 million or 41.8% of the equity portfolio. Investments in the financial sector represented 33.5% while investments in pharmaceutical companies, retail specialty companies, energy companies and information technology companies represented 7.7%, 6.0%, 9.0% and 10.7%, respectively, of the equity portfolio at December 31, 2007. The table below summarizes the Group’s equity price risk and shows the effect of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 2007. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios.


		Estimated Fair		Hypothetical
Estimated Fair		Value After		Percentage Increase
Value of Equity		Hypothetical		(Decrease) in
Securities at	Hypothetical	Change in		Stockholders’
12/31/07	Price Change	Prices		Equity(1)
(Dollars in thousands)

$17,930	20% increase	$	21,516		1.7	%
$17,930	20% decrease	$	14,344		(1.7	)%


(1)		Net of tax


ITEM 8.	*FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.*

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Mercer Insurance Group, Inc. and Subsidiaries:

We have audited the accompanying consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

The Company adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payment, effective January 1, 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercer Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 17, 2008, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ KPMG LLP

Philadelphia, Pennsylvania

March 17, 2008

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Consolidated Balance Sheets
December 31, 2007 and 2006


	2007			2006
	(Dollars in thousands, except share amounts)

ASSETS
Investments, at fair value:
Fixed-income securities, available for sale, at fair value (cost $321,978 and $274,769, respectively)	$	324,238			273,454
Equity securities, at fair value (cost $12,500 and $10,940, respectively)		17,930			16,522
Short-term investments, at cost, which approximates fair value		—			7,692

Total investments		342,168			297,668
Cash and cash equivalents		21,580			17,618
Premiums receivable		36,339			38,030
Reinsurance receivables		83,844			87,987
Prepaid reinsurance premiums		9,486			16,383
Deferred policy acquisition costs		20,528			16,708
Accrued investment income		3,582			3,204
Property and equipment, net		13,056			11,936
Deferred income taxes		7,670			7,775
Goodwill		5,416			5,625
Other assets		2,766			4,033

Total assets	$	546,435			506,967

LIABILITIES AND EQUITY
Liabilities:
Losses and loss adjustment expenses	$	274,399			250,455
Unearned premiums		88,024			81,930
Accounts payable and accrued expenses		14,622			13,442
Other reinsurance balances		14,734			24,588
Trust preferred securities		15,559			15,542
Advances under line of credit		3,000			3,000
Other liabilities		2,691			2,171

Total liabilities		413,029			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 7,075,333 shares and 7,064,233 shares, outstanding 6,717,693 and 6,582,232 shares		—			—
Additional paid-in capital		70,394			68,473
Accumulated other comprehensive income		4,896			2,815
Retained Earnings		67,613			54,629
Unearned ESOP shares		(3,131	)		(3,757	)
Treasury stock, 505,814 and 503,513 shares		(6,366	)		(6,321	)

Total stockholders’ equity		133,406			115,839

Total liabilities and stockholders’ equity	$	546,435			506,967

See accompanying notes to consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings
Years ended December 31, 2007, 2006 and 2005


	2007		2006		2005
	(Dollars in thousands, except per share data)

Revenue:
Net premiums earned	$	146,675		137,673		74,760
Investment income, net of expenses		13,053		10,070		4,467
Net realized investment gains		24		151		1,267
Other revenue		1,929		2,035		772

Total revenue		161,681		149,929		81,266

Expenses:
Losses and loss adjustment expenses		91,186		87,697		43,384
Amortization of deferred policy acquisition costs (related party amounts of $1,141, $1,212 and $1,256, respectively)		38,763		32,694		16,849
Other expenses		10,528		13,242		10,766
Interest expense		1,215		1,212		306

Total expenses		141,692		134,845		71,305
Income before income taxes		19,989		15,084		9,961
Income taxes		5,754		4,449		2,941

Net income	$	14,235		10,635		7,020

Net income per common share:
Basic	$	2.32		1.77		1.18
Diluted	$	2.25		1.71		1.14

See accompanying notes to consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity
Years ended December 31, 2007, 2006 and 2005


								Accumulated						Unearned
					Additional			other						restricted			Unearned
	Preferred		Common		paid-in			comprehensive			Retained			stock			ESOP			Treasury
	stock		stock		capital			income			earnings			compensation			shares			stock			Total
	(Dollars in thousands)

Balance, December 31, 2004	$	—		—		67,651			5,186			37,876			(2,242	)		(5,009	)		(3,054	)		100,408
Net income												7,020												7,020
Unrealized losses on securities:
Unrealized holding losses arising during period, net of related income tax benefit of $772									(1,499	)														(1,499	)
Less reclassification adjustment for gains included in net income, net of related income tax expense of $431									(836	)														(836	)

Other comprehensive loss																								(2,335	)

Comprehensive income																								4,685

Forfeiture of restricted stock grant						(92	)								92
Unearned restricted stock compensation						197									(197	)
Amortization of restricted stock compensation															693									693
Tax benefit from stock compensation plan						11																		11
ESOP shares committed						206												626						832
Treasury stock purchased																					(3,230	)		(3,230	)

Balance, December 31, 2005	$	—		—		67,973			2,851			44,896			(1,654	)		(4,383	)		(6,284	)		103,399
Net income												10,635												10,635
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax expense of $62									120															120
Less reclassification adjustment for gains included in net income, net of related income tax expense of $80									(156	)														(156	)

Other comprehensive loss																								(36	)

Comprehensive income																								10,599

Reclassification of unearned restricted stock compensation						(1,654	)								1,654									—
Stock compensation plan amortization						1,398																		1,398
Tax benefit from stock compensation plan						129																		129
ESOP shares committed						627												626						1,253
Treasury stock purchased																					(37	)		(37	)
Dividends to shareholders												(902	)											(902	)

Balance, December 31, 2006	$	—		—		68,473			2,815			54,629			—			(3,757	)		(6,321	)		115,839

Net income												14,235												14,235
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax benefit of $1,436									2,787															2,787
Less reclassification adjustment for gains included in net income, net of related income tax benefit of $271									(527	)														(527	)
Defined benefit pension plan, net of related income tax benefit of $92									(179	)														(179	)

Other comprehensive income																								2,081

Comprehensive income																								16,316

Stock compensation plan amortization						1,043																		1,043
Tax benefit from stock compensation plan						153																		153
ESOP shares committed						549												626						1,175
Treasury stock purchased																					(45	)		(45	)
Issuance of common stock						176																		176
Dividends to shareholders												(1,251	)											(1,251	)

Balance, December 31, 2007	$	—		—		70,394			4,896			67,613			—			(3,131	)		(6,366	)		133,406

See accompanying notes to consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
Years ended December 31, 2007, 2006 and 2005


	2007			2006			2005
	(Dollars in thousands)

Cash flows from operating activities:
Net income	$	14,235			10,635			7,020
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of fixed assets		2,135			2,587			1,895
Net amortization of premium		1,272			1,039			592
Amortization of restricted stock compensation		1,043			1,398			704
ESOP share commitment		1,175			1,253			832
Net realized investment gains		(24	)		(151	)		(1,267	)
Deferred income tax		(967	)		(4,168	)		380
Change in assets and liabilities:
Premiums receivable		1,691			(533	)		4,408
Reinsurance receivables		4,143			(8,773	)		(3,155	)
Prepaid reinsurance premiums		6,897			5,171			1,301
Deferred policy acquisition costs		(3,820	)		(5,919	)		(2,775	)
Other assets		319			388			(1,759	)
Losses and loss adjustment expenses		23,944			38,776			10,232
Unearned premiums		6,094			2,948			(795	)
Other reinsurance balances		(9,854	)		6,014			(3,319	)
Other		897			6			(927	)

Net cash provided by operating activities		49,180			50,671			13,367

Cash flows from investing activities:
Purchase of fixed income securities, available for sale		(84,083	)		(193,614	)		(35,054	)
Purchase of equity securities		(3,632	)		(5,543	)		(1,012	)
Sale (purchase) of short-term investments, net		7,692			(3,403	)		(4,289	)
Sale and maturity of fixed income securities, available for sale		35,602			148,593			56,228
Sale of equity securities		3,425			3,844			10,309
Purchase of subsidiary, net of cash acquired		—			—			(30,276	)
Purchase of property and equipment, net		(3,255	)		(2,797	)		(1,655	)

Net cash used in investing activities		(44,251	)		(52,920	)		(5,749	)

Cash flows from financing activities:
Purchase of treasury stock		(45	)		(37	)		(3,230	)
Tax benefit from stock compensation plans		153			129			—
Proceeds from issuance of common stock		176			—			—
Dividends to shareholders		(1,251	)		(902	)		—

Net cash used in financing activities		(967	)		(810	)		(3,230	)

Net increase (decrease) in cash and cash equivalents		3,962			(3,059	)		4,388
Cash and cash equivalents at beginning of year		17,618			20,677			16,289

Cash and cash equivalents at end of year	$	21,580			17,618			20,677

Cash paid during the year for:
Interest	$	1,163			1,222			353
Income taxes	$	5,900			7,745			3,550

See accompanying notes to consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)


(1)	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


*(a)*	*Description of Business*

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 (see note 18).

The companies in the Group are operated under common management. The Group’s operating subsidiaries are licensed collectively in twenty two states, but are currently focused on doing business in seven states; Arizona, California, Nevada, New Jersey, New York, Oregon and Pennsylvania. MIC and MICNJ recently became licensed to write property and casualty insurance in New York. FPIC holds an additional fifteen state licenses outside of the Group’s current focus area. Currently, only direct mail surety is being written in some of these states.

