**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**





(Mark
                One)x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF****THE
                SECURITIES EXCHANGE ACT OF 1934****For
                the Quarterly Period Ended June 30,
                2007****or**o
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF****THE
                SECURITIES EXCHANGE ACT OF 1934****For
                the Transition Period from ______________ to
                ______________**





**COMMISSION
      FILE NO. 000-51480**





**JAMES
      RIVER GROUP, INC.**


*(Exact
      Name of Registrant as Specified in Its Charter)*





**Delaware**
            
            **05-0539572***(State
                or Other Jurisdiction of*
              *Incorporation
                or Organization)*
            
            *(I.R.S.
                Employer*
              *Identification
                No.)***300
                Meadowmont Village Circle, Suite 333**
              **Chapel
                Hill, North Carolina**
            
            **27517***(Address
                of Principal Executive Offices)*
            
            *(Zip
                Code)***(919)
                883-4171***(Registrant’s
                Telephone Number, Including Area Code)**(Former
                Name, Former Address and Former Fiscal Year, If Changed Since Last
                Report)*





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





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





**Large
                Accelerated Filer**o
            **Accelerated
                Filer**x
            **Non-Accelerated
                Filer**o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act).


**Yes**o **No**x





On
      August
      1, 2007, 15,138,708 shares of the registrant’s common stock, par value $0.01 per
      share, were outstanding.








**INDEX**


**PART
                I.**
            
            **FINANCIAL
                INFORMATION**
            
            **Page**Item
                1.
            Financial
                Statements:Condensed
                Consolidated Balance Sheets
            
            1Condensed
                Consolidated Income Statements
            
            3Condensed
                Consolidated Statements of Cash Flows
            
            4Notes
                to Condensed Consolidated Financial Statements
            
            5Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            13Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            
            30Item
                4.
            Controls
                and Procedures
            
            31**PART
                II.**
            
            **OTHER
                INFORMATION**Item
                1.
            Legal
                Proceedings
            
            32Item
                1A.
            Risk
                Factors
            
            32Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            
            33Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            
            33Item
                6.
            Exhibits
            
            34Signatures
            
            36





**PART
      I - FINANCIAL INFORMATION**





**Item
      1.**  **Financial
      Statements.**





**Condensed
      Consolidated Balance Sheets**





**(Unaudited)**
              **June
                30,**
              **2007**
            
            **December
                31,**
              **2006***(in
                thousands)***Assets**Investments
                available-for-sale, at fair value:Fixed
                maturity securities (amortized cost: 2007 - $522,730; 2006 -
              $488,232)
            
            $
            513,411
            
            $
            486,016Equity
                securities (cost: 2007 - $23,266; 2006 - $8,536)
            
            
            23,983
            
            
            8,703Total
                investments available-for-sale
            
            
            537,394
            
            
            494,719Cash
                and cash equivalents
            
            
            45,305
            
            
            40,319Accrued
                investment income
            
            
            5,746
            
            
            5,471Premiums
                receivable and agents’ balances
            
            
            32,473
            
            
            34,862Reinsurance
                recoverable on unpaid losses
            
            
            97,144
            
            
            90,495Reinsurance
                recoverable on paid losses
            
            
            4,093
            
            
            7,041Prepaid
                reinsurance premiums
            
            
            22,362
            
            
            31,626Deferred
                policy acquisition costs
            
            
            18,086
            
            
            15,005Deferred
                tax assets
            
            
            18,133
            
            
            13,016Federal
                income taxes receivable
            
            
            587
            
            
            -Due
                from reinsurers
            
            
            2,645
            
            
            -Other
                assets
            
            
            9,555
            
            
            9,167Total
                assets
            
            $
            793,523
            
            $
            741,721





*See
      accompanying notes.*


1


**Condensed
      Consolidated Balance Sheets (continued)**


**(Unaudited)**
                **June
                  30,**
                **2007**
              
              **December
                  31,**
                **2006***(in
                  thousands, except for share data)***Liabilities
                  and stockholders’ equity**Liabilities:Reserve
                  for losses and loss adjustment expenses
              
              $
              350,998
              
              $
              300,294Unearned
                  premiums
              
              
              133,729
              
              
              131,286Payables
                  to reinsurers
              
              
              -
              
              
              5,672Senior
                  debt
              
              
              15,000
              
              
              15,000Junior
                  subordinated debt
              
              
              43,300
              
              
              43,300Funds
                  held
              
              
              8,609
              
              
              15,567Accrued
                  expenses
              
              
              12,062
              
              
              11,510Federal
                  income taxes payable
              
              
              -
              
              
              613Other
                  liabilities
              
              
              4,046
              
              
              4,087Total
                  liabilities
              
              
              567,744
              
              
              527,329Commitments
                  and contingenciesStockholders’
                  equity:Common
                  Stock - $0.01 par value; 100,000,000 shares authorized;
                2007:
                  15,138,708 shares issued and outstanding; 2006:
                15,117,308
                  shares issued and outstanding
              
              
              151
              
              
              151Common
                  stock warrants
              
              
              524
              
              
              524Additional
                  paid-in capital
              
              
              176,341
              
              
              175,437Convertible
                  preferred stock - $0.01 par value; 5,000,000 shares
                authorized
                  and no shares outstanding
              
              
              -
              
              
              -177,016
              
              
              176,112Notes
                  receivable from employees
              
              
              (535
              )
              
              (535
              )Retained
                  earnings
              
              
              54,889
              
              
              40,147Accumulated
                  other comprehensive loss
              
              
              (5,591
              )
              
              (1,332
              )Total
                  stockholders’ equity
              
              
              225,779
              
              
              214,392Total
                  liabilities and stockholders’ equity
              
              $
              793,523
              
              $
              741,721


*See
      accompanying notes.*


2


**Condensed
      Consolidated Income Statements (Unaudited)**





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***(in
                thousands, except for share data)***Revenues**Gross
                written premiums
            
            $
            79,449
            
            $
            74,634
            
            $
            159,537
            
            $
            142,799Ceded
                written premiums
            
            
            (7,877
            )
            
            (19,810
            )
            
            (24,095
            )
            
            (34,287
            )Net
                written premiums
            
            
            71,572
            
            
            54,824
            
            
            135,442
            
            
            108,512Change
                in net unearned premiums
            
            
            (8,585
            )
            
            (2,222
            )
            
            (12,206
            )
            
            (7,821
            )Net
                earned premiums
            
            
            62,987
            
            
            52,602
            
            
            123,236
            
            
            100,691Net
                investment income
            
            
            5,951
            
            
            4,506
            
            
            11,722
            
            
            8,499Net
                realized investment losses
            
            
            (19
            )
            
            (49
            )
            
            (27
            )
            
            (84
            )Other
                income
            
            
            68
            
            
            46
            
            
            138
            
            
            88Total
                revenues
            
            
            68,987
            
            
            57,105
            
            
            135,069
            
            
            109,194**Expenses**Losses
                and loss adjustment expenses
            
            
            36,954
            
            
            30,214
            
            
            71,222
            
            
            59,431Other
                operating expenses
            
            
            17,659
            
            
            13,384
            
            
            33,568
            
            
            25,409Interest
                expense
            
            
            1,298
            
            
            896
            
            
            2,582
            
            
            1,673Total
                expenses
            
            
            55,911
            
            
            44,494
            
            
            107,372
            
            
            86,513Income
                before taxes
            
            
            13,076
            
            
            12,611
            
            
            27,697
            
            
            22,681Federal
                income tax expense
            
            
            3,920
            
            
            4,060
            
            
            8,414
            
            
            7,301**Net
                income**
            
            $
            9,156
            
            $
            8,551
            
            $
            19,283
            
            $
            15,380**Earnings
                per share:**Basic
            
            $
            0.60
            
            $
            0.57
            
            $
            1.27
            
            $
            1.02Diluted
            
            $
            0.56
            
            $
            0.53
            
            $
            1.19
            
            $
            0.96**Cash
                dividends declared per common share**
            
            $
            0.15
            
            $
            -
            
            $
            0.30
            
            $
            -








*See
      accompanying notes.*


3


**Condensed
      Consolidated Statements** **of
      Cash Flows (Unaudited)**


**Six****Months Ended June 30,****2007**
              
              **2006***(**in
                  thousands)*
 **Operating
                  activities**
 Net
                  cash provided by operating activities
              
              $
              60,309
              
              $
              72,610**Investing
                  activities**Securities
                  available-for-sale:Purchases
                  - fixed maturity securities
              
              
              (102,434
              )
              
              (142,375
              )Purchases
                  - equity securities
              
              
              (15,964
              )
              
              -Maturities
                  and calls - fixed maturity securities
              
              
              23,737
              
              
              14,700Sales
                  - fixed maturity securities
              
              
              43,114
              
              
              24,105Sales
                  - equity securities
              
              
              1,311
              
              
              -Net
                  payable to securities brokers
              
              
              270
              
              
              1,671Purchases
                  of property and equipment
              
              
              (560
              )
              
              (195
              )Investment
                  in real estate joint venture
              
              
              (620
              )
              
              -Net
                  cash used in investing activities
              
              
              (51,146
              )
              
              (102,094
              )**Financing
                  activities**Proceeds
                  from issuance of Common Stock
              
              
              219
              
              
              173Excess
                  tax benefits from stock option exercises
              
              
              145
              
              
              75Issuance
                  of junior subordinated debt
              
              
              -
              
              
              20,000Issuance
                  costs
              
              
              -
              
              
              (27
              )Dividends
                  paid to common stockholders
              
              
              (4,541
              )
              
              -Net
                  cash (used in) provided by financing activities
              
              
              (4,177
              )
              
              20,221Change
                  in cash and cash equivalents
              
              
              4,986
              
              
              (9,263
              )Cash
                  and cash equivalents at beginning of period
              
              
              40,319
              
              
              41,029Cash
                  and cash equivalents at end of period
              
              $
              45,305
              
              $
              31,766





*See
      accompanying notes.*


4


**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)**





**June
      30, 2007**





**1.**  **Accounting
      Policies and Basis of Presentation**





**Basis
      of Presentation**





The
      accompanying condensed consolidated financial statements and notes have been
      prepared in accordance with United States generally accepted accounting
      principles for interim financial information and do not contain all of the
      information and footnotes required by United States generally accepted
      accounting principles for complete financial statements. Readers are urged
      to
      review the Company’s 2006 audited consolidated financial statements contained in
      Form 10-K for a more complete description of the Company’s business and
      accounting policies. In the opinion of management, all adjustments necessary
      for
      a fair presentation of the condensed consolidated financial statements have
      been
      included. Such adjustments consist only of normal recurring items. Interim
      results are not necessarily indicative of results of operations for the full
      year. The consolidated balance sheet as of December 31, 2006 was derived
      from the Company’s audited annual consolidated financial
      statements.