The Group’s business activities are separated into three operating segments, which are commercial lines of insurance, personal lines of insurance and the investment function. The commercial lines of business consist primarily of multi-peril and commercial auto coverage. These two commercial lines represented 64% and 17%, respectively, of the Group’s net premiums written in 2007 and 61% and 14%, respectively, of the Group’s net premiums written in 2006. The personal lines business consists primarily of homeowners insurance in Pennsylvania and New Jersey and private passenger automobile insurance in Pennsylvania. These two personal lines represented 8% and 4%, respectively, of the Group’s net written premiums in 2007 and 10% and 4%, respectively, of the Group’s net written premiums in 2006.


*(b)*	*Consolidation Policy and Basis of Presentation*

The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities, and include the accounts of each member of the Group since the date of acquisition. The insurance subsidiaries 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. FPIC joined the Pool effective January 1, 2006, after receiving regulatory approvals. Each insurer’s share in the Pool is based on their respective statutory surplus as of the beginning of each year. The effects of the Pool as well as all other significant intercompany accounts and transactions have been eliminated in consolidation.


*(c)*	*Use of Estimates*

The preparation of the accompanying financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates include liabilities for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance, deferred income tax assets and investment valuation and assessment of other than temporary impairment of investments. Actual results could differ from those estimates.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


*(d)*	*Concentration of Risk*

The Group’s business is subject to concentration risk with respect to geographic concentration. Although the Group’s operating subsidiaries are licensed collectively in twenty two states, direct premiums written for three states, California, New Jersey and Pennsylvania, constituted 55%, 27% and 7% of the 2007 direct premium written, 53%, 28% and 8% of the 2006 direct premium written, and 25%, 54%, and 16% of the 2005 direct premium written. Consequently, changes in the California, New Jersey or Pennsylvania legal, regulatory or economic environment could adversely affect the Group.

For the year ending December 31, 2007 and 2006, there were no agents in the Group that individually produced greater than 5% of the Group’s direct written premiums. For the year ending December 31, 2005, approximately 17% of the Group’s direct premiums written were produced by two agents, including one who is a related party (see Note 16 for information about related party transactions).


*(e)*	*Investments*

Due to periodic shifts in the portfolio arising from income tax planning strategies and asset-liability matching, as well as the need to be flexible in responding to changes in the securities markets and economic factors, management considers the entire portfolio of fixed-income securities as available for sale. Fixed-income securities available for sale are stated at fair value. Equity securities are carried at fair value. 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 accumulated other comprehensive income and, accordingly, have no effect on net income.

Interest on fixed-income securities is credited to income as it accrues on the principal amounts outstanding, adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method. Premiums and discounts on mortgage-backed securities are amortized/accreted using anticipated prepayments with changes in anticipated prepayments, which are evaluated semi-annually, accounted for prospectively. The model used to determine anticipated prepayment assumptions for mortgage-backed securities uses separate home sale, refinancing, curtailment, and full pay-off components, derived from a variety of industry sources as used by the Group’s fixed income securities manager.

Realized gains and losses are determined on the specific identification basis. When the fair value of any investment is lower than its cost, an assessment is made to determine if the decline is other than temporary. If the decline is deemed to be other than temporary, the investment is written down to fair value and the amount of the write-down is charged to income as a realized loss. The fair value of the investment becomes its new cost basis.


*(f)*	*Cash and Cash Equivalents and Short-term Investments*

Cash and cash equivalents, and short-term investments are carried at cost which approximates fair value. The Group considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.

Cash and cash equivalents as of December 31, 2007 and 2006 include restricted cash of $506 and $683, respectively, consisting of funds held for surety bonds.


*(g)*	*Fair Values of Financial Instruments*

The Group has used the following methods and assumptions in estimating its fair values:

Investments — The fair values for fixed-income securities available for sale are based on quoted market prices, when available. If not available, fair values are based on values obtained from investment brokers. Fair values for marketable equity securities are based on quoted market prices.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The fair value of an equity security the Group holds in a reinsurance company is based on the estimated selling price of the company based on current offers, which is lower than statutory book value. After receipt of a bona fide offer to purchase this security, the stock must first be offered to the investors or its other shareholders at the lower of statutory book value or the offered price. The investors also have the ability to determine that the potential purchaser is not appropriate and void such an offer. The carrying value of this investment was $776 and $938 at December 31, 2007 and 2006, respectively.

Cash and cash equivalents, and short-term investments — The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values.

Premium and reinsurance receivables — The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values.

Trust preferred securities and line of credit obligations — The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair values.

Interest rate swaps — The estimated fair value of the interest rate swaps is based on valuations received from the financial institution counterparties.


*(h)*	*Reinsurance*

The Group cedes insurance to, and assumes insurance from, unrelated insurers to limit its maximum loss exposure through risk diversification. Ceded reinsurance receivables and unearned premiums are reported as assets; loss and loss adjustment expense reserves are reported gross of ceded reinsurance credits, unless the reinsurance contract includes a right of offset. Premiums receivable is recorded gross of ceded premiums payable. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information.


*(i)*	*Deferred Policy Acquisition Costs*

Acquisition costs such as commissions, premium taxes, and certain other expenses which vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated net realizable value, which gives effect to premiums to be earned, anticipated investment income, loss and loss adjustment expenses, and certain other maintenance costs expected to be incurred as the premiums are earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premium.

(j) Property and Equipment

Property and equipment are carried at cost less accumulated depreciation calculated on the straight-line basis. Property is depreciated over useful lives generally ranging from five to forty years. Equipment is depreciated over three to ten years.

The Group applies the provisions of Statement of Position (SOP) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” to account for internally developed computer software costs. In accordance with SOP 98-1, the Group has capitalized $2,499, $942 and $939 in software development costs, respectively, in 2007, 2006 and 2005. Amortization expense of $648 and $641, respectively, was recorded in 2007 and 2006. The unamortized balance was $3,973 and $2,122 at December 31, 2007 and 2006, respectively. These costs are amortized over their useful lives, ranging from three to five years, from the dates the systems technology becomes operational.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The carrying value of property and equipment is reviewed for recoverability including an evaluation of the estimated useful lives of such assets. Impairment is recognized only if the carrying amount of the property and equipment is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset. A change in the estimated useful lives of such assets is treated as a change in estimate and is accounted for prospectively.

Upon disposal of assets, the cost and related accumulated depreciation is removed from the accounts and the resulting gain or loss is included in income.


*(k)*	*Premium Revenue*

Premiums include direct writings plus reinsurance assumed less reinsurance ceded to other insurers and are recognized as revenue over the period that coverage is provided using the daily pro-rata method. Audit premiums and premium adjustments are recorded when they are considered probable and adequate information exists to estimate the premium. Unearned premiums represent that portion of direct premiums written that are applicable to the unexpired terms of policies in force and is reported as a liability. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers and is reported as an asset. Premiums receivable are reported net of an allowance for estimated uncollectible premium amounts. Revenue related to service fees is earned over the installment period. Agency commission and related fees are recognized based on the policy issue date.


*(l)*	*Losses and Loss Adjustment Expenses*

The liability for losses includes the amount of claims which have been reported to the Group and are unpaid at the statement date as well as provision for claims incurred but not reported, after deducting anticipated salvage and subrogation. The liability for loss adjustment expenses is determined as a percentage of the liability for losses based on the historical ratio of paid adjustment expenses to paid losses by line of business.

Estimates of liabilities for losses and loss adjustment are necessarily based on estimates, and the amount of losses and loss adjustment expenses ultimately paid may be more or less than such estimates. Changes in the estimates for losses and loss adjustment expenses are recognized in the period in which they are determined.


*(m)*	*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, vest over a period of three or five years, and are outstanding for 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 to five years.

Prior to January 1, 2006, the Group accounted for this plan under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”. Under the principles of APB 25, as permitted by SFAS No. 123, stock-based compensation was recognized for grants of restricted stock in the consolidated statement of earnings for the year ended December 31, 2005, but not for grants of stock options because options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Group adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment”, using the modified-prospective-transition method. Consolidated statement of earnings for prior periods have not been retrospectively adjusted for SFAS No. 123R.

The Group adopted SFAS No. 123R on January 1, 2006 with no impact upon adoption. The compensation expense recorded (after tax benefit) in the consolidated statements of earnings for stock options (net of forfeitures) for the years ended December 31, 2007 and 2006 was $439 and $555, respectively. The compensation expense recorded (after tax benefit) in the consolidated statements of earnings for restricted stock (net of forfeitures) for the years ended December 31, 2007 and 2006 was $336 and $442, respectively. There would have been no charge to

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

earnings for stock option grants if the Group had continued to account for stock-based compensation under APB 25 for unvested stock options. SFAS No. 123R also eliminated the presentation of the contra-equity account “Unearned restricted stock compensation,” resulting in a reclass of $1,654 to Additional paid-in capital upon adoption.

As of December 31, 2007, the Group has $1.0 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 2.1 years.

The following table shows the pro-forma effect on the consolidated statement of earnings and earnings per share as if the Group had applied SFAS No. 123 to stock options granted under its plan prior to the adoption of SFAS No. 123R on January 1, 2006.


	Year Ended
	December 31,
	2005

Net income, as reported		7,020
Plus: Share-based compensation expense included in reported net income, net of related tax effects		457
Less: Total share-based compensation expense determined under fair value based method for all awards, net of related tax effects		(995	)
Pro forma net income		6,482
Basic earnings per share:
As reported		1.18
Pro forma		1.09
Diluted earnings per share:
As reported		1.14
Pro forma		1.05


*(n)*	*Income Taxes*

The Group uses the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of the Group’s assets and liabilities and operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. 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.


*(o)*	*Goodwill and Intangible Assets*

Goodwill is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Group determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, “Business Combinations”. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Group has two reporting units with goodwill as of December 31, 2007 and 2006. The Group performed the annual impairment tests as of December 31, 2007 and 2006, and the results indicated that the fair value of the reporting units exceeded their carrying amounts.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

Intangible assets held by the Group have definite lives and the value is amortized on a straight-line basis over their useful lives, ranging from eight to fourteen years. The carrying amount of these intangible assets are regularly reviewed for indicators of impairments in value. Impairment is recognized only if the carrying amount of the intangible asset is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset.


*(p)*	*Derivative Instruments and Hedging Activities*

The Group entered into four interest rate swap agreements to hedge against interest rate risk on its floating rate Trust preferred securities. Interest rate swaps are contracts to convert, for a period of time, the floating rate of the Trust preferred securities into a fixed rate without exchanging the instruments themselves.

The Group accounts for its interest rate swaps in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities”. The Group has designated the interest rate swaps as non-hedge instruments. Accordingly, the Group recognizes the fair value of the interest rate swaps as assets or liabilities on the consolidated balance sheets with the changes in fair value recognized in the consolidated statement of earnings. The estimated fair value of the interest rate swaps is based on valuations received from the financial institution counterparties.


*(q)*	*Earnings per Share*

Earnings per share (EPS) is computed in accordance with SFAS No. 128, “Earnings per Share”. Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of Diluted EPS reflects the effect of potentially dilutive securities.


*(r)*	*Recent Accounting Pronouncements*

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

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.


*(s)*	*Reclassifications*

Reclassifications have been made in the 2006 and 2005 financial statements and notes to conform them to the presentation of the 2007 financial statements.


(2)	INVESTMENTS

Net investment income, net realized investment gains (losses), and change in unrealized gains (losses) on investment securities are as follows.

Net investment income and net realized investment gains (losses):


	2007			2006			2005

Investment income:
Fixed income securities	$	13,356			11,044			5,195
Equity securities		319			514			559
Cash and equivalents		613			614			636
Other		829			245			112

Gross investment income		15,117			12,417			6,502
Less investment expenses		2,064			2,347			2,035

Net investment income		13,053			10,070			4,467

Net realized gains (losses):
Fixed income securities		—			(402	)		(608	)
Equity securities, net		798			638			1,751
Mark-to-market valuation for interest rate swaps		(774	)		(94	)		122
Other		—			9			2

Net realized investment gains		24			151			1,267

Net investment income and net realized investment gains	$	13,077			10,221			5,734

Investment expenses include salaries, advisory fees and other miscellaneous expenses attributable to the maintenance of investment activities.

The changes in unrealized (losses) gains of securities are as follows:


	2007			2006			2005

Fixed-income securities	$	3,575			747			(1,617	)
Equity securities		(152	)		(800	)		(1,920	)

	$	3,423			(53	)		(3,537	)

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The cost and estimated market value of available-for-sale fixed-income and equity investment securities at December 31, 2007 and 2006 are shown below.


			Gross		Gross		Estimated
			Unrealized		Unrealized		Fair
	Cost(1)		Gains		Losses		Value

2007
Fixed-income securities, available for sale:
U.S. government and government agencies(2)	$	83,016		814		115		83,715
Obligations of states and political subdivisions		142,873		1,230		77		144,026
Industrial and miscellaneous		65,109		552		453		65,208
Mortgage-backed securities		30,980		412		103		31,289

Total fixed maturities		321,978		3,008		748		324,238

Equity securities:
At estimated market value		12,500		5,726		296		17,930

Total	$	334,478		8,734		1,044		342,168


			Gross		Gross		Estimated
			Unrealized		Unrealized		Fair
	Cost(1)		Gains		Losses		Value

2006
Fixed-income securities, available for sale:
U.S. government and government agencies	$	75,683		191		893		74,981
Obligations of states and political subdivisions		116,361		579		642		116,298
Industrial and miscellaneous		53,298		203		784		52,717
Mortgage-backed securities		29,427		214		183		29,458

Total fixed maturities		274,769		1,187		2,502		273,454

Equity securities:
At estimated market value		10,940		5,682		100		16,522

Total	$	285,709		6,869		2,602		289,976


(1)		Original cost of equity securities; original cost of fixed-income securities adjusted for amortization of premium and accretion of discount.

(2)		Includes approximately $56,142 and $48,840 (cost) and $56,637 and $48,548 (estimated fair value) of mortgage-backed securities backed by the U.S. government and government agencies as of December 31, 2007 and 2006, respectively.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The estimated market value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2007 are as follows:


	Less than 12 Months				12 Months or Longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	6,242	$	24	$	12,089	$	91	$	18,331	$	115
Obligations of states and political		—		—		—		—
subdivisions		4,535		9		12,386		68		16,921		77
Corporate securities		5,586		108		22,842		345		28,428		453
Mortgage-backed securities		484		16		7,679		87		8,163		103

Total fixed maturities		16,847		157		54,996		591		71,843		748

Total equity securities		4,155		276		84		20		4,239		296

Total securities in a temporary unrealized loss position	$	21,002	$	433	$	55,080	$	611	$	76,082	$	1,044

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The estimated market value and unrealized loss for securities in a temporary unrealized loss position as of December 31, 2006 are as follows:


	Less than 12 Months				12 Months or Longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	4,834	$	24	$	50,353	$	869	$	55,187	$	893
Obligations of states and political subdivisions		24,948		90		40,918		552		65,866		642
Corporate securities		4,211		17		41,850		767		46,061		784
Mortgage-backed securities		4,481		24		13,266		159		17,747		183

Total fixed maturities		38,474		155		146,387		2,347		184,861		2,502

Total equity securities		1,991		100		—		—		1,991		100

Total securities in a temporary unrealized loss position	$	40,465	$	255	$	146,387	$	2,347	$	186,852	$	2,602

The amortized cost and estimated fair value of fixed-income securities at December 31, 2007, by contractual maturity, are shown below (note that mortgage-backed securities in the below table include securities backed by the U.S. government and agencies). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.


	Amortized		Estimated
	Cost		Fair Value

Due in one year or less	$	13,210		13,217
Due after one year through five years		83,197		83,572
Due after five years through ten years		88,870		89,551
Due after ten years		49,579		49,972

		234,856		236,312
Mortgage-backed securities		87,122		87,926

	$	321,978		324,238

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The gross realized gains and losses on investment securities are as follows:


	2007			2006			2005

Gross realized gains	$	1,032			1,023			2,386
Gross realized losses		(1,008	)		(872	)		(1,119	)

	$	24			151			1,267

The gross realized investment losses included write-downs for the other than temporary impairment of securities totaling $138, $121 and $517 for the years ended 2007, 2006 and 2005, respectively.

Proceeds from the sales of securities were $39,027, $152,438 and $66,537 in 2007, 2006, and 2005, respectively.

Accumulated other comprehensive income was net of deferred income taxes of $2,615 and $1,451 applicable to net unrealized investment gains at December 31, 2007 and 2006, respectively.

The amortized cost of invested securities on deposit with regulatory authorities at December 31, 2007 and 2006 was $4,913 and $4,954, respectively.


(3)	DEFERRED POLICY ACQUISITION COSTS

Changes in deferred policy acquisition costs are as follows:


	2007			2006			2005

Balance, January 1	$	16,708			10,789			8,014
Acquisition costs deferred		42,583			38,613			19,624
Amortization charged to earnings		(38,763	)		(32,694	)		(16,849	)

Balance, December 31	$	20,528			16,708			10,789


(4)	PROPERTY AND EQUIPMENT

Property and equipment was as follows:


	2007			2006

Property and equipment:
Land	$	1,720			1,720
Buildings and improvements		7,607			7,607
Furniture, fixtures, and equipment		15,556			12,850

		24,883			22,177
Accumulated depreciation		(11,827	)		(10,241	)

	$	13,056			11,936

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(5)	LIABILITIES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

Activity in the liabilities for losses and loss adjustment expenses is summarized as follows:


	2007			2006			2005

Balance at January 1	$	250,455			211,679			36,028
Less reinsurance recoverable on unpaid losses and loss expenses		(85,933	)		(78,744	)		(3,063	)

Net balance, January 1		164,522			132,935			32,965
Reserves acquired in subsidiary acquisition, net		—			—			91,894

Net balance, as adjusted		164,522			132,935			124,859
Incurred related to:
Current year		83,015			79,275			43,921
Prior years		8,171			8,422			(537	)

Total incurred		91,186			87,697			43,384

Paid related to:
Current year		22,589			23,284			20,729
Prior years		41,102			32,826			14,579

Total paid		63,691			56,110			35,308

Net balance, December 31		192,017			164,522			132,935
Plus reinsurance recoverable on unpaid losses and loss expenses		82,382			85,933			78,744

Balance at December 31	$	274,399			250,455			211,679


				Year Ended December 31,
										2004
	Total			2006			2005			and Prior
				(In thousands)

Commercial multi-peril	$	5,911		$	(1,792	)	$	7,655		$	48
Commercial automobile		(2,504	)		(1,786	)		(749	)		31
Other liability		4,388			1,068			1,155			2,165
Workers’ compensation		(787	)		153			(184	)		(756	)
Homeowners		1,220			377			270			573
Personal automobile		101			(197	)		212			86
Other lines		(158	)		(33	)		27			(152	)

Net prior year development	$	8,171		$	(2,210	)	$	8,386		$	1,995

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

Commercial multi-peril

Commercial automobile

Other liability

With $12.4 million of recorded reserves, net of reinsurance, at December 31, 2007, other liability is the Group’s third largest reserved line of business, representing 6% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2007. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the other liability line of business increased by $4.4 million in 2007. The development of net ultimate losses on the other liability line of business was primarily the result of increased loss reserves and outside litigation expenses on larger East coast claims that are in the process of settlement.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The following table presents the increase (decrease) in the liability for unpaid losses and loss adjustment expenses attributable to insured events of prior years incurred in the year ended December 31, 2006 by line of business. Amounts shown in the 2005 column of the table include all 2005 and prior accident year development for FPIC, which was acquired on October 1, 2005, and accounted for as a purchase business combination.