Significant
      intercompany transactions and balances have been eliminated.





**Estimates
      and Assumptions**





Preparation
      of the condensed consolidated financial statements in conformity with United
      States generally accepted accounting principles requires management to make
      estimates and assumptions that affect the amounts reported in the condensed
      consolidated financial statements and accompanying disclosures. Those estimates
      are inherently subject to change, and actual results may ultimately differ
      from
      those estimates.





**New
      Accounting Standards**





In
      June
      2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
      No. 48, *Accounting
      for Uncertainty in Income Taxes, an interpretation of FASB Statement No.
      109* (FIN
      48). FIN 48 clarifies the accounting for uncertain tax positions. The
      interpretation prescribes a recognition threshold and measurement attribute
      for
      the financial statement recognition and measurement of a tax position taken
      or
      expected to be taken in a tax return. The Company adopted FIN 48 on January
      1,
      2007, and adoption of FIN 48 had no effect on the Company’s financial position
      or results of operations.





In
      September 2006, the FASB issued Statement No. 157, *Fair
      Value Measurements* (Statement 157). Statement 157 defines fair value, establishes a framework
      for
      measuring fair value in United States generally accepted accounting principles
      and expands disclosures about fair value measurements. Statement 157 is
      effective for financial statements issued for fiscal years beginning after
      November 15, 2007 with earlier application encouraged. The Company is currently
      evaluating the impact of adopting Statement 157 on its financial
      statements.





In
      February 2007, the FASB issued Statement No. 159, *The
      Fair Value Option for Financial Assets and Liabilities,* (Statement 159). Statement 159 permits entities to choose to measure many
      financial instruments and certain other items at fair value with changes in
      fair
      value included in current earnings. The election is made on specified election
      dates, can be made on an instrument-by-instrument basis and is irrevocable.
      Statement 159 is effective for financial statements issued for fiscal years
      beginning after November 15, 2007. The Company is currently evaluating the
      impact of adopting Statement 159 on its financial statements.





**2.** **Proposed
          Transaction**





On
      June
      11, 2007, the Company entered into an Agreement and Plan of Merger (the Merger
      Agreement), with Franklin Holdings (Bermuda), Ltd., a Bermuda company (Parent)
      and Franklin Acquisition Corp., a Delaware corporation and a wholly-owned direct
      subsidiary of Parent (Merger Sub). Under the terms of the Merger Agreement,
      Merger Sub will be merged with and into the Company, and as a result, the
      Company will continue as the surviving corporation and a wholly-owned subsidiary
      of Parent (the Merger). Parent is a Bermuda-based holding company and member
      of
      the D. E. Shaw group, a global investment management firm. The Company
      is


5





**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**








**2.** **Proposed
          Transaction (continued)**





permitted,
      under the terms of the Merger Agreement, to continue to pay regular quarterly
      cash dividends until the consummation of the Merger, such amount not to exceed
      $0.15 per share per quarter.





Subject
      to the terms and conditions set forth in the Merger Agreement, at the effective
      time of the Merger, each outstanding share of Common Stock, other than shares
      as
      to which appraisal rights under Delaware law may have been perfected, will
      be
      canceled and converted into the right to receive $34.50 in cash per share,
      without interest (the Merger Consideration). In addition, at the effective
      time
      of the Merger, (a) each outstanding option to purchase Common Stock (vested
      or
      unvested) will be canceled and the holder will be entitled to receive an amount
      of cash equal to the difference between the Merger Consideration and the
      exercise price of the applicable stock option without interest and less any
      required withholding taxes, and (b) each outstanding warrant to purchase Common
      Stock will be converted into the right to receive, upon exercise of such
      warrant, the
      Merger Consideration the holder of such warrant would have been entitled to
      receive upon consummation of the Merger if such holder had been, immediately
      prior to the Merger, the holder of the number of shares of Common Stock then
      issuable upon exercise in full of
      such
      warrant or, if the holder and the Company agree, canceled and extinguished,
      and
      the holder thereof will be entitled to receive, following exercise or
      cancellation, as the case may be, an amount in cash equal to the excess (if
      any)
      of (a) the product of (x) the number of shares of Common Stock subject to the
      warrant and (y) the Merger Consideration, minus (b) the aggregate exercise
      price
      of the warrant, without interest and less any required withholding
      taxes.





The
      closing of the Merger is expected to occur in the fourth quarter of 2007,
      subject to the receipt of stockholder approval and regulatory approvals and
      satisfaction or waiver of other customary closing conditions. The Company and
      Parent filed notification and report forms relating to the Merger under the
      Hart-Scott-Rodino Act (the HSR Act) with the Federal Trade Commission (the
      FTC)
      and the Department of Justice. On July 20, 2007, the FTC granted early
      termination of the waiting period under the HSR Act with respect to the Merger.
      Parent made the required filings for regulatory approval relating to the Merger
      with the insurance commissioners of North Carolina and Ohio, the states in
      which
      the Company's insurance subsidiaries are domiciled, on July 11, 2007. The Merger
      is not subject to a financing condition and equity commitments for the full
      amount of the Merger Consideration plus funds sufficient to pay all related
      fees
      and expenses required to be paid or funded as of or prior to the consummation
      of
      the Merger have been received by Parent from affiliates of the D.E. Shaw
      group.





The
      Company and Parent each have certain termination rights under the terms of
      the
      Merger Agreement, including the right by either party to terminate the Merger
      Agreement if the Merger has not been consummated on or before December 15,
      2007.
      In the event that the Merger Agreement is terminated under certain circumstances
      set forth in the Merger Agreement, the Company will be required to pay a fee
      of
      approximately $11.5 million to Parent and reimburse Parent for an amount not
      to
      exceed approximately $3.6 million for transaction fees and expenses incurred
      by
      Parent and its affiliates.





On
      August
      3, 2007, the Company filed a preliminary proxy statement with the Securities
      and
      Exchange Commission containing information about the Merger and a special
      meeting of stockholders, to be called, at which the Company’s stockholders will
      be asked to vote on a proposal to approve the Merger Agreement. The definitive
      proxy statement, when filed, will include the date of the special meeting of
      stockholders and the record date for the special meeting. On August 5, 2007,
      the
      Company’s right to solicit competing proposals ended under the terms of the
      Merger Agreement. The Company did not receive any competing proposals during
      the
      solicitation period.





6





**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**








**3.**  **Stock
      Based Compensation**





A
      summary
      of stock option activity is as follows:




**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***($
                in thousands, except for share data)*Other
                operating expenses recognized for stock based
              compensation
            
            $
            275
            
            $
            238
            
            $
            540
            
            $
            461Related
                tax benefits of stock based compensation
            
            $
            96
            
            $
            84
            
            $
            189
            
            $
            162Option
                Grant Activity:Number
                of options granted
            
            
            -
            
            
            45,000
            
            
            17,500
            
            
            45,000Weighted-average
                fair value on the date of grant
            
            $
            -
            
            $
            11.71
            
            $
            11.00
            
            $
            11.71Option
                Exercise Activity:Cash
                received from stock options exercised
            
            $
            25
            
            $
            -
            
            $
            219
            
            $
            173Shares
                of common stock issued in connection with
              stock
                options exercised
            
            
            2,500
            
            
            -
            
            
            21,400
            
            
            17,255Intrinsic
                value of options exercised
            
            $
            56
            
            $
            -
            
            $
            416
            
            $
            217Income
                tax benefit of options exercised
            
            $
            19
            
            $
            -
            
            $
            145
            
            $
            75





The
      Company uses a Black-Scholes-Merton option pricing model in determining the
      fair
      value of the options granted. The following table summarizes the assumptions
      used to estimate the fair value of the Company’s share-based awards issued
      during the six months ended June 30, 2007:





Weighted-average
                expected life
            
            7
                yearsExpected
                stock price volatility
            
            35.00%Risk-free
                interest rate
            
            4.67%Dividend
                yield
            
            2.00%





For
      all
      awards, the expected life is based on the midpoint between the vesting period
      and the contractual term of the award. Stock price volatility is estimated
      based
      on stock price volatility data for similar property/casualty companies in the
      period following their respective initial public offerings. The risk-free
      interest rate assumption is based on the seven-year U.S. Treasury rate at the
      date of grant. The dividend yield assumption is based upon the rate of expected
      future dividend payments over the life of the options at the time that the
      options were granted.





As
      of
      June 30, 2007, there was $2.5 million of estimated unrecognized compensation
      cost related to non-vested option awards expected to be charged to earnings
      over
      a weighted-average period of 2.4 years.


7


**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**








**4.**   **Earnings
      Per Share**





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***(in
                thousands, except for share data)*Net
                income -*numerator
                for basic and diluted*
              *earnings
                per share*
            
            $
            9,156
            
            $
            8,551
            
            $
            19,283
            
            $
            15,380Weighted
                - average common shares
              outstanding
                   -*denominator
                for basic*
              *earnings
                per share*
            
            
            15,137,856
            
            
            15,087,308
            
            
            15,131,149
            
            
            15,081,571Dilutive
                potential common shares:Options
            
            
            984,639
            
            
            823,822
            
            
            958,308
            
            
            779,293Warrants
            
            
            104,230
            
            
            91,945
            
            
            102,171
            
            
            87,802Weighted
                - average common shares and
              dilutive
                potential common shares outstanding
              -*denominator
                for diluted earnings per share*
            
            
            16,226,725
            
            
            16,003,075
            
            
            16,191,628
            
            
            15,948,666Earnings
                per share:Basic
            
            $
            0.60
            
            $
            0.57
            
            $
            1.27
            
            $
            1.02Diluted
            
            $
            0.56
            
            $
            0.53
            
            $
            1.19
            
            $
            0.96





**5.**  **Income
      Taxes**





Income
                tax expense differs from the amounts computed by applying the Federal
                statutory income tax rate to income before income taxes primarily
                due to
                interest income on tax-advantaged state and municipal securities.
                The
                Company did not have any unrecognized tax benefits at June 30, 2007
                or
                January 1, 2007, the date FIN 48 was adopted. Tax year 2003 and all
                subsequent tax years remain subject to examination by the Internal
                Revenue
                Service.