	Year Ended December 31,
										2003
	Total			2005			2004			and Prior
				(In thousands)

Commercial multi-peril	$	9,618		$	7,941		$	334		$	1,343
Commercial automobile		(1,968	)		(2,085	)		29			88
Other liability		(292	)		(510	)		129			89
Workers’ compensation		525			50			1,021			(546	)
Homeowners		(55	)		204			810			(1,069	)
Personal automobile		571			57			217			297
Other lines		23			(132	)		(13	)		168

Net prior year development	$	8,422		$	5,525		$	2,527		$	370

A discussion of factors contributing to an increase (decrease) in the liability for unpaid losses and loss adjustment expenses for the Group’s two major lines of business, representing 81% of total carried loss and loss adjustment expenses at December 31, 2006, follows:

Commercial multi-peril

With $120.1 million of recorded reserves, net of reinsurance, at December 31, 2006, commercial multi-peril is the line of business that carries the largest net loss and loss adjustment expense reserves, representing 73% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2006. As a result of changes in estimates of insured events in prior years, the liabilities for prior year losses and loss adjustment expenses for the commercial multi-peril line of business increased by $9.6 million in 2006.

The strengthening of net loss and loss adjustment expense reserves in the commercial multi-peril line reflects refinement in the assumptions and techniques supporting the reserve estimates, primarily on the contractor liability book of business. Contractor liability claims, particularly construction defect claims, are long-tailed in nature and develop over a period of ten to twelve years, based on the related statute of limitations. The increase in the estimates of insured events of prior years relates primarily to a higher than expected level of claims being reported in 2006 for such prior years. Actuarial methods are used to predict future development which is assumed to follow an expected pattern that is supported by historical data and industry trends. This line of business and related reserving assumptions are inherently uncertain and several factors, including newly observed trends, taken into consideration in the actuarial analysis can cause volatility in the determination of net ultimate losses.

Commercial automobile

With $13.4 million of recorded reserves, net of reinsurance, at December 31, 2006, commercial automobile is the Group’s second largest reserved line of business, representing 8% of the Group’s total carried net loss and loss adjustment expense reserves at December 31, 2006. As a result of changes in estimates of insured events in prior years, the liabilities for losses and loss adjustment expenses for the commercial automobile line of business decreased by $2.0 million in 2006. The development of net ultimate losses on the commercial automobile line of business was better than expected in 2006, primarily as a result of a reduction in claims frequency and a lower than expected incurred. The Group’s expansion into heavy vehicle programs such as ready mix and aggregate haulers has not translated into the expected increased level of loss activity.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(6)	REINSURANCE

The Group has geographic exposure to catastrophe losses in its operating territories. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, explosion, severe weather, and fire. The incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas. However, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Group generally seeks to reduce its exposure to catastrophe through individual risk selection and the purchase of catastrophe reinsurance.

In the ordinary course of business, the Group seeks to limit its exposure to loss on individual claims and from the effects of catastrophes by entering into reinsurance contracts with other insurance companies. Reinsurance is ceded on excess of loss and pro-rata bases with the Group’s retention in 2007 not exceeding $750 per occurrence and in 2006 and 2005 not exceeding $500 per occurrence. Insurance ceded by the Group does not relieve it of its primary liability as the originating insurer.

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.

Prior to 2007, some of the Group’s reinsurance treaties (primarily FPIC treaties) included provisions that establish minimum and maximum cessions and allow limited participation in the profit of the ceded business. Generally, the Group shares on a limited basis in the profitability through contingent ceding commissions. Exposure to the loss experience is contractually defined at minimum and maximum levels, and the terms of such contracts are fixed at inception. Since estimating the emergence of claims to the applicable reinsurance layers is subject to significant uncertainty, the net amounts that will ultimately be realized may vary significantly from the estimated amounts presented in the Group’s results of operations.

Effective January 1, 2006, FPIC restructured its property reinsurance agreement covering the first $2,000 of loss from an 80% quota share to a $1,650 excess of $350 excess of loss contract to take advantage of the Group’s 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 and earned premium for the year ended December 31, 2006. There was no similar impact in 2007 relating to this restructuring.

During the third quarter of 2006, the Group commuted all reinsurance agreements with Alea North America Insurance Company (Alea). These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation, the Group received a cash payment of $4.5 million, and recorded a pre-tax net loss on commutation of $160.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The effect of reinsurance with unrelated insurers on premiums written and earned is as follows:


	2007			2006			2005

Premiums written:
Direct	$	182,907			185,745			92,240
Assumed		1,383			2,374			2,868
Ceded		(24,623	)		(42,328	)		(19,842	)

Net	$	159,667			145,791			75,266

Premiums earned:
Direct	$	176,395			182,633			93,205
Assumed		1,801			2,539			2,696
Ceded		(31,521	)		(47,499	)		(21,141	)

Net	$	146,675			137,673			74,760

The effect of reinsurance with unrelated insurers on unearned premiums as of December 31, 2007 and 2006 is as follows:


	2007		2006

Direct	$	87,487		80,976
Assumed		537		954

Gross	$	88,024		81,930

The effect of reinsurance with unrelated insurers on the liability for losses and loss adjustment expenses, and on losses and loss adjustment expenses incurred is as follows:


	2007		2006

Liabilities:
Direct	$	268,438		244,316
Assumed		5,961		6,139

Gross	$	274,399		250,455


	2007			2006			2005

Losses and loss expenses incurred:
Direct	$	107,141			115,995			48,856
Assumed		1,185			3,908			2,249
Ceded		(17,140	)		(32,206	)		(7,721	)

Net	$	91,186			87,697			43,384

The Group performs credit reviews of its reinsurers, focusing on financial stability. To the extent that a reinsurer may be unable to pay losses for which it is liable under the terms of a reinsurance agreement, the Group is exposed to the risk of continued liability for such losses.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(7)	RETIREMENT PLANS AND DEFERRED COMPENSATION PLAN

The Group maintains a 401(k) qualified retirement savings plan covering substantially all employees. Benefits are based on an employee’s annual compensation, with new employees participating after a six-month waiting period. The Group matches a percentage of each employees’ pre-tax contribution and also contributes an amount equal to 2% of each employee’s annual compensation. Deferral amounts in excess of the qualified plan limitations, as well as Group contributions on such compensation, are funded into nonqualified plans benefiting affected individuals. The cost for these benefits was $510, $469 and $177 for 2007, 2006 and 2005, respectively. In addition, the Group generally makes a discretionary contribution each year, based on Group profitability, to both the qualified 401(k) plan, and, where applicable, to the nonqualified plans. The cost for this portion of the retirement plan was $463, $389 and $201 for 2007, 2006 and 2005, respectively.

The Group sponsored the FPIG 401(k) Plan for employees of FPIG effective with the acquisition of FPIG on October 1, 2005 (see note 11). All employees of FPIC, as defined in the FPIG 401(k) Plan, who have completed six months of service were eligible for participation in the Plan. The Group matched 100% of the employee’s pre-tax contribution up to $2, on an annual basis. In the fourth quarter of 2005, the Group recognized a cost of $19 for the FPIG 401(k) Plan. Effective January 1, 2006, the FPIG 401(k) Plan was terminated and all eligible employees were rolled into the Group’s 401(k) Plan described in the preceding paragraph.

The Group has an unfunded noncontributory defined benefit plan for its directors. The plan provides for monthly payments for life upon retirement, with a minimum payment period of ten years. The net periodic benefit cost for this plan amounted to $166, $145, and $115 for 2007, 2006, and 2005 respectively. Assumptions used in estimating the projected benefit obligation of the plan are the discount rate (6.3% in 2007 and 6.0% in 2006) and retirement age (65). Benefit payments for the plan were $34 in 2007 and 2006. Costs accrued under this plan amounted to $1,301 and $897 at December 31, 2007 and 2006, respectively.

The Group also maintains nonqualified deferred compensation plans for its directors and officers. Under the plans, participants may elect to defer receipt of all or a portion of their fees or salary amounts, although there is no match by the Group. Amounts deferred by directors and officers, together with accumulated earnings, are distributed either as a lump sum or in installments over a period of not greater than ten years. Deferred compensation, including accumulated earnings, amounted to $1,438 and $1,222 at December 31, 2007 and 2006, respectively.

The Group has purchased Company-owned life insurance covering key individuals. The Group’s cost, net of increases in cash surrender value, for the Company-owned life insurance was $(208), $(23) and $16 for the years ended December 31, 2007, 2006 and 2005, respectively. The cash surrender value of the Company-owned life insurance totaled $1,548 and $1,003 at December 31, 2007 and 2006, respectively, and is included in other assets.