8


**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**








**6.**  **Reserve
      for Losses and Loss Adjustment Expenses**





A
      $2.8
      million reserve redundancy developed in the three months ended June 30, 2007
      on
      the direct business written arising from prior accident years. Of this
      development, $3.9 million of favorable development occurred in the Excess and
      Surplus Insurance segment’s casualty lines primarily related to the 2005 and
      2004 accident years. The Excess and Surplus Insurance segment’s property lines
      experienced $534,000 of adverse development primarily related to hurricane
      losses in the 2005 accident year. Adverse development on prior accident years
      for direct business for the Workers’ Compensation Insurance segment in the three
      months ended June 30, 2007 was $512,000, with $711,000 of adverse development
      on
      the 2006 accident year exceeding $199,000 of favorable development on the 2005
      and 2004 accident years.





A
      $2.0
      million reserve redundancy developed in the three months ended June 30, 2006
      on
      direct business written arising from prior accident years. Of this development,
      $1.5 million of favorable development occurred in the Excess and Surplus
      Insurance segment’s casualty lines, with $1.2 million of this favorable
      development coming from the 2004 accident year. Favorable development in the
      Excess and Surplus Insurance segment’s property lines of $513,000 primarily
      related to the 2005 accident year.





A
      $5.8
      million reserve redundancy developed in the six months ended June 30, 2007
      on
      direct business written arising from prior accident years. Of this development,
      $6.0 million of favorable development occurred in the Excess and Surplus
      Insurance segment’s casualty lines primarily related to the 2005 and 2004
      accident years. Adverse development in the Excess and Surplus Insurance
      segment’s property lines during the six months ended June 30, 2007 of $645,000
      primarily related to hurricane losses in the 2005 accident year. Favorable
      development on prior accident years for the Workers’ Compensation Insurance
      segment in the six months ended June 30, 2007 was $415,000.





A
      $4.4
      million redundancy developed in the six months ended June 30, 2006 on the direct
      business written arising from prior accident years. Of this development, $3.0
      million of favorable development occurred in the Excess and Surplus Insurance
      segment’s casualty lines, with $2.4 million of this favorable development coming
      from the 2004 accident year. Favorable development in the Excess and Surplus
      Insurance segment’s property lines of $1.1 million primarily related to the 2005
      accident year. Favorable development for direct business written by the Workers’
Compensation Insurance segment totaled $242,000.





**7.**  **Comprehensive
      Income**





The
      following table summarizes the components of comprehensive income:





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***(in
                thousands)*Net
                unrealized losses arising during the period,
              before
                taxes
            
            $
            (7,477
            )
            $
            (4,078
            )
            $
            (6,580
            )
            $
            (8,593
            )Income
                taxes
            
            
            2,617
            
            
            1,426
            
            
            2,303
            
            
            3,007Net
                unrealized losses arising during the period,
              net
                of taxes
            
            
            (4,860
            )
            
            (2,652
            )
            
            (4,277
            )
            
            (5,586
            )Less
                reclassification adjustment:Net
                losses realized in net income
            
            
            (19
            )
            
            (49
            )
            
            (27
            )
            
            (84
            )Income
                taxes
            
            
            6
            
            
            17
            
            
            9
            
            
            29Reclassification
                adjustment for losses realized
              in
                net income
            
            
            (13
            )
            
            (32
            )
            
            (18
            )
            
            (55
            )Other
                comprehensive loss
            
            
            (4,847
            )
            
            (2,620
            )
            
            (4,259
            )
            
            (5,531
            )Net
                income
            
            
            9,156
            
            
            8,551
            
            
            19,283
            
            
            15,380Comprehensive
                income
            
            $
            4,309
            
            $
            5,931
            
            $
            15,024
            
            $
            9,849





9





**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**





**8.**  **Contingent
      Liabilities**





The
      Company is aware of one lawsuit filed in connection with the proposed Merger
      of
      the Company with members of the D. E. Shaw group. On June 13, 2007,
      Levy Investments filed a purported class action (the Levy complaint) in the
      Superior Court for Orange County, North Carolina against the Company, all of
      the
      directors of the Company and the D. E. Shaw group. The Levy complaint
      alleges, among other things, that the Company’s directors breached their
      fiduciary duties to stockholders in approving the Merger Agreement and that
      the
      negotiation and structure of the proposed Merger are the result of an unfair
      process. The Levy complaint seeks, among other things, class certification
      and
      an injunction preventing the completion of the Merger, and a declaration that
      the directors breached their fiduciary duties. The Company believes the Levy
      complaint is without merit and plans to defend it vigorously.





The
      Company is a party to various lawsuits arising in the ordinary course of its
      operations. The Company believes that the ultimate resolution of these matters
      will not materially impact its financial position or results of
      operations.





**9.** **Segment
      Information**





The
      Company has three reportable segments: the Excess and Surplus Insurance segment,
      the Workers’ Compensation Insurance segment and the Corporate and Other segment.
      Segment profit (loss) is measured by underwriting profit (loss), which is
      generally defined as net earned premiums less loss and loss adjustment expenses
      and other operating expenses of the insurance segments. Segment results are
      reported prior to the effects of the intercompany reinsurance pooling agreement
      between the Company’s insurance subsidiaries. The following table summarizes
      segment results:





**Excess
                and Surplus Insurance**
            
            **Workers’
                Compensation Insurance**
            
            **Corporate
                and Other**
            
            **Total***(in
                thousands)***Three
                Months Ended June 30, 2007**Gross
                written premiums
            
            $
            64,469
            
            $
            14,980
            
            $
            -
            
            $
            79,449Net
                earned premiums
            
            
            48,744
            
            
            14,243
            
            
            -
            
            
            62,987Segment
                revenues
            
            
            53,729
            
            
            15,275
            
            
            (17
            )
            
            68,987Underwriting
                profit of insurance segments
            
            
            11,019
            
            
            225
            
            
            -
            
            
            11,244Net
                investment income
            
            
            4,839
            
            
            1,018
            
            
            94
            
            
            5,951Interest
                expense
            
            
            -
            
            
            -
            
            
            1,298
            
            
            1,298Segment
                assets
            
            
            659,899
            
            
            112,418
            
            
            21,206
            
            
            793,523**Three
                Months Ended June 30, 2006**Gross
                written premiums
            
            $
            63,788
            
            $
            10,846
            
            $
            -
            
            $
            74,634Net
                earned premiums
            
            
            43,316
            
            
            9,286
            
            
            -
            
            
            52,602Segment
                revenues
            
            
            46,754
            
            
            9,972
            
            
            379
            
            
            57,105Underwriting
                profit of insurance segments
            
            
            9,760
            
            
            410
            
            
            -
            
            
            10,170Net
                investment income
            
            
            3,487
            
            
            674
            
            
            345
            
            
            4,506Interest
                expense
            
            
            -
            
            
            -
            
            
            896
            
            
            896Segment
                assets
            
            
            558,025
            
            
            83,659
            
            
            30,680
            
            
            672,364





10


**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**








**9.** **Segment
          Information (continued)**





**Excess
                and Surplus Insurance**
            
            **Workers’
                Compensation Insurance**
            
            **Corporate
                and Other**
            
            **Total***(in
                thousands)***Six
                Months Ended June 30, 2007**Gross
                written premiums
            
            $
            129,948
            
            $
            29,589
            
            $
            -
            
            $
            159,537Net
                earned premiums
            
            
            96,133
            
            
            27,103
            
            
            -
            
            
            123,236Segment
                revenues
            
            
            105,798
            
            
            29,128
            
            
            143
            
            
            135,069Underwriting
                profit of insurance segments
            
            
            19,191
            
            
            3,070
            
            
            -
            
            
            22,261Net
                investment income
            
            
            9,527
            
            
            1,994
            
            
            201
            
            
            11,722Interest
                expense
            
            
            -
            
            
            -
            
            
            2,582
            
            
            2,582Segment
                assets
            
            
            659,899
            
            
            112,418
            
            
            21,206
            
            
            793,523**Six
                Months Ended June 30, 2006**Gross
                written premiums
            
            $
            121,556
            
            $
            21,243
            
            $
            -
            
            $
            142,799Net
                earned premiums
            
            
            82,900
            
            
            17,791
            
            
            -
            
            
            100,691Segment
                revenues
            
            
            89,382
            
            
            19,086
            
            
            726
            
            
            109,194Underwriting
                profit (loss) of insurance segments
            
            
            17,891
            
            
            (233
            )
            
            -
            
            
            17,658Net
                investment income
            
            
            6,566
            
            
            1,272
            
            
            661
            
            
            8,499Interest
                expense
            
            
            -
            
            
            -
            
            
            1,673
            
            
            1,673Segment
                assets
            
            
            558,025
            
            
            83,659
            
            
            30,680
            
            
            672,364





The
      following table reconciles the underwriting profit (loss) of the insurance
      segments by individual segment to consolidated income before taxes:





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***(in
                thousands)*Underwriting
                profit (loss) of insurance segments:Excess
                and Surplus Insurance
            
            $
            11,019
            
            $
            9,760
            
            $
            19,191
            
            $
            17,891Workers’
                Compensation Insurance
            
            
            225
            
            
            410
            
            
            3,070
            
            
            (233
            )Total
                underwriting profit of insurance segments
            
            
            11,244
            
            
            10,170
            
            
            22,261
            
            
            17,658Other
                operating expenses of the Corporate and
              Other
                segment
            
            
            (2,870
            )
            
            (1,166
            )
            
            (3,815
            )
            
            (1,807
            )Underwriting
                profit (a)
            
            
            8,374
            
            
            9,004
            
            
            18,446
            
            
            15,851Net
                investment income
            
            
            5,951
            
            
            4,506
            
            
            11,722
            
            
            8,499Net
                realized investment losses
            
            
            (19
            )
            
            (49
            )
            
            (27
            )
            
            (84
            )Other
                income
            
            
            68
            
            
            46
            
            
            138
            
            
            88Interest
                expense
            
            
            (1,298
            )
            
            (896
            )
            
            (2,582
            )
            
            (1,673
            )Consolidated
                income before taxes
            
            $
            13,076
            
            $
            12,611
            
            $
            27,697
            
            $
            22,681





(a)
            Other
                operating expenses of the Corporate and Other segment for the three
                months
                and six months ended June 30, 2007 include $2.0 million of legal,
                accounting, and investment banking fees associated with the proposed
                transaction. (See Note 2)


11





**Notes
      to Condensed Consolidated Financial Statements**


**(Unaudited)
      (continued)**





**10.**  **Other
      Operating Expenses**





Other
      operating expenses consist of the following:





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***(in
                thousands)*Other
                underwriting expenses of the insurance segments
            
            $
            5,033
            
            $
            3,856
            
            $
            10,887
            
            $
            7,563Amortization
                of policy acquisition costs
            
            
            9,756
            
            
            8,362
            
            
            18,866
            
            
            16,039Other
                operating expenses of the Corporate and Other segment
            
            
            2,870
            
            
            1,166
            
            
            3,815
            
            
            1,807Total
            
            $
            17,659
            
            $
            13,384
            
            $
            33,568
            
            $
            25,409





**11.** **Investment
          in Joint Venture**





During
      the second quarter of 2007, the Company invested $620,000 as a one-third owner
      of a real estate joint venture, Forest Avenue Office, LLC. This joint venture
      will own and construct a commercial office building which will eventually house
      the Company’s Richmond, Virginia operations. The investment is recorded in
“other assets” in the accompanying balance sheet.





**12.**  **Subsequent
      Events**





On
      July
      2, 2007, the Company completed an acquisition of 100% of the stock of Align
      Financial Group, a wholesale and retail insurance agency with principal offices
      in San Diego, California.





In
      July
      2007, the Company invested an additional $1.6 million to a real estate joint
      venture (see Note 11), bringing the Company’s total investment in the real
      estate joint venture to $2.3 million.


12





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





On
      June
      11, 2007, the Company announced that it had signed a definitive merger agreement
      under which a Bermuda-based holding company and member of the
      D. E. Shaw group, a global investment management firm, would acquire
      the Company. In connection with the transaction, during the second quarter,
      the
      Company incurred $2.0 million of pre-tax transaction costs ($1.3 million
      after-tax, or $0.08 per diluted share) for legal, accounting and investment
      banking services. See - “Proposed Transaction”.





**OVERVIEW**





James
      River Group, Inc. is an insurance holding company that primarily owns and
      manages property/casualty insurance companies focused on specialty insurance
      niches. We seek to:





**·**
            earn
                a profit from underwriting; and**·**
            produce
                a return on average equity of 15% or
                greater.





Earning
      a
      profit from underwriting means that we intend for the premiums we earn in any
      period to be sufficient to pay all of the losses and loss adjustment expenses
      we
      incur during the period as well as all of the expenses associated with our
      operations. We
      use
      underwriting profit or loss as a basis for evaluating our underwriting
      performance. Our strategy is to operate at a lower expense ratio than many of
      our competitors; focus our efforts on the specialty insurance market where
      profits have historically been better than in the standard market; underwrite
      each risk individually in order to apply our expertise to each risk we
      underwrite; use technology to provide our employees and managers with timely
      and
      accurate information about our business; and actively manage claims in
      accordance with the terms of our insurance contracts. Our underwriting profit
      for the three months ended June 30, 2007 (which included the $2.0 million of
      transaction costs as noted above) was $8.4 million, a decrease from the
      underwriting profit of $9.0 million reported for the same period last year.
      For
      the six months ended June 30, 2007, our underwriting profit was $18.4 million,
      an increase over the underwriting profit of $15.9 million reported for the
      same
      period last year. Excluding the transaction costs noted above, our adjusted
      underwriting profit for the three-month and six-month periods ended June 30,
      2007 was $10.4 million and $20.5 million, respectively. These adjusted amounts
      represent a 15.4% and 29.1% increase over the underwriting profit of the prior
      year, respectively.





We
      calculate return on equity by dividing net income by average stockholders’
equity for the period on an annualized basis. Our overall financial goal is
      to
      produce an annual return on equity of at least 15.0%. Our annualized return
      on
      equity, including the transaction costs noted above, was 16.3% for the quarter
      ended June 30, 2007 and 17.5 % for the six months ended June 30, 2007, compared
      to the return for the same periods in 2006 which were 18.6% and 17.0%,
      respectively.





We
      are
      organized into three reportable segments, which are separately managed business
      units:





**·**
            The
                Excess and Surplus Insurance segment offers commercial excess and
                surplus
                lines liability and property insurance in 48 states and the District
                of
                Columbia through James River Insurance Company (James River
                Insurance);**·**
            The
                Workers’ Compensation Insurance segment offers workers’ compensation
                coverage primarily for the residential construction industry in North
                Carolina and, in 2007, Virginia through Stonewood Insurance Company
                (Stonewood Insurance); and**·**
            The
                Corporate and Other segment consists of management and treasury activities
                of our holding company and interest expense associated with our
                debt.





James
      River Insurance and Stonewood Insurance each have a financial strength rating
      of
“A-” (Excellent) from A.M. Best.


13





**RESULTS
      OF OPERATIONS**




The
      following table compares the components of net income for the three and six
      months ended June 30, 2007 and 2006:





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **%
                Change**
            
            **2007**
            
            **2006**
            
            **%
                Change***($
                in thousands)*Gross
                written premiums
            
            $
            79,449
            
            $
            74,634
            
            
            *6.5*
            *%*
            $
            159,537
            
            $
            142,799
            
            
            *11.7*
            *%*Net
                retention (a)
            
            
            90.1
            %
            
            73.5
            %
            
            
            
            
            84.9
            %
            
            76.0
            %Net
                written premiums
            
            $
            71,572
            
            $
            54,824
            
            
            *30.5*
            *%*
            $
            135,442
            
            $
            108,512
            
            
            *24.8*
            *%*Net
                earned premiums
            
            $
            62,987
            
            $
            52,602
            
            
            *19.7*
            *%*
            $
            123,236
            
            $
            100,691
            
            
            *22.4*
            *%*Losses
                and loss adjustment expenses
            
            
            (36,954
            )
            
            (30,214
            )
            
            *22.3*
            *%*
            
            (71,222
            )
            
            (59,431
            )
            
            *19.8*
            *%*Other
                operating expenses (b)
            
            
            (17,659
            )
            
            (13,384
            )
            
            *31.9*
            *%*
            
            (33,568
            )
            
            (25,409
            )
            
            *32.1*
            *%*Underwriting
                profit (c)
            
            
            8,374
            
            
            9,004
            
            
            *(7.0*
            *%)*
            
            18,446
            
            
            15,851
            
            
            *16.4*
            *%*Net
                investment income
            
            
            5,951
            
            
            4,506
            
            
            *32.1*
            *%*
            
            11,722
            
            
            8,499
            
            
            *37.9*
            *%*Net
                realized investment losses
            
            
            (19
            )
            
            (49
            )
            
            *(61.2*
            *%)*
            
            (27
            )
            
            (84
            )
            
            *(67.9*
            *%)*Other
                income
            
            
            68
            
            
            46
            
            
            *47.8*
            *%*
            
            138
            
            
            88
            
            
            *56.8*
            *%*Interest
                expense
            
            
            (1,298
            )
            
            (896
            )
            
            *44.9*
            *%*
            
            (2,582
            )
            
            (1,673
            )
            
            *54.3*
            *%*Federal
                income tax expense
            
            
            (3,920
            )
            
            (4,060
            )
            
            *(3.4*
            *%)*
            
            (8,414
            )
            
            (7,301
            )
            
            *15.2*
            *%*Net
                income
            
            $
            9,156
            
            $
            8,551
            
            
            *7.1*
            *%*
            $
            19,283
            
            $
            15,380
            
            
            *25.4*
            *%*Ratios:Loss
                ratio
            
            
            58.7
            %
            
            57.4
            %
            
            *-*
            
            
            57.8
            %
            
            59.0
            %
            
            *-*Expense
                ratio (b)
            
            
            28.0
            %
            
            25.4
            %
            
            *-*
            
            
            27.2
            %
            
            25.2
            %
            
            *-*Combined
                ratio (b)
            
            
            86.7
            %
            
            82.9
            %
            
            *-*
            
            
            85.0
            %
            
            84.3
            %
            
            *-*





(a)  Net
                retention is defined as the ratio of net written premiums to gross
                written
                premiums.(b)  Includes
                $2.0 million of transaction costs for the quarter and six months
                ended
                June 30, 2007.(c)  See
                “Reconciliation of Non-GAAP Measures” for further
                detail.





**Results
      of Operations**





Net
      income was $9.2 million, or $0.56 per diluted share, for the three months ended
      June 30, 2007, compared to $8.6 million, or $0.53 per diluted share, for the
      three months ended June 30, 2006. For the six-month period ended June 30, 2007,
      net income was $19.3 million, or $1.19 per diluted share, compared to the prior
      year’s net income of $15.4 million, or $0.96 per diluted share. Net income for
      the 2007 periods included $2.0 million of pre-tax transaction costs (or $0.08
      per diluted share) for legal, accounting and investment banking services.
      Weighted-average diluted shares outstanding were 16.2 million and 16.0 million
      for the quarter ended June 30, 2007 and 2006, respectively (16.2 million and
      15.9 million on a year-to-date basis, respectively).





Our
      combined ratio for the three months ended June 30, 2007 was 86.7%. The combined
      ratio is a measure of underwriting performance and represents the relationship
      of incurred losses, loss adjustment expenses and other operating expenses to
      net
      earned premiums. A combined ratio of less than 100% indicates an underwriting
      profit, while a combined ratio greater than 100% reflects an underwriting loss.
      The combined ratio for the quarter included $2.8 million, or 4.5 percentage
      points, of net favorable reserve development on direct business written by
      the
      Company on prior accident years including $3.9 million of favorable reserve
      development from the Excess and Surplus Insurance segment’s casualty business
      offset by $534,000 of adverse development from the Excess and Surplus Insurance
      segment’s property business and $512,000 of adverse development from the
      Workers’ Compensation Insurance segment.


14


The
      combined ratio for the six months ended June 30, 2007 of 85.0% included $5.8
      million, or 4.7 percentage points, of net favorable reserve development on
      direct business written by the Company from prior accident years including
      $6.0
      million of favorable reserve development from the Excess and Surplus Insurance
      segment’s casualty business and $415,000 of favorable reserve development from
      the Workers’ Compensation Insurance segment offset by $645,000 of adverse
      development from the Excess and Surplus Insurance segment’s property
      business.





Included
      in our combined ratio, our expense ratio increased to 28.0% for the second
      quarter of 2007 compared to 25.4% for the second quarter of 2006. For the
      six-month period ended June 30, 2007 our expense ratio increased from 25.2%
      in
      2006 to 27.2% for the six-month period ended June 30, 2007. This increase was
      primarily attributable to the $2.0 million in transaction costs (representing
      3.2 percentage points and 1.6 percentage points in our expense ratio for the
      three-month and six-month periods, respectively).