On December 15, 2003, MIG was formed from the conversion of Mercer Mutual Insurance Company from the mutual to the stock form of ownership (“the Conversion”). The Group established an Employee Stock Ownership Plan (ESOP) and issued 626,111 shares to the ESOP at the Conversion offering price. The ESOP signed a promissory note in the amount of $6,261 to purchase the shares, which is due in 10 equal annual installments with interest at 4%. Shares purchased are held in a suspense account for allocation among participating employees as the loan is repaid, and are allocated to participants based on compensation as described in the plan. During 2007, 2006 and 2005, 62,611 shares were allocated to employee participants. Compensation expense equal to the fair value of the shares allocated is recognized ratably over the period that the shares are committed to be allocated to the employees. In 2007, 2006 and 2005 the Group recognized compensation expense of $1,175, $1,253 and $832, respectively, related to the ESOP. As of December 31, 2007, the cost of the 313,056 shares issued to the ESOP but not yet allocated to its employee participants is classified within equity as unearned ESOP shares.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(8)	FEDERAL INCOME TAXES

The tax effect of temporary differences that give rise to the Group’s net deferred tax asset as of December 31 is as follows:


	2007		2006

Net loss reserve discounting	$	6,708		5,675
Net unearned premiums		5,397		4,483
Compensation and benefits		1,269		1,079
Market discount on investments		325		472
Contingent ceding commission payable		4,190		4,060
Impairment of investments		102		54
Other		432		444

Deferred tax assets		18,423		16,267

Deferred policy acquisition costs		6,980		5,681
Unrealized gain on investments		2,615		1,451
Depreciation		292		443
Other		866		917

Deferred tax liabilities		10,753		8,492

Net deferred tax asset	$	7,670		7,775

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management believes it is more likely than not the Group will realize the benefits of the deferred tax assets at December 31, 2007 and 2006.

Actual income tax expense differed from expected tax expense, computed by applying the United States federal corporate income tax rate of 34% to income before income taxes, as follows:


	2007			2006			2005

Expected tax expense	$	6,796			5,129			3,387
Tax-exempt interest		(1,392	)		(1,115	)		(424	)
Dividends received deduction		(65	)		(104	)		(112	)
Non-deductible ESOP expense		187			213			70
Non-deductible options expense		86			74			—
Graduated tax rate adjustment		190			245			—
Company-owned life insurance		(71	)		(8	)		5
Other		23			15			15

Income tax expense	$	5,754			4,449			2,941

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The components of the provision for income taxes are as follows:


	2007			2006			2005

Current	$	6,721			8,617			2,561
Deferred		(967	)		(4,168	)		380

Income tax expense	$	5,754			4,449			2,941

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 December 31, 2007, the Group has no 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. The tax years 2004 through 2007 were open for federal tax examination as of December 31, 2007.


(9)	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.

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.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:

Financial data by segment is as follows:


	2007		2006			2005

Revenues:
Net premiums earned:
Commercial lines	$	125,427	$	115,461		$	52,279
Personal lines		21,248		22,212			22,481

Total net premiums earned		146,675		137,673			74,760
Net investment income		13,053		10,070			4,467
Net realized investment gains		24		151			1,267
Other		1,929		2,035			772

Total revenues	$	161,681	$	149,929		$	81,266

Income before income taxes:
Underwriting income (loss):
Commercial lines	$	5,964	$	4,246		$	3,383
Personal lines		234		(60	)		431

Total underwriting income		6,198		4,186			3,814
Net investment income		13,053		10,070			4,467
Net realized investment gains		24		151			1,267
Other		714		677			413

Income before income taxes	$	19,989	$	15,084		$	9,961

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(10)	STATUTORY FINANCIAL INFORMATION

A reconciliation of the Group’s statutory net income and surplus to the Group’s net income and stockholders’ equity, under U.S. generally accepted accounting principles, is as follows:


	2007			2006			2005

Net income:
Statutory net income	$	12,280			8,173			8,899
Deferred policy acquisition costs		3,820			1,027			(785	)
Deferred federal income taxes		733			4,168			(380	)
Dividends from affiliates		(2,002	)		(1,501	)		—
Parent holding company loss		(1,226	)		(1,816	)		(747	)
Other		630			584			33

GAAP net income	$	14,235			10,635			7,020

Surplus:
Statutory surplus	$	122,688			114,863
Deferred policy acquisition costs		20,528			16,708
Deferred federal income taxes		(3,354	)		(2,344	)
Nonadmitted assets		6,518			4,811
Unrealized gain (loss) on fixed-income securities		2,260			(1,315	)
Holding company		(18,643	)		(18,988	)
Other		3,409			2,104

GAAP stockholders’ equity	$	133,406			115,839

The Group’s insurance companies are required to file statutory financial statements with various state insurance regulatory authorities. Statutory financial statements are prepared in accordance with accounting principles and practices prescribed or permitted by the various states of domicile. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Furthermore, the NAIC adopted the Codification of Statutory Accounting Principles effective January 1, 2001. The codified principles are intended to provide a comprehensive basis of accounting recognized and adhered to in the absence of conflict with, or silence of, state statutes and regulations. The effects of such do not affect financial statements prepared under U.S. generally accepted accounting principles.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

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, 2007, the amount available for payment of dividends from FPIC in 2008, without the prior approval, is approximately $6.0 million.

The NAIC has risk-based capital (RBC) requirements that require insurance companies to calculate and report information under a risk-based formula which measures statutory capital and surplus needs based on a regulatory definition of risk in a company’s mix of products and its balance sheet. All of the Group’s insurance subsidiaries have an RBC amount above the authorized control level RBC, as defined by the NAIC.

(11) ACQUISITIONS, GOODWILL AND INTANGIBLE ASSETS

On October 1, 2005, the Group acquired all of the outstanding common stock of FPIG for $41,107 in cash (including related transaction costs), and its results of operations have been included in the consolidated financial statements of the Group since that date (see note 1(a)). The acquisition was made through a merger whereby FPIG Acquisition Corp, a Delaware corporation wholly owned by the Group, merged with and into FPIG, which then became the surviving entity operating under the Certificate of Incorporation and Bylaws of FPIG Acquisition Corp. as a wholly owned subsidiary of the Group. Accordingly, this transaction has been accounted for as a purchase business combination by applying fair value estimates to the acquired assets, liabilities and commitments of FPIG as of October 1, 2005.

The acquisition was made to further the Group’s goal of achieving additional product and geographic diversity and expansion of its commercial lines book.

The purchase price was as follows:


Cash purchase price of FPIG	$	40,394
Transaction costs of acquisition		713

Purchase price	$	41,107

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

The purchase price has been allocated based on an estimate of the fair value of the assets acquired and liabilities assumed as of October 1, 2005, as follows:


	As of
	October 1, 2005

Investments	$	152,342
Cash and equivalents		10,831
Premiums receivable		30,688
Reinsurance receivables		73,525
Prepaid reinsurance premiums		21,282
Accrued investment income		1,646
Property and equipment		2,223
Intangible assets		484
Goodwill		960
Deferred income taxes		3,908
Other assets		1,606
Loss and loss adjustment expenses		(165,419	)
Unearned premium		(45,770	)
Other reinsurance balances		(21,032	)
Accounts payable, accrued expenses and other liabilities		(7,646	)
Advances under line of credit		(3,000	)
Trust preferred securities		(15,521	)

Allocated purchase price	$	41,107

The allocated purchase price calculated above results in an estimate of the fair value of assets acquired and liabilities assumed as of the merger date, as follows:


	As of October 1,
	2005

Assets acquired	$	299,495
Liabilities assumed, including debt obligations of $18,521		(258,388	)

Allocated purchase price	$	41,107

Intangible assets acquired:


			Approximate
	Amount Assigned as of		Weighted-Average
	October 1, 2005		Amortization Period

Amortizable intangible asset acquired:
Agency Force(a)	$	374		8 years
Favorable lease(b)		110		14 years

		484		9.4 years

Non-amortizable intangible asset acquired:
Goodwill		960		N/A

		960

Total	$	1,444


(a)		Represents the value of the agency force through which FPIC products are sold.

(b)		Represents the value of the below-market favorable lease terms associated with the building leased by FPIC

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

Intangible assets consist of the following:


	2007			2006

Intangible assets subject to amortization	$	484			484
Less accumulated amortization		(122	)		(68	)

Net intangible assets subject to amortization	$	362			416

Amortization expense for intangible assets subject to amortization was $54, $54 and $14 in 2007, 2006 and 2005. Estimated amortization expense for 2008 and future years is as follows:


2008	$	54
2009		54
2010		54
2011		54
2012		54
Thereafter		92

Total estimated amortization	$	362

The following unaudited pro forma information presents the combined results of operations of MIG and FPIG for the twelve months ended December 31, 2005 with pro forma purchase accounting adjustments as if the acquisition had been consummated as of the beginning of the periods presented. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on the dates indicated, or of future results of the Group.


(For the Year Ended December 31, in Thousands, Except per Share Data)	2005

Revenue	$	122,451
Net income	$	8,517
Net income per share — basic	$	1.43
Net income per share — diluted	$	1.38

The goodwill associated with the acquisition of FPIG will not be tax-deductible.

Since the merger date, the final tax return was filed for FPIG, resulting in a $8 reduction of goodwill in 2006. In addition, goodwill was reduced by $209 as a result of the adoption of FIN 48 as of January 1, 2007. The change in the carrying amount of goodwill for the years ended December 31, 2007 and 2006 is as follows:


	2007			2006

Balance beginning of year	$	5,625			5,633
Adjustment to goodwill for final FPIG tax return		—			(8	)
Adjustment to goodwill for adoption of FIN 48		(209	)		—

Balance end of year	$	5,416			5,625

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(12)	EARNINGS PER SHARE

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


	Year Ended December 31
	2007		2006		2005

Numerator for basic and diluted earnings per share:
Net income	$	14,235	$	10,635	$	7,020

Denominator for basic earnings per share:
weighted average shares outstanding		6,144		6,023		5,943
Effect of stock incentive plans		181		199		217
Denominator for diluted earnings per share:

weighted average shares outstanding		6,325		6,222		6,160

Basic earnings per share	$	2.32	$	1.77	$	1.18

Diluted earnings per share	$	2.25	$	1.71	$	1.14

The denominator for diluted earnings per share does not include the effect of outstanding stock options that have an anti-dilutive effect. For the year ended December 31, 2007 and 2006, 40,000 stock options were considered to be anti-dilutive and were excluded from the earnings per share calculation. For the year ended December 31, 2005, there were no stock options that were considered to be anti-dilutive and excluded from the earnings per share calculation.