In
      the
      prior year, the combined ratio for the three months ended June 30, 2006 was
      82.9%. It included $2.0 million or 3.9 percentage points, of favorable reserve
      development on direct business written by the Company from prior accident years.
      This favorable development arose as follows: $1.5 million of favorable
      development from the Excess and Surplus Insurance segment’s casualty business,
      $513,000 of favorable development from the Excess and Surplus Insurance
      segment’s property business and $19,000 of favorable development for the
      Workers’ Compensation Insurance segment.





In
      the
      prior year, the combined ratio for the six months ended June 30, 2006 was 84.3%.
      It included $4.4 million, or 4.3 percentage points, of net favorable reserve
      development on direct business written by the Company from prior accident years.
      This net favorable development arose as follows: $3.0 million of favorable
      development from the Excess and Surplus Insurance segment’s casualty business,
      $1.1 million of favorable development from the Excess and Surplus Insurance
      segment’s property lines and $242,000 of favorable development for the Workers’
Compensation Insurance segment.





**Adjusted
      Results of Operations Excluding Transaction Costs of $2.0
      Million**





The
      following presentation of adjusted results of operations excludes $2.0 million
      of pre-tax transaction costs (or $0.08 per diluted share) for legal, accounting
      and investment banking services. See - “Reconciliation of Non-GAAP
      Measures”.





Adjusted
      net income was $10.5 million, or $0.64 per diluted share, for the three months
      ended June 30, 2007, compared to $8.6 million, or $0.53 per diluted share,
      for
      the three months ended June 30, 2006. For the six-month period ended June 30,
      2007, adjusted net income was $20.6 million, or $1.27 per diluted share,
      compared to the prior year’s net income of $15.4 million, or $0.96 per diluted
      share.





Our
      adjusted combined ratio for the three months ended June 30, 2007 was 83.5%.
      It
      included $2.8 million, or 4.5 percentage points, of net favorable reserve
      development on direct business written by the Company on prior accident years.
      This is fairly consistent with the combined ratio for the prior year’s second
      quarter of 82.9% which is noted above.





The
      adjusted combined ratio for the six months ended June 30, 2007 of 83.4% included
      $5.8 million, or 4.7 percentage points, of net favorable reserve development
      on
      direct business written by the Company on prior accident years. This is lower
      than the combined ratio for the first six months of the prior year of 84.3%,
      which is noted above.





Included
      in our adjusted combined ratio, our adjusted expense ratio decreased to 24.8%
      for the second quarter of 2007 compared to 25.4% for the second quarter of
      2006.
      For the six-month period ended June 30, our adjusted expense ratio remained
      relatively stable from 25.2% in 2006 to 25.6% in 2007.


15


***Premiums***





The
      following table summarizes the growth in premium volume by component and
      business segment: **





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **%
                Change**
            
            **2007**
            
            **2006**
            
            **%
                Change***($
                in thousands)*Gross
                written premiums:Excess
                and Surplus Insurance
            
            $
            64,469
            
            $
            63,788
            
            
            *1.1*
            *%*
            $
            129,948
            
            $
            121,556
            
            
            *6.9*
            *%*Workers’
                Compensation Insurance
            
            
            14,980
            
            
            10,846
            
            
            *38.1*
            *%*
            
            29,589
            
            
            21,243
            
            
            *39.3*
            *%*$
            79,449
            
            $
            74,634
            
            
            *6.5*
            *%*
            $
            159,537
            
            $
            142,799
            
            
            *11.7*
            *%*Net
                written premiums:Excess
                and Surplus Insurance
            
            $
            57,696
            
            $
            45,368
            
            
            *27.2*
            *%*
            $
            107,319
            
            $
            89,944
            
            
            *19.3*
            *%*Workers’
                Compensation Insurance
            
            
            13,876
            
            
            9,456
            
            
            *46.7*
            *%*
            
            28,123
            
            
            18,568
            
            
            *51.5*
            *%*$
            71,572
            
            $
            54,824
            
            
            *30.5*
            *%*
            $
            135,442
            
            $
            108,512
            
            
            *24.8*
            *%*Net
                earned premiums:Excess
                and Surplus Insurance
            
            $
            48,744
            
            $
            43,316
            
            
            *12.5*
            *%*
            $
            96,133
            
            $
            82,900
            
            
            *16.0*
            *%*Workers’
                Compensation Insurance
            
            
            14,243
            
            
            9,286
            
            
            *53.4*
            *%*
            
            27,103
            
            
            17,791
            
            
            *52.3*
            *%*$
            62,987
            
            $
            52,602
            
            
            *19.7*
            *%*
            $
            123,236
            
            $
            100,691
            
            
            *22.4*
            *%*





The
      excess and surplus insurance industry has been facing a softening market where
      price competition from other carriers as well as the standard insurance market
      has begun to intensify. Despite this, gross written premiums for the second
      quarter and six months ended June 30, 2007 for the Excess and Surplus Insurance
      segment grew 1.1% and 6.9%, respectively. The increases reflect an increase
      in
      renewal business as well as penetration and growth in this segment’s broker
      network. The number of brokers submitting business to the Excess and Surplus
      Insurance segment grew 11.9% from 219 for the three months ended June 30, 2006
      to 245 for the three months ended June 30, 2007.





Gross
      written premiums for the Workers’ Compensation Insurance segment for the three
      months ended June 30, 2007 increased significantly over the quarter ended June
      30, 2006. This is attributable to an 18.7% increase in submissions for the
      second quarter on new business (21.4% on a year-to-date basis) coupled with
      an
      increase in renewals over the prior year. During 2007, the Workers’ Compensation
      Insurance segment began to write policies in Virginia (although the total gross
      written premiums during 2007 was only $57,000). The increase in premiums noted
      above resulted from increased penetration with existing agents as well as a
      13.6% increase in new agents (the number of producing agencies in the Workers’
Compensation Insurance network increased from 132 at June 30, 2006 to 150 at
      June 30, 2007). Additionally, gross written premiums for the three months ended
      June 30, 2007 and 2006 included $601,000 and $657,000, respectively, of assumed
      premiums from our allocation from the North Carolina involuntary workers’
compensation pool. For the six months ended June 30, 2007 and 2006, assumed
      premiums from the pool were $1.4 million and $1.2 million,
      respectively.





The
      ratio
      of net written premiums to gross written premiums is referred to as our net
      retention. For the three months ended June 30, 2007 and 2006, our net retention
      was 90.1% and 73.5%, respectively (84.9% and 76.0%, respectively, on a
      year-to-date basis). The net retention for the Excess and Surplus Insurance
      segment was 89.5% and 71.1% for the three months ended June 30, 2007 and 2006,
      respectively (82.6% and 74.0%, respectively, on a year-to-date basis). The
      increase in net retention in the Excess and Surplus Insurance segment is
      attributable to a June 1, 2007 change in the Company’s property reinsurance
      program from quota share to excess of loss. This change resulted in a reduction
      of ceded written premiums (and a corresponding increase in net written premiums)
      of $8.6 million in the second quarter of 2007. The net retention for the
      Worker’s Compensation Insurance segment was 92.6% and 87.2% for the three months
      ended June 30, 2007 and 2006, respectively (95.0% and 87.4%, respectively,
      on a
      year-to-date basis). The increase in net retention in the Workers’ Compensation
      Insurance segment is attributable, in part, to a change in the segment’s
      reinsurance program where it increased its retention from $750,000 to $1.0
      million per occurrence effective January 1, 2007. The remainder of the increase
      is attributable to the recording of reinsurance deposit
      payments.


16


Premiums
      are earned ratably over the terms of our insurance policies, generally twelve
      months, and net earned premiums were affected by the growth in written premiums
      over the prior year.





***Underwriting
      Results***





The
      following table compares our combined ratios by segment **:**





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Excess
                and Surplus Insurance
            
            
            77.4
            %
            
            77.5
            %
            
            80.0
            %
            
            78.4
            %Workers’
                Compensation Insurance
            
            
            98.4
            %
            
            95.6
            %
            
            88.7
            %
            
            101.3
            %Total
            
            
            86.7
            %
            
            82.9
            %
            
            85.0
            %
            
            84.3
            %





*Excess
      and Surplus Insurance*





Underwriting
      results for the Excess and Surplus Insurance segment are as
      follows:





**Three
                Months Ended June 30,**
            
            
            
            **Six****Months Ended June 30,****2007**
            
            **2006**
            
            **%
                Change**
            
            **2007**
            
            **2006**
            
            **%
                Change***($
                in thousands)*Gross
                written premiums
            
            $
            64,469
            
            $
            63,788
            
            
            *1.1*
            *%*
            $
            129,948
            
            $
            121,556
            
            
            *6.9*
            *%*Net
                written premiums
            
            $
            57,696
            
            $
            45,368
            
            
            *27.2*
            *%*
            $
            107,319
            
            $
            89,944
            
            
            *19.3*
            *%*Net
                earned premiums
            
            $
            48,744
            
            $
            43,316
            
            
            *12.5*
            *%*
            $
            96,133
            
            $
            82,900
            
            
            *16.0*
            *%*Losses
                and loss
              adjustment
                expenses
            
            
            (26,323
            )
            
            (23,945
            )
            
            *9.9*
            *%*
            
            (54,226
            )
            
            (46,312
            )
            
            *17.1*
            *%*Underwriting
                expenses
            
            
            (11,402
            )
            
            (9,611
            )
            
            *18.6*
            *%*
            
            (22,716
            )
            
            (18,697
            )
            
            *21.5*
            *%*Underwriting
                profit (1)
            
            $
            11,019
            
            $
            9,760
            
            
            *12.9*
            *%*
            $
            19,191
            
            $
            17,891
            
            
            *7.3*
            *%*Ratios:Loss
                ratio
            
            
            54.0
            %
            
            55.3
            %
            
            -
            
            
            56.4
            %
            
            55.9
            %
            
            -Expense
                ratio
            
            
            23.4
            %
            
            22.2
            %
            
            -
            
            
            23.6
            %
            
            22.6
            %
            
            -Combined
                ratio
            
            
            77.4
            %
            
            77.5
            %
            
            -
            
            
            80.0
            %
            
            78.4
            %
            
            -





(1)
                See - “Reconciliation of Non-GAAP
                Measures”.





The
      combined ratio for the Excess and Surplus Insurance segment for the three months
      ended June 30, 2007 was 77.4%, comprised of a loss ratio of 54.0% and an expense
      ratio of 23.4%. This included $3.4 million, or 6.9 percentage points, of net
      favorable reserve development in our loss estimates for prior accident years
      consisting of $3.9 million arising from casualty business offset by $534,000
      of
      adverse development from property business. This compares to the prior year’s
      second quarter combined ratio of 77.5%, comprised of a loss ratio of 55.3%
      and
      an expense ratio of 22.2%. The prior year’s combined ratio for the second
      quarter included $2.0 million, or 4.7 percentage points, of favorable
      development consisting of $1.5 million of favorable development on casualty
      business and $513,000 on property business.





The
      expense ratio for the second quarter increased from 22.2% in 2006 to 23.4%
      for
      the three months ended June 30, 2007. This is primarily attributable to an
      increase in compensation-related items.





As
      a
      result of the items discussed above, our underwriting profit increased 12.9%
      from $9.8 million for the three months ended June 30, 2006 to $11.0 million
      for
      the three months ended June 30, 2007.


17


The
      combined ratio for the Excess and Surplus Insurance segment for the six months
      ended June 30, 2007 was 80.0%, comprised of a loss ratio of 56.4% and an expense
      ratio of 23.6%. This included $5.4 million, or 5.6 percentage points, of net
      favorable development in our loss estimates for prior accident years consisting
      of $6.0 million arising from casualty business offset by $645,000 of adverse
      development from property business. This compares to the first six months of
      the
      prior year’s combined ratio of 78.4%, comprised of a loss ratio of 55.9% and an
      expense ratio of 22.6%. The prior year’s combined ratio included $4.1 million,
      or 5.0 percentage points, of favorable reserve development in our loss estimates
      for prior accident years which included $3.0 million of favorable development
      on
      casualty business and $1.1 million on property business.





The
      expense ratio for the six months ended June 30 increased from 22.6% in 2006
      to
      23.6% in 2007. This is primarily attributable to an increase in
      compensation-related items.





As
      a
      result of the items discussed above, underwriting profit of the Excess and
      Surplus Insurance segment increased 7.3% from $17.9 million for the six months
      ended June 30, 2006 to $19.2 million for the six months ended June 30,
      2007.





Underwriting
      results by major line of business within the Excess and Surplus Insurance
      segment are as follows:





**Three
                Months Ended June 30, 2007**
            
            **Six
                Months Ended June 30, 2007****Casualty
                Lines**
            
            **Property
                Lines**
            
            **Total**
            
            **Casualty
                Lines**
            
            **Property
                Lines**
            
            **Total***($
                in thousands)*Net
                earned premiums
            
            $
            47,503
            
            $
            1,241
            
            $
            48,744
            
            $
            94,389
            
            $
            1,744
            
            $
            96,133Losses
                and loss adjustment expenses
            
            $
            24,959
            
            $
            1,364
            
            $
            26,323
            
            $
            51,941
            
            $
            2,285
            
            $
            54,226Loss
                ratio
            
            
            52.5
            %
            
            109.9
            %
            
            54.0
            %
            
            55.0
            %
            
            131.0
            %
            
            56.4
            %





**Three
                Months Ended
                June 30, 2006**
            
            **Six
                Months Ended June 30, 2006****Casualty
                Lines**
            
            **Property
                Lines**
            
            **Total**
            
            **Casualty
                Lines**
            
            **Property
                Lines**
            
            **Total***($
                in thousands)*Net
                earned premiums
            
            $
            41,624
            
            $
            1,692
            
            $
            43,316
            
            $
            79,327
            
            $
            3,573
            
            $
            82,900Losses
                and loss adjustment expenses
            
            $
            23,866
            
            $
            79
            
            $
            23,945
            
            $
            45,175
            
            $
            1,137
            
            $
            46,312Loss
                ratio
            
            
            57.3
            %
            
            4.7
            %
            
            55.3
            %
            
            56.9
            %
            
            31.8
            %
            
            55.9
            %





The
      loss
      ratio for property lines for the three and six months ended June 30, 2007
      reflects adverse development on prior accident years which had a more prominent
      effect on the loss ratio due to the low net earned premium volume noted
      above.


18


*Workers’
      Compensation Insurance*





Underwriting
      results for the Workers’ Compensation Insurance segment are as
      follows:





**Three
                Months Ended June 30,**
            
            
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **%
                Change**
            
            **2007**
            
            **2006**
            
            **%
                Change***($
                in thousands)*Gross
                written premiums
            
            $
            14,980
            
            $
            10,846
            
            
            *38.1*
            *%*
            $
            29,589
            
            $
            21,243
            
            
            *39.3*
            *%*Net
                written premiums
            
            $
            13,876
            
            $
            9,456
            
            
            *46.7*
            *%*
            $
            28,123
            
            $
            18,568
            
            
            *51.5*
            *%*Net
                earned premiums
            
            $
            14,243
            
            $
            9,286
            
            
            *53.4*
            *%*
            $
            27,103
            
            $
            17,791
            
            
            *52.3*
            *%*Losses
                and loss adjustment expenses
            
            
            (10,631
            )
            
            (6,269
            )
            
            *69.6*
            *%*
            
            (16,996
            )
            
            (13,119
            )
            
            *29.6*
            *%*Underwriting
                expenses
            
            
            (3,387
            )
            
            (2,607
            )
            
            *29.9*
            *%*
            
            (7,037
            )
            
            (4,905
            )
            
            *43.5*
            *%*Underwriting
                profit (loss)(1)
            
            $
            225
            
            $
            410
            
            
            *(45.1*
            *%)*
            $
            3,070
            
            $
            (233
            )
            
            *-*Ratios:Loss
                ratio
            
            
            74.6
            %
            
            67.5
            %
            
            -
            
            
            62.7
            %
            
            73.7
            %
            
            -Expense
                ratio
            
            
            23.8
            %
            
            28.1
            %
            
            -
            
            
            26.0
            %
            
            27.6
            %
            
            -Combined
                ratio
            
            
            98.4
            %
            
            95.6
            %
            
            -
            
            
            88.7
            %
            
            101.3
            %
            
            -





(1)
                See - “Reconciliation of Non-GAAP
                Measures”.





The
      combined ratio for the Workers’ Compensation Insurance segment for the three
      months ended June 30, 2007 was 98.4%, comprised of a loss ratio of 74.6% and
      an
      expense ratio of 23.8%. The loss ratio included $512,000, or 3.6 percentage
      points, of adverse reserve development on prior accident years for direct
      business. This compares to the prior year’s second quarter combined ratio of
      95.6%, comprised of a loss ratio of 67.5% and an expense ratio of 28.1%. The
      loss ratio for the second quarter of the prior year included $19,000, or 0.2
      percentage points, of favorable development on direct business from prior
      accident years. **** The
      results for the quarter ended June 30, 2007 reflected higher loss
      activity.





The
      expense ratio for the second quarter decreased from 28.1% in 2006 to 23.8%
      for
      the three months ended June 30, 2007. This decrease primarily reflects the
      management of growth in underwriting and other expenses while achieving
      significant growth in earned premiums.





As
      a
      result of the items discussed above, our underwriting profit decreased from
      $410,000 for the three months ended June 30, 2006 to $225,000 for the three
      months ended June 30, 2007.





The
      combined ratio for the Workers’ Compensation Insurance segment for the six
      months ended June 30, 2007 was 88.7%, comprised of a loss ratio of 62.7% and
      an
      expense ratio of 26.0%. The loss ratio included $415,000, or 1.5 percentage
      points, of net favorable reserve development on prior accident years. For
      the
      six months ended June 30, 2006, the Workers’ Compensation Insurance segment had
      a
      combined ratio of 101.3%, comprised of a loss ratio of 73.7% and an expense
      ratio of 27.6%. The loss ratio included high loss activity in the first quarter
      of 2006 offset by $242,000, or 1.4 percentage points, of favorable reserve
      development on direct business from prior accident years.





The
      expense ratio of the Workers’ Compensation Insurance segment for the six months
      ended June 30, 2007 of 26.0% improved over the prior year of 27.6% principally
      due to the management of growth in underwriting and other expenses while
      achieving significant growth in earned premiums.





As
      a
      result of the items discussed above, our underwriting profit (loss) of the
      Workers’ Compensation Insurance segment increased from a loss of $233,000 for
      the six months ended June 30, 2006 to a profit of $3.1 million for the six
      months ended June 30, 2007.


19


***Reserves***





The
      Company’s gross reserve for losses and loss adjustment expenses at June 30, 2007
      was $351.0 million. Of this amount, 75.2% relates to amounts that are incurred
      but not reported (IBNR). The Company’s gross reserves for losses and loss
      adjustment expenses by segment are summarized as follows:





**Gross
                Reserves at****June 30, 2007****Case**
            
            **IBNR**
            
            **Total***(in
                thousands)*Excess
                and Surplus InsuranceCasualty
                Lines
            
            $
            51,159
            
            $
            224,322
            
            $
            275,481Property
                Lines
            
            
            18,295
            
            
            14,997
            
            
            33,292Workers’
                Compensation Insurance
            
            
            17,485
            
            
            24,740
            
            
            42,225Total
            
            $
            86,939
            
            $
            264,059
            
            $
            350,998





At
      June
      30, 2007, the amount of net reserves related to IBNR was 79.2% of the total
      net
      reserve for losses and loss adjustment expenses. The Company’s net reserves for
      losses and loss adjustment expenses by segment are summarized as
      follows:





**Net
                Reserves at****June 30, 2007****Case**
            
            **IBNR**
            
            **Total***(**in
                thousands)*Excess
                and Surplus InsuranceCasualty
                Lines
            
            $
            31,065
            
            $
            174,511
            
            $
            205,576Property
                Lines
            
            
            4,581
            
            
            5,129
            
            
            9,710Workers’
                Compensation Insurance
            
            
            17,228
            
            
            21,340
            
            
            38,568Total
            
            $
            52,874
            
            $
            200,980
            
            $
            253,854





***Other
      Operating Expenses***





Other
      operating expenses for the Company include both the underwriting, acquisition
      and insurance expenses of the Excess and Surplus Insurance segment and the
      Workers’ Compensation Insurance segment as well as the expenses of the Corporate
      and Other segment.





*Corporate
      and Other Segment*





Other
      operating expenses for the Corporate and Other segment include personnel costs
      associated with holding company employees, directors’ fees, professional fees
      and various other corporate expenses. A majority of these costs are reimbursed
      by our subsidiaries. These reimbursements are included primarily as underwriting
      expenses in the results of our insurance subsidiaries. Other operating expenses
      of the Corporate and Other segment represent the expenses of the holding company
      that were not reimbursed by our subsidiaries, including costs associated with
      potential acquisitions and other strategic initiatives. These costs may vary
      from period-to-period based on the status of these initiatives. In 2007, other
      operating expenses for this segment included $2.0 million of pre-tax transaction
      costs for legal, accounting and investment banking services.