(13)	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 December 31, 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. All 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. During 2007, the Group made no grants of restricted stock, incentive stock options and non-qualified stock options. A total of 3,000 shares of restricted stock and 19,400 incentive stock options were forfeited during 2007. A total of 14,100 incentive stock options granted under the Plan were exercised during 2007. Upon exercise, new shares were issued to the option holder.

In determining the charge to the consolidated statement of earnings for 2007 and 2006 and the pro-forma effect for 2005 described in Note 1(m), 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

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

over a historical period. The weighted average assumptions used in applying the Black-Scholes-Merton model are shown below:


	For the Year Ended December 31,
	2007		2006			2005

Risk-free interest rate		N/A		4.62	%		4.04	%
Expected term		N/A		6.9 years			7.5 years
Dividend yield		N/A		0.77	%		0.00	%
Expected volatility		N/A		30.94	%		18.44	%

The weighted-average fair value of options granted under the Plan was $11.05 and $4.44 for 2006 and 2005, respectively. There were no options granted in 2007.

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


				Weighted Average
	Number of			Exercise Price
	Shares			per Share

Outstanding at December 31, 2006		636,700		$	13.21
Granted — 2007		0			0.00
Exercised — 2007		(14,100	)		12.43
Forfeited — 2007		(19,400	)		12.85

Outstanding at December 31, 2007		603,200		$	13.24

Exercisable at:
December 31, 2007		509,533		$	12.57
Weighted-average remaining contractual life					6.6 years
Compensation remaining to be recognized for unvested stock options at December 31, 2007 (millions)				$	0.5
Weighted-average remaining amortization period					2.2 years
Aggregate Intrinsic Value of outstanding options, December 31, 2007 (millions)				$	3.2
Aggregate Intrinsic Value of exercisable options, December 31, 2007 (millions)				$	2.8

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


				Weighted
				Average
	Number of			Exercise Price
	Shares			per Share

Unvested restricted stock at December 31, 2006		106,334		$	13.61
Granted — 2007		0			0.00
Vested — 2007		(58,750	)		12.89
Forfeited — 2007		(3,000	)		12.21

Unvested restricted stock at December 31, 2007		44,584		$	14.66

Compensation remaining to be recognized for unvested restricted stock at December 31, 2007 (millions)				$	0.5
Weighted-average remaining amortization period					1.8 years

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)


(14)	COMMITMENTS AND CONTINGENCIES

The Group becomes involved with certain claims and legal actions arising in the ordinary course of business operations. Such legal actions involve disputes by policyholders relating to claims payments as well as other litigation. In addition, the Group’s business practices are regularly subject to review by various state insurance regulatory authorities. These reviews may result in changes or clarifications of the Group’s business practices, and may result in fines, penalties or other sanctions. In the opinion of management, while the ultimate outcome of these actions and these regulatory proceedings cannot be determined at this time, they are not expected to result in liability for amounts material to the financial condition, results of operations, or liquidity, of the Group.

As of December 31, 2007, the Group occupied office space and leased equipment and vehicles under various operating leases that have remaining noncancelable lease terms in excess of one year. Operating leases extending beyond 2009 represent two five-year lease option extensions relating to the FPIG office building in Rocklin, California. Although these options are cancelable, the Group currently intends on exercising these lease extension options. A summary of minimum future lease commitments, including the options on the FPIG building, as of December 31, 2007 follows:


	Minimum
	Requirements

Year ending December 31:
2008		411
2009		409
2010		409
2011		381
2012		368
Thereafter		2,976

	$	4,954

Rental expenses of approximately $437 and $474 for the years ended December 31, 2007 and 2006, respectively, has been charged to income in the accompanying consolidated statement of earnings.

The Group’s executives are parties to employment agreements with the Group which include customary provisions for severance and change of control.


(15)	RETALIATORY TAX REFUND

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 2007 consolidated statement of earnings, with $2.5 million recorded in the quarter ended 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

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

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.


(16)	RELATED-PARTY TRANSACTIONS

The Group produces a large percentage of its business through one insurance agent, Davis Insurance Agency (Davis), the owner of which is also a Board member of the Group. In 2007, 2006 and 2005, premiums written through Davis totaled 4%, 4% and 8%, respectively, of the Group’s direct written premiums. Commissions paid to Davis were $1,177, $1,187 and $1,231 in 2007, 2006 and 2005, respectively.

Van Rensselaer, Ltd., which is owned by William V.R. Fogler, a director, has provided equities investment management services to the Group since the year 1980. Fees to Van Rensselaer, Ltd. amounted to $128, $117 and $161 in 2007, 2006 and 2005, respectively.

Thomas, Thomas & Hafer of Harrisburg, PA is a law firm the Company uses for claims handling assistance. The brother of the Chief Executive Officer of the Group is a partner of the firm. Fees to Thomas, Thomas & Hafer amounted to $60, $73 and $52 in 2007, 2006 and 2005, respectively.


(17)	LINE OF CREDIT

As of December 31, 2007 and 2006, FPIG owed $3,000 under a $5,000 and $4,000 bank line of credit, respectively. The line of credit bears interest at the bank’s base rate or an optional rate based on LIBOR. The effective annual interest rate as of December 31, 2007 and 2006 was 7.25% and 8.25%, respectively. The line of credit includes covenants to maintain certain financial requirements including a minimum A.M. Best rating and minimum statutory surplus. All covenants were in compliance as of December 31, 2007 and 2006.


(18)	TRUST PREFERRED SECURITIES

The Group had the following Trust Preferred Securities outstanding as of December 31, 2007:


						Maturity
	Issue Date	Amount			Interest Rate	Date

Financial Pacific Statutory Trust I	12/4/2002	$	5,155		LIBOR + 4.00%	12/4/2032
Financial Pacific Statutory Trust II	5/15/2003		3,093		7.35% fixed thru 5/15/2008 thereafter converting to floating LIBOR + 4.10%	5/15/2033
Financial Pacific Statutory Trust III	9/30/2003		7,740		LIBOR + 4.05%	9/30/2033

Total Trust Preferred Securities			15,988
Less: Unamortized issuance costs			(429	)

Total		$	15,559

FPIG formed three statutory business trusts for the purpose of issuing Floating Rate Capital Securities (Trust preferred securities) and investing the proceeds thereof in Junior Subordinated Debentures of FPIG. FPIG holds $488 of common stock securities issued to capitalize the Trusts. Trust preferred securities totaling $15,500 were issued to the public.

Financial Pacific Statutory Trust I (Trust I) is a Connecticut statutory business trust. The Trust issued 5,000 shares of the Trust preferred securities at a price of $1 per share for $5,000. The Trust purchased $5,155 in

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

Junior Subordinated Debentures from the Group that mature on December 4, 2032. The annual effective rate of interest at December 31, 2007 is 9.13%.

Financial Pacific Statutory Trust II (Trust II) is a Connecticut statutory business trust. The Trust issued 3,000 shares of the Trust preferred securities at a price of $1 per share for $3,000. The Trust purchased $3,093 in Junior Subordinated Debentures from the Group that mature on May 15, 2033. The annual effective rate of interest at December 31, 2007 is 7.35%.

Financial Pacific Statutory Trust III (Trust III) is a Delaware statutory business trust. The Trust issued 7,500 shares of the Trust preferred securities at a price of $1 per share for $7,500. The Trust purchased $7,740 in Junior Subordinated Debentures from the Group that mature on September 30, 2033. The annual effective rate of interest at December 31, 2007 is 9.28%.

The Group has the right, at any time, so long as there are no continuing events of default, to defer payments of interest on the Junior Subordinated Debentures for a period not exceeding 20 consecutive quarters; but not beyond the stated maturity of the Junior Subordinated Debentures. To date no interest has been deferred. FPIG entered into an interest rate swap agreement to hedge the floating interest rate on the Junior Subordinated Debentures (note 19).

The Trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the Junior Subordinated Debentures at maturity or their earlier redemption. The Group has the right to redeem the Junior Subordinated Debentures after December 4, 2007 for Trust I, after May 15, 2008 for Trust II and after September 30, 2008 for Trust III. The Group has not exercised these rights as of December 31, 2007.


(19)	INTEREST RATE SWAP AGREEMENT FOR VARIABLE-RATE DEBT

The Group had the following interest rate swaps outstanding as of December 31, 2007:

Notional

Counterparty

Maturity

Effective Date

Amount

Counterparty Pays

Receives

Date

US Bank (Trust I)

3/14/2003

5,000

3 Month LIBOR

3.5025% fixed

3/4/2008

Union Bank of California (Trust III)

10/15/2003

7,500

3 Month LIBOR

3.3350% fixed

9/30/2008

Union Bank of California (Trust I)

12/4/2007

5,000

3 Month LIBOR

4.7400% fixed

12/4/2012

Union Bank of California (Trust II)

5/15/2008

3,000

3 Month LIBOR

4.8000% fixed

5/15/2013

Union Bank of California (Trust III)

9/30/2008

7,500

3 Month LIBOR

4.8400% fixed

9/30/2013

The Group has interest-rate related hedging instruments to manage its exposure on its debt instruments. The type of hedging instruments utilized by the Group are interest rate swap agreements (swaps). Interest differentials to be paid or received because of swap agreements are reflected as an adjustment in the consolidated statement of earnings over the swap period. By using hedging financial instruments to hedge exposures to changes in interest rates, the Group exposes itself to market risk.

Market risk is the adverse effect on the value of a financial instrument that results from a change in interest rates. Credit risk is the failure of the counterparty to perform under the terms of the contract. When the fair value of a contract is positive, the counterparty owes the Group, which creates credit risk for the Group. When the fair value of a contract is negative, the Group owes the counterparty and, therefore, it does not possess credit risk. The Group minimizes the credit risk in hedging instruments by entering into transactions with high-quality counterparties whose credit rating is higher than Aa.