The
      total
      operating expenses of the Corporate and Other segment were $2.9 million and
      $1.2
      million for the three months ended June 30, 2007 and 2006, respectively. These
      expenses were $3.8 and $1.8 million for the six months ended June 30, 2007
      and
      2006, respectively. Total operating expenses for the quarter and six months
      ended June 30, 2007 included the $2.0 million of transaction-related
      expenses.


20





***Investing
      Results***





Net
      investment income for the three months ended June 30, 2007 was $6.0 million,
      an
      increase from the $4.5 million for the three months ended June 30, 2006. For
      the
      six months ended June 30, 2007, net investment income was $11.7 million, an
      increase from the $8.5 million for the six months ended June 30, 2006. The
      increase in net investment income reflects the significant growth in our cash
      and invested assets from $465.2 million at June 30, 2006 to $582.7 million
      at
      June 30, 2007 and an increase in our average investment yield. The growth in
      our
      invested assets is a result of an increase in our net written premiums. The
      following table summarizes our investment returns:





**Three
                Months Ended June 30,**
            
            **Six****Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Annualized
                gross investment yield on:Average
                cash and invested assets
            
            
            4.4
            %
            
            4.3
            %
            
            4.5
            %
            
            4.3
            %Average
                fixed maturity securities
            
            
            4.6
            %
            
            4.3
            %
            
            4.6
            %
            
            4.2
            %Annualized
                tax equivalent yield on:Average
                fixed maturity securities
            
            
            5.4
            %
            
            4.8
            %
            
            5.4
            %
            
            4.7
            %





Our
      cash
      and invested assets consist of fixed maturity securities, equity securities
      and
      cash and cash equivalents. Our fixed maturity and equity securities are
      classified as available-for-sale and are carried at fair value with unrealized
      gains and losses on these securities reported, net of tax, as a separate
      component of accumulated other comprehensive income (loss). The average duration
      of our fixed maturity security portfolio at June 30, 2007 is approximately
      4.7
      years.





The
      amortized cost and fair value of our investments in available-for-sale
      securities were as follows:





**June****30, 2007**
            
            **December
                31, 2006****Cost
                or Amortized Cost**
            
            **Fair**
              **Value**
            
            **%
                of**
              **Total**
              **Fair
                Value**
            
            **Cost
                or Amortized**
              **Cost**
            
            **Fair**
              **Value**
            
            **%
                of**
              **Total**
              **Fair
                Value***($**in thousands)*Fixed
                maturity securities:State
                and municipal
            
            $
            229,285
            
            $
            226,170
            
            
            *42.1*
            *%*
            $
            198,627
            
            $
            200,264
            
            
            *40.5*
            *%*Mortgage-backed
            
            
            103,921
            
            
            101,688
            
            
            *18.9*
            *%*
            
            92,673
            
            
            91,760
            
            
            *18.5*
            *%*Corporate
            
            
            75,465
            
            
            73,778
            
            
            *13.7*
            *%*
            
            88,561
            
            
            86,895
            
            
            *17.6*
            *%*Asset-backed
            
            
            64,897
            
            
            63,915
            
            
            *11.9*
            *%*
            
            59,226
            
            
            58,889
            
            
            *11.9*
            *%*Obligations
                of U.S.
              government
                corporations
              and
                agencies
            
            
            25,960
            
            
            25,548
            
            
            *4.8*
            *%*
            
            25,954
            
            
            25,568
            
            
            *5.2*
            *%*U.S.
                Treasury securities and
              obligations
                guaranteed by
              the
                U.S. Government
            
            
            23,202
            
            
            22,312
            
            
            *4.1*
            *%*
            
            23,191
            
            
            22,640
            
            
            *4.5*
            *%*Total
                fixed maturity securities
            
            
            522,730
            
            
            513,411
            
            
            *95.5*
            *%*
            
            488,232
            
            
            486,016
            
            
            *98.2*
            *%*Equity
                securities
            
            
            23,266
            
            
            23,983
            
            
            *4.5*
            *%*
            
            8,536
            
            
            8,703
            
            
            *1.8*
            *%*Total
                investments
            
            $
            545,996
            
            $
            537,394
            
            
            *100.0*
            *%*
            $
            496,768
            
            $
            494,719
            
            
            *100.0*
            *%*





21


The
      amortized cost and fair value of our investments in fixed maturity securities
      summarized by contractual maturity were as follows:





**June****30, 2007****Amortized**
              **Cost**
            
            **Fair**
              **Value**
            
            **%
                of**
              **Total**
              **Fair
                Value***(**$
                in thousands)*Due
                in:One
                year or less
            
            $
            26,040
            
            $
            25,808
            
            
            *5.0*
            *%*After
                one year through five years
            
            
            81,926
            
            
            80,056
            
            
            *15.6*
            *%*After
                five years through ten years
            
            
            91,733
            
            
            89,675
            
            
            *17.5*
            *%*After
                ten years
            
            
            154,213
            
            
            152,269
            
            
            *29.7*
            *%*Mortgage-backed
            
            
            103,921
            
            
            101,688
            
            
            *19.8*
            *%*Asset-backed
            
            
            64,897
            
            
            63,915
            
            
            *12.4*
            *%*Total
            
            $
            522,730
            
            $
            513,411
            
            
            *100.0*
            *%*





At
      June
      30, 2007, our fixed maturity security portfolio had a net unrealized loss of
      $9.3 million, representing 1.8% of the amortized cost of the portfolio. The
      majority of the unrealized losses on fixed maturity securities at June 30,
      2007
      are interest rate related. Each fixed maturity security and equity security
      in
      our portfolio had a fair value that was greater than 91.0% of its amortized
      cost
      (or cost for equity securities) at June 30, 2007. None of the fixed maturity
      securities with unrealized losses has ever missed or been delinquent on a
      scheduled principal
      or interest payment. At June 30, 2007, 97.2% of our fixed maturity security
      portfolio was rated ‘‘A-’’ or better by Standard & Poor’s or received an
      equivalent rating from another nationally recognized rating
      agency.





We
      have
      concluded that none of the available-for-sale securities with unrealized losses
      at June 30, 2007 has experienced an other-than-temporary impairment. We
      considered our intent and ability to hold the securities for a sufficient time
      to allow for a recovery in value in this determination.





The
      balance of our cash and cash equivalents was $45.3 million at June 30, 2007.
      The
      percentage of cash and cash equivalents to cash and invested assets was 7.8%
      at
      June 30, 2007 compared to 7.5% at December 31, 2006. At June 30, 2007, cash
      and
      invested assets per share was $38.49 compared to $35.39 at December 31,
      2006.





In
      the fourth quarter of 2006, we began to invest in equity securities, principally
      in various market indices. Over time, up to 10.0% of cash and invested assets
      may be invested in equity securities. At June 30, 2007, equity securities of
      $24.0 million represented 4.1% of total cash and invested assets.





At
      June 30, 2007, the Company held $4.6 million in par value of securitizations
      of
      alternative-A and sub-prime mortgages, all of which are rated “AAA” by the
      established ratings agencies.





***Interest
      Expense***





Interest
      expense totaled $1.3 million and $896,000 for the three months ended June 30,
      2007 and 2006, respectively. For the six months ended June 30, 2007 and 2006,
      this amount was $2.6 million and $1.7 million, respectively. Interest expense
      relates to $15.0 million of senior debt and $43.3 million of junior subordinated
      debt. Interest on these notes accrues at floating rates, and the increase in
      interest expense reflects increases in the overall rate environment over the
      past 12 months as well as the issuance of the additional $20.6 million of junior
      subordinated debt in June 2006.





***Income
      Taxes***





For
      the
      three-month and six-month periods ended June 30, 2007 and 2006, income tax
      expense differs from the amount computed by applying the Federal statutory
      income tax rate to income before taxes primarily due to interest income on
      tax-advantaged state and municipal securities. Our effective tax rates were
      30.0% and 32.2%, respectively, for the three months ended June 30, 2007 and
      2006. For the six months ended June 30, 2007 and 2006,


22


those
      rates were 30.4% and 32.2% respectively. State and municipal securities
      represented 44.1% of our fixed maturity security portfolio at June 30, 2007
      compared to 36.4% at June 30, 2006.





The
      Company does not have any unrecognized tax benefits at June 30, 2007. Tax year
      2003 and all subsequent tax years remain subject to examination by the Internal
      Revenue Service.





**LIQUIDITY
      AND CAPITAL RESOURCES**





**Sources
      and Uses of Funds**





We
      are
      organized as a holding company with all of our operations being conducted by
      our
      wholly-owned insurance subsidiaries. Accordingly, our holding company receives
      cash through loans from banks, issuance of equity and debt securities, corporate
      service fees or dividends received from our insurance subsidiaries, payments
      from our subsidiaries pursuant to our consolidated tax allocation agreement
      and
      other transactions.





The
      payment to us of dividends by our subsidiaries is limited by statute. In
      general, these restrictions require that dividends be paid out of earned surplus
      and limit the aggregate amount of dividends or other distributions that our
      subsidiaries may declare or pay within any 12-month period without advance
      regulatory approval. The maximum amount of dividends available to us from our
      insurance subsidiaries during 2007 without regulatory approval is $33.8 million.
      However, insurance regulators have broad powers to prevent the reduction of
      statutory surplus to inadequate levels and could refuse to permit the payment
      of
      dividends under any applicable formula.





At
      June
      30, 2007, cash and invested assets at our holding company totaled $16.5
      million.





During
      the second quarter of 2007, the Company invested $620,000 as a minority partner
      in a real estate joint venture. This joint venture will own and construct a
      commercial office building which will eventually house the Company’s Richmond,
      Virginia operations. The investment is recorded in “other assets” in the
      accompanying financial statements. During July 2007, the Company invested an
      additional $1.6 million in the joint venture.





Our
      net
      written premium to surplus ratio (defined as annualized net written premiums
      to
      statutory surplus) is reviewed by management as well as our rating agency as
      a
      measure of leverage and efficiency of deployed capital. As we have a relatively
      limited operating history, the rating agency’s metrics require us to have a
      lower premium to surplus ratio than that of some of our competitors. For the
      three months ended June 30, 2007, our annualized net written premium to surplus
      ratio was 1.2 to 1.0 (1.1 to 1.0 for the six months ended June 30,
      2007).