The Group is party to interest rate swap agreements to hedge the floating interest rate on the Junior Subordinated Debentures purchased by Trust I, Trust II and Trust III. The variable-rate debt obligations expose

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

the Group to variability in interest payments due to changes in interest rates. Management believes it is prudent to limit the variability of a portion of its interest payments. To meet this objective, management enters into swap agreements to manage fluctuations in cash flows resulting from interest rate risk. These swaps change the variable-rate cash flow exposure on the debt obligations to fixed-rate cash flows. Under the terms of the interest rate swaps, the Group makes fixed interest rate payments and receives variable interest rate payments, thereby creating the equivalent of fixed-rate debt.

As of December 31, 2007 and 2006 the Group was party to interest-rate swap agreements with an aggregate notional principal amount of $28,000. For the year ended December 31, 2007 and 2006, the Group recognized the change in the economic value of the interest rate swap agreements which is recognized in the consolidated statement of earnings as a realized loss of $774 and $94, respectively. The estimated fair value of the interest-rate swap agreements included in other assets was $(379) and $395 as of December 31, 2007 and 2006, respectively.


(20)	FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Group accepts various forms of collateral for issuance of its surety bonds including cash, irrevocable letters of credit and certificates of deposit. The Group’s policy is to record in the accompanying consolidated financial statements only those funds received as cash deposits. The off-balance sheet collateral held by the Group consists solely of irrevocable letters of credit totaling $478 and $1,808 as of December 31, 2007 and 2006, respectively.


(21)	QUARTERLY FINANCIAL DATA (unaudited)

The Group’s unaudited quarterly financial information is as follows:


	First Quarter						Second Quarter						Third Quarter						Fourth Quarter
	2007			2006			2007(1)			2006			2007(1)			2006			2007			2006
	(Unaudited, in thousands, except per share data)

Net premiums written	$	34,801		$	39,695		$	47,206		$	41,234		$	41,110		$	34,809		$	36,549		$	30,053
Net premiums earned		33,988			33,537			35,076			33,631			37,303			35,004			40,308			35,501
Net investment income earned		2,941			2,091			3,771			2,369			2,880			2,597			3,461			3,013
Net realized gains (losses)		(47	)		307			680			298			(366	)		(505	)		(243	)		51
Net income		2,553			2,650			5,790			2,895			3,012			2,194			2,880			2,896
Other comprehensive income (loss)		224			(1,752	)		(2,390	)		(1,599	)		2,751			3,264			1,496			51
Comprehensive income	$	2,777		$	898		$	3,400		$	1,296		$	5,763		$	5,458		$	4,376		$	2,947
Net income per share Basic	$	0.42			0.44		$	0.95			0.48		$	0.49			0.36		$	0.46			0.48
Diluted	$	0.41			0.43		$	0.92			0.47		$	0.47			0.35		$	0.45			0.46


(1)		See note 15


ITEM 9.	*CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.*

None.


ITEM 9A.	*CONTROLS AND PROCEDURES.*


(a)	Evaluation of Disclosure Controls and Procedures

Mercer Insurance Group, Inc’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Group’s disclosure controls and procedures as of December 31, 2007, and based on that evaluation they have concluded that these controls and procedures are effective as of that date.


(b)	Changes in Internal Control Over Financial Reporting

There have been no changes in the Group’s internal control over financial reporting during the fourth quarter of 2007 that have materially affected, or are reasonably likely to materially affect, the Group’s internal control over financial reporting.


(c)	Management’s Annual Report on Internal Control Over Financial Reporting

The management of Mercer Insurance Group, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting for the Group. With the participation of the Chief Executive Officer and the Chief Financial Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework and criteria established in Internal Control — Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation, our management has concluded that our internal control over financial reporting was effective as of December 31, 2007.

Mercer Insurance Group, Inc.’s auditor, KPMG LLP, an independent registered public accounting firm, has issued an audit report on the effectiveness of our internal control over financial reporting. This audit report appears below.



		Mercer Insurance Group, Inc.

March 17, 2008		By: /s/ Andrew R. Speaker Andrew R. Speaker President and Chief Executive Officer

March 17, 2008		By: /s/ David B. Merclean David B. Merclean Senior Vice President of Finance and Chief Financial Officer

100

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Mercer Insurance Group, Inc.:

We have audited Mercer Insurance Group. Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercer Insurance Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing other such procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion Mercer Insurance Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007, and our report dated March 17, 2008, expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Philadelphia, Pennsylvania

March 17, 2008

101


ITEM 9B.	*OTHER INFORMATION.*

None.

PART III


ITEM 10.	*DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.*

The information required by Item 10 is incorporated by reference to Registrant’s definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2007.


ITEM 11.	*EXECUTIVE COMPENSATION.*

The information required by Item 11 is incorporated by reference to Registrant’s definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2007.


ITEM 12.	*SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.*

The information required by Item 12 is incorporated by reference to Registrant’s definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2007.


ITEM 13.	*CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.*

The information required by Item 13 is incorporated by reference to Registrant’s definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2007.


ITEM 14.	*PRINCIPAL ACCOUNTING FEES AND SERVICES.*

The information required by Item 14 is incorporated by reference to Registrant’s definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days after December 31, 2007.

102

PART IV


ITEM 15.	*EXHIBITS, FINANCIAL STATEMENT SCHEDULES.*

(a) (1) The following consolidated financial statements are filed as a part of this report in Item 8.

Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:

Consolidated Balance Sheets as of December 31, 2007 and 2006

Consolidated Statements of Earnings for Each of the Years in the Three-year Period Ended December 31, 2007

Consolidated Statements of Stockholders’ Equity for Each of the Years in the Three-year Period Ended December 31, 2007

Consolidated Statements of Cash Flows for Each of the Years in the Three-year Period Ended December 31, 2007

Notes to Consolidated Financial Statements

(2) The following consolidated financial statement schedules for the years 2007, 2006 and 2005 are submitted herewith:

Financial Statement Schedules:

Report of Independent Registered Public Accounting Firm

Schedule I. Summary of Investments — Other Than Investments in Related Parties

Schedule II. Condensed Financial Information of Parent Company

Schedule III. Supplementary Insurance Information

Schedule IV. Reinsurance

Schedule V. Allowance for Uncollectible Premiums and other Receivables

Schedule VI. Supplemental Information

Schedule VI. Supplemental Insurance Information Concerning Property and Casualty Subsidiaries

All other schedules are omitted because they are not applicable or the required information is included in the financial statements or notes thereto.

(3) Exhibits:

The exhibits required by Item 601 of Regulation SK are listed in the Exhibit Index. Documents not accompanying this report are incorporated by reference as indicated on the Exhibit Index.

103

EXHIBIT INDEX


Number			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.)
	4	.1	Form of certificate evidencing shares of common stock 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.)
	10	.1	Mercer Insurance Group, Inc. Employee Stock Ownership Plan (incorporated by reference herein to the Company’s Pre-effective Amendment No. 3 on Form S-1, SEC File No. 333-104897.)
	10	.2	Employment Agreement, dated as of April 1, 2004, among BICUS Services Corporation, Mercer Insurance Company and Andrew R. Speaker (incorporated by reference herein to the Company’s Annual Report on Form 10-K, SEC File No. 000-25425, for the fiscal year ended December 31, 2003.)
	10	.3	Employment Agreement, dated as of April 1, 2004, among BICUS Services Corporation, Mercer Insurance Company and Paul D. Ehrhardt (incorporated by reference herein to the Company’s Annual Report on Form 10-K, SEC File No. 000-25425, for the fiscal year ended December 31, 2003.)
	10	.4	Amended and Restated Employment Agreement, dated as of March 15, 2007, among BICUS Services Corporation, Mercer Insurance Group, Inc., Mercer Insurance Company and David B. Merclean (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, 2006.)
	10	.5	Employment Agreement, dated as of October 1, 2006, among BICUS Services Corporation, Mercer Insurance Group, Inc., Mercer Insurance Company and Paul R. Corkery (incorporated by reference herein to the Company’s Quarterly Report on Form 10-Q, SEC File No. 000-25425, for the quarter ended September 30, 2006.)
	10	.6	Amendment No. 1 to Employment Agreement, dated as of March 15, 2007, among BICUS Services Corporation, Mercer Insurance Group, Inc., Mercer Insurance Company and Paul R. Corkery (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, 2006.)
	10	.7	Mercer Mutual Insurance Company Executive Nonqualified ’Excess’ Plan dated June 1, 2002 (incorporated by reference herein to the Company’s Pre-effective Amendment no. 3 on Form S-1, SEC File No. 333-104897.)
	10	.8	Mercer Mutual Insurance Company Benefit Agreement dated December 11, 1989, as amended (incorporated by reference herein to the Company’s Pre-effective Amendment no. 3 on Form S-1, SEC File No. 333-104897.)
	10	.9	Mercer Insurance Group, Inc. 2004 Stock Incentive Plan, as amended through January 18, 2006 (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, 2005.)
	10	.10	Mercer Insurance Group, Inc. 401(k) Mirror Plan (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, 2006.)
	14	.1	Code of Ethics (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.)
	23		Consent of independent registered public accounting firm (filed herewith.)
	31	.1	Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)
	31	.2	Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)
	32	.1	Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)
	32	.2	Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)

104

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.



		Mercer Insurance Group, Inc.

March 17, 2008		By: /s/ Andrew R. Speaker Andrew R. Speaker President and Chief Executive Officer and a Director

March 17, 2008		By: /s/ David B. Merclean David B. Merclean Senior Vice President of Finance and Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.