**Cash
      Flows**





Our
      sources of operating funds consist primarily of premiums written, investment
      income and proceeds from offerings of debt and equity securities. We use
      operating cash flows primarily to pay operating expenses, losses and loss
      adjustment expenses and income taxes.





**Six****Months
                Ended June 30,****2007**
            
            **2006***(in
                thousands)*Cash
                and cash equivalents provided by (used in):Operating
                activities
            
            $
            60,309
            
            $
            72,610Investing
                activities
            
            
            (51,146
            )
            
            (102,094
            )Financing
                activities
            
            
            (4,177
            )
            
            20,221Change
                in cash and cash equivalents
            
            $
            4,986
            
            $
            (9,263
            )





The
      decrease in net cash provided by operating activities for the six-months ended
      June 30, 2007 is due primarily to a decrease in reinsurance recoveries on paid
      losses (since the first six months of 2006 had significant recoveries on
      reinsurance from hurricane-related losses paid by the Company in 2005).


23





Cash
      used
      in financing activities for the six months ended June 30, 2007 relates primarily
      to the $4.5 million of common
      stock dividends paid during 2007. Cash provided by financing activities in
      the
      prior year primarily relates to the proceeds of the trust preferred transaction
      which closed on June 15, 2006.





**Senior
      Debt and Junior Subordinated Debt**





In
      May
      2004, we issued $15.0 million of senior debt due April 29, 2034, with net
      proceeds to us of $14.5 million. The senior debt is not redeemable by the holder
      or subject to sinking fund requirements. Interest accrues quarterly and is
      payable in arrears at a floating rate per annum equal to three-month LIBOR
      plus
      3.85%. The senior debt is redeemable prior to its stated maturity at our option
      in whole or in part, on or after May 15, 2009. The terms of the senior debt
      contain certain covenants, which, among other things, restrict our assuming
      senior indebtedness secured by our Common Stock or our subsidiaries’ capital
      stock or issuing shares of our subsidiaries’ capital stock. We are in compliance
      with all such covenants at June 30, 2007.





We
      have
      sold trust preferred securities through three Delaware statutory trusts
      sponsored and wholly-owned by us. Each trust used the net proceeds from the
      sale
      of its trust preferred securities to purchase our floating rate junior
      subordinated debt. The following table summarizes the nature and terms of the
      junior subordinated debt and trust preferred securities outstanding at June
      30,
      2007:


**James
                  River**
                **Capital
                  Trust I**
              
              **James
                  River**
                **Capital
                  Trust II**
              
              **James
                  River**
                **Capital
                  Trust III***($
                  in thousands)*Issue
                  date
              
              
              May
                  26, 2004
              
              
              December
                  15, 2004
              
              
              June
                  15, 2006Principal
                  amount of trust preferred securities
              
              $
              7,000
              
              $
              15,000
              
              $
              20,000Principal
                  amount of junior subordinated debt
              
              $
              7,217
              
              $
              15,464
              
              $
              20,619Maturity
                  date of junior subordinated debt,
                unless
                  accelerated earlier
              
              
              May
                  24, 2034
              
              
              December
                  15, 2034
              
              
              June
                  15, 2036Trust
                  common stock
              
              $
              217
              
              $
              464
              
              $
              619Interest
                  rate, per annum
              
              
              Three-Month
                LIBOR
                  plus 4.0%
              
              
              Three-Month
                LIBOR
                  plus 3.4%
              
              
              Three-Month
                LIBOR
                  plus 3.0%Redeemable
                  at 100% of principal amount at
                our
                  option on or after
              
              
              May
                  24, 2009
              
              
              December
                  15, 2009
              
              
              June
                  15, 2011





We
      have
      provided a full, irrevocable and unconditional guarantee of payment of the
      obligations of each of the trusts under the trust preferred securities. The
      indentures for the junior subordinated debt contain certain covenants with
      which
      we are in compliance as of June 30, 2007.





At
      June
      30, 2007, the ratio of total debt outstanding to total capitalization (defined
      as total debt outstanding plus total stockholders’ equity) was 20.5%. We use
      capital to support our premium growth and having debt as part of our capital
      structure allows us to generate higher earnings per share and book value per
      share results than we could by using equity alone. Our target debt to total
      capitalization ratio is 35.0% or less.





**Reinsurance**





We
      enter
      into reinsurance contracts to limit our exposure to potential losses arising
      from large risks and to provide additional capacity for growth. Our reinsurance
      has been contracted under excess of loss and quota share reinsurance contracts.
      In excess of loss reinsurance, the reinsurer agrees to assume all or a portion
      of the ceding company’s losses in excess of a specified amount. In excess of
      loss reinsurance, the premium payable to the reinsurer is negotiated by the
      parties based on their assessment of the amount of risk being ceded to the
      reinsurer because the reinsurer does not share proportionately in the ceding
      company’s losses. In quota share reinsurance, the reinsurer agrees to assume a
      specified percentage of the ceding company’s losses arising out of a defined
      class of business in exchange for a corresponding percentage of premiums. For
      the three months ended June 30, 2007 and 2006, our net retention was 90.1%
      and
      73.5%, respectively. For the six months ended June 30, 2007 and 2006, our net
      retention was 84.9% and 76.0%, respectively.


24


On
      June
      1, 2007, the Company changed its property reinsurance program from quota share
      to excess of loss. This change resulted in a reduction of ceded written premiums
      (and a corresponding increase in net written premiums) of $8.6 million in the
      second quarter of 2007.





The
      following is a summary of our casualty reinsurance effective July 1,
      2007:





**Line
                of Business**
            
            **Company
                Retention**Primary
                Casualty
            
            Up
                to $2.0 million per occurrenceExcess
                Casualty
            
            $500,000
                per occurrence(1)Workers’
                Compensation
            
            $1.0
                million per occurrence and losses above $20.0 million per occurrence
                and
                above $10.0 million on any one life





(1)
            For
                policies with an occurrence limit of $1.0 million or higher, the
                excess
                casualty treaty is set such that our retention is $500,000. For policies
                where we also write an underlying primary casualty policy, the excess
                casualty reinsurance reduces our retention to $100,000, which when
                added
                to our retention on the primary casualty coverage, results in a total
                retention of $1.1 million on that risk.





The
      following is a summary of our property reinsurance in place as of June 30,
      2007:





**Line
                of Business**
            
            **Company
                Retention**Primary
                Property
            
            $1.0
                million per riskExcess
                Property
            
            $2.0
                million per risk





Additionally,
      we have a property reinsurance treaty that covers our per occurrence exposure
      to
      terrorism as provided under the Terrorism Risk Insurance Act of 2002. This
      treaty covers $3.0 million in excess of $2.0 million per risk.





We
      use
      catastrophe-modeling software to analyze the risk of severe losses from
      hurricanes and earthquakes. We model our portfolio of insurance policies in
      force each month and track our accumulations of exposed values geographically
      to
      manage our concentration in any one area. We do not write any primary property
      insurance with wind coverage within 100 miles of the Southeast and Gulf
      coasts of the United States or within 30 miles of the Northeast coast of the
      United States. In that area, we have reduced the concentration of exposed limits
      on excess property in any 50 mile area to $50.0 million or less. We have imposed
      a similar limitation on earthquake exposed property we write.





We
      measure exposure to potential catastrophe losses in terms of probable maximum
      loss, which is an estimate of the amount we would expect to pay in any one
      catastrophe event over a specified period of time (i.e. a return period). We
      manage this potential loss by purchasing catastrophe reinsurance
      coverage.





Effective
      June 1, 2007, we purchased catastrophe reinsurance of $47.5 million in excess
      of
      our $2.5 million per event retention. This coverage has one reinstatement in
      the
      event we exhaust any of the coverage. We also purchased $2.5 million of coverage
      in excess of $2.5 million retention for a third and fourth event. Based upon
      our
      modeling, a $50 million gross catastrophe loss is expected to exceed our
      500 year probable maximum loss. In the event of a $50 million gross property
      catastrophe loss to the Company, we estimate our net after-tax cost at
      approximately $5.2 million, including reinstatement premiums. In addition to
      our
      retention, we would retain any losses in excess of our reinsurance coverage
      limits.





Reinsurance
      contracts do not relieve us from our obligations to policyholders. The failure
      of a reinsurer to honor its obligations could result in losses to us, and
      therefore, we establish allowances for amounts considered uncollectible. At
      June
      30, 2007, there was no allowance for uncollectible reinsurance recoverables.
      James River Insurance and Stonewood Insurance generally target reinsurers with
      A.M. Best financial strength ratings of ‘‘A-’’ (Excellent) or
      better.





At
      June
      30, 2007, we had reinsurance recoverables on unpaid losses of $97.1 million
      and
      reinsurance recoverables on paid losses of $4.1 million. Included in reinsurance
      recoverables on paid and unpaid losses at June 30, 2007 are $10.1 million of
      recoverables related to Hurricane Katrina and $9.8 million related to Hurricane
      Wilma. All but $2.9 million of our total recoverables on
      paid and unpaid losses at June 30, 2007 were from companies with A.M. Best
      ratings of “A-” or better or are collateralized.




25





**NEW
      ACCOUNTING STANDARDS**





In
      June
      2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
      No. 48, *Accounting
      for Uncertainty in Income Taxes, an interpretation of FASB Statement No.
      109* (FIN
      48). FIN 48 clarifies the accounting for uncertain tax positions. The
      interpretation prescribes a recognition threshold and measurement attribute
      for
      the financial statement recognition and measurement of a tax position taken
      or
      expected to be taken in a tax return. We adopted FIN 48 on January 1, 2007,
      and
      adoption of FIN 48 had no effect on our financial position or results of
      operations.





**RECENT
      ACCOUNTING PRONOUNCEMENTS**





In
      September 2006, the FASB issued Statement No. 157, *Fair
      Value Measurements* (Statement 157). Statement 157 defines fair value, establishes a framework
      for
      measuring fair value in generally accepted accounting principles and expands
      disclosures about fair value measurements. Statement 157 is effective for
      financial statements issued for fiscal years beginning after November 15, 2007
      with earlier application encouraged. We are currently evaluating the impact
      of
      adopting Statement 157 on our financial statements.





In
      February 2007, the FASB issued Statement No. 159, *The
      Fair Value Option for Financial Assets and Liabilities* ,
      (Statement 159). Statement 159 permits entities to choose to measure many
      financial instruments and certain other items at fair value with changes in
      fair
      value included in current earnings. The election is made on specified election
      dates, can be made on an instrument-by-instrument basis, and