By:	/s/ Roland D. Boehm Roland D. Boehm	Vice Chairman of the Board of Directors	March 17, 2008

By:	/s/ H. Thomas Davis H. Thomas Davis	Director	March 17, 2008

By:	/s/ William V. R. Fogler William V. R. Fogler	Director	March 17, 2008

By:	/s/ William C. Hart William C. Hart	Director	March 17, 2008

By:	/s/ George T. Hornyak, Jr. George T. Hornyak, Jr.	Chairman of the Board of Directors	March 17, 2008

By:	/s/ Samuel J. Malizia Samuel J. Malizia	Director	March 17, 2008

By:	/s/ Richard U. Niedt Richard U. Niedt	Director	March 17, 2008

By:	/s/ Andrew R. Speaker Andrew R. Speaker	President and Chief Executive Officer and a Director	March 17, 2008

By:	/s/ Richard G. Van Noy Richard G. Van Noy	Director	March 17, 2008

105

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Mercer Insurance Group, Inc. and Subsidiaries:

Under date of March 17, 2008, we reported on the consolidated balance sheets of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007, which are included in the annual report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules in the annual report on Form 10-K. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.

In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

The Company adopted Statement of Financial Accounting Standards No. 123 (R), Share Based Payment, effective January 1, 2006.

/s/ KPMG LLP

Philadelphia, Pennsylvania

March 17, 2008

106

MERCER INSURANCE GROUP, INC.

SCHEDULE II — CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY

Condensed Balance Sheets
December 31, 2007 and 2006


	2007			2006
	(Dollars in thousands)

ASSETS
Investment in common stock of subsidiaries (equity method)	$	135,083		$	118,883
Investment in preferred stock of subsidiaries (equity method)		2,475			2,475
Cash and cash equivalents		2,404			1,554
Goodwill		1,797			1,797
Deferred tax asset		337			302
Other assets		801			722

Total assets	$	142,897		$	125,733


LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Accounts payable and accrued expenses	$	1		$	89
Other liabilities		9,490			9,805

Total liabilities		9,491			9,894

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 7,075,333 shares and 7,064,233 shares, outstanding 6,717,693 shares and 6,582,232 shares		—			—
Additional paid-in capital		70,394			68,473
Accumulated other comprehensive income:
Unrealized gains in investments, net of deferred income taxes		4,896			2,815
Retained Earnings		67,613			54,629
Unearned ESOP shares		(3,131	)		(3,757	)
Treasury stock, 505,814 and 503,513 shares		(6,366	)		(6,321	)

Total stockholders’ equity		133,406			115,839

Total liabilities and stockholders’ equity	$	142,897		$	125,733

See accompanying report of independent registered public accounting firm.

108

MERCER INSURANCE GROUP, INC.

SCHEDULE II — CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY

Condensed Statements of Cash Flows

For the Years ended December 31, 2007, 2006 and 2005


	2007			2006			2005
	(Dollars in thousands)

Cash flows from operating activities:
Net income	$	14,235			10,635			7,020
Dividends from subsidiaries		1,500			1,125			10,000
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in net income of subsidiaries		(15,620	)		(12,551	)		(7,646	)
Accretion of discount		—			—			136
ESOP share commitment		1,175			1,253			832
Net realized investment losses		—			—			211
Amortization of restricted stock compensation		1,043			1,398			704
Deferred income tax		(35	)		(169	)		(5	)
Other		(305	)		366			10,017

Net cash provided by operating activities		1,993			2,057			21,269

Cash flows from investing activities:
Purchase of fixed income securities		—			—			(4,317	)
Sale and maturity of fixed income securities		—			—			26,864
Sale of short-term investments		—			—			—
Purchase of subsidiary		—			—			(41,108	)

Net cash used in investing activities		—			—			(18,561	)

Cash flows from financing activities:
Tax benefit from stock compensation plans		153			129			—
Dividends to shareholders		(1,251	)		(902	)		—
Purchase of treasury stock		(45	)		(37	)		(3,230	)

Net cash used in financing activities		(1,143	)		(810	)		(3,230	)

Net increase (decrease) in cash and cash equivalents		850			1,247			(522	)
Cash and cash equivalents at beginning of year		1,554			307			829

Cash and cash equivalents at end of year	$	2,404			1,554			307

Cash paid during the year for:
Interest	$	—			—			—
Income taxes		—			—			—

See accompanying report of independent registered public accounting firm.

110

Mercer Insurance Group, Inc. and Subsidiaries
For the years ended December 31, 2007, 2006 and 2005

Schedule III — Supplementary Insurance Information


			Future Policy
	Deferred		Benefits,				Other Policy
	Policy		Losses, Claims,				Claims and		Net
	Acquisition		and Loss		Unearned		Benefits		Premium
Segment	costs		Expenses		Premiums		Payable		Earned
	(Dollars in thousands)

December 31, 2007
Commercial lines	$	17,679		263,571		76,489				125,427
Personal lines		2,849		10,828		11,535				21,248

Total	$	20,528		274,399		88,024		—		146,675

December 31, 2006
Commercial lines	$	14,075		240,239		69,865				115,461
Personal lines		2,633		10,216		12,065				22,211

Total	$	16,708		250,455		81,930		—		137,672

December 31, 2005
Commercial lines	$	8,231		200,992		67,391				52,279
Personal lines		2,558		10,687		11,591				22,481

Total	$	10,789		211,679		78,982		—		74,760


			Benefits,
			Claims,
	Net		Losses and				Other
	Investment		Settlement		Amortization		Operating		Premiums
	Income		Expenses		of DPAC		Expenses		Written

December 31, 2007
Commercial lines				76,293		33,267		9,903		139,360
Personal lines				14,893		5,496		625		20,307

Total	$	13,053		91,186		38,763		10,528		159,667

December 31, 2006
Commercial lines				73,529		27,397		10,435		123,829
Personal lines				14,168		5,297		2,807		21,962

Total	$	10,070		87,697		32,694		13,242		145,791

December 31, 2005
Commercial lines				30,481		11,296		6,032		52,634
Personal lines				12,903		5,553		4,734		22,632

Total	$	4,467		43,384		16,849		10,766		75,266

See accompanying report of independent registered public accounting firm.

111

Mercer Insurance Group, Inc. and Subsidiaries

Schedule VI — Supplemental Information

For the years ended December 31, 2007, 2006 and 2005


	Deferred		Reserve for		Discount
	Policy		Losses and		if any				Net		Net
	Acquisition		Loss Adj.		Deducted in		Unearned		Earned		Investment
Affiliation with Registrant	Costs		Expenses		Column C		Premiums		Premiums		Income
	(Dollars in thousands)

Year ended December 31, 2007	$	20,528		274,399		—		88,024		146,675		13,053
Year ended December 31, 2006		16,708		250,455		—		81,930		137,673		10,070
Year ended December 31, 2005		10,789		211,679		—		78,982		74,760		4,467


	Losses and LAE							Paid
	Incurred							Losses and		Net
	Current		Prior			Amortization		Adjustment		Written
	Year		Year			of DPAC		Expenses		Premiums
	(Dollars in thousands)

Year ended December 31, 2007		83,015		8,171			38,763		63,691		159,667
Year ended December 31, 2006		79,275		8,422			32,694		56,110		145,791
Year ended December 31, 2005		43,921		(537	)		16,849		35,309		75,266

See accompanying report of independent registered public accounting firm.

114


PART I			3
ITEM 1. Business			3
ITEM 1A. Risk Factors			29
ITEM 1B. Unresolved Staff Comments			33
ITEM 2. Properties			33
ITEM 3. Legal Proceedings			33
ITEM 4. Submission of Matters to a Vote of Security Holders			33
PART II			34
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			34
ITEM 6. Selected Financial Data			36
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			37
ITEM 7A Quantitative and Qualitative Disclosures about Market Risk			61
ITEM 8. Financial Statements and Supplementary Data			65
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			100
ITEM 9A. Controls and Procedures			100
ITEM 9B. Other Information			102
PART III			102
ITEM 10. Directors, Executive Officers and Corporate Governance			102
ITEM 11. Executive Compensation			102
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			102
ITEM 13. Certain Relationships and Related Transactions, and Director Independence			102
ITEM 14. Principal Accounting Fees and Services			102
PART IV			103
ITEM 15. Exhibits, Financial Statement Schedules			103
Consent of independent registered public accounting firm
Certification of Chief Executive Officer in accordance with Section 302
Certification of Chief Financial Officer in accordance with Section 302
Certification of Chief Executive Officer in accordance with Section 906
Certification of Chief Financial Officer in accordance with Section 906


			Market		Balance
Type of Investment	Cost		Value		Sheet
	(Dollars in thousands)

Fixed maturities:
Bonds:
United States Government and government agencies and authorities	$	83,016		83,715		83,715
States, municipalities and political subdivisions		142,873		144,026		144,026
All Other		96,089		96,497		96,497

Total bonds		321,978		324,238		324,238
Preferred stock		2,291		2,175		2,175

Total fixed maturities		324,269		326,413		326,413

Equity securities:
Common stocks:
Banks, trust and insurance companies		1,371		3,035		3,035
Industrial, miscellaneous and all other		8,838		12,720		12,720

Total equity securities		10,209		15,755		15,755

Short-term investments

Total investments	$	334,478		342,168		342,168


					Assumed				Percentage
			Ceded to		from				of Amount
	Gross		Other		other		Net		Assumed
Premiums Earned	Amount		Companies		Companies		Amount		to Net
	(Dollars in thousands)

For the year ended December 31, 2007	$	176,395		31,521		1,801		146,675		1.2	%
For the year ended December 31, 2006		182,633		47,499		2,539		137,673		1.8	%
For the year ended December 31, 2005		93,205		21,141		2,696		74,760		3.6	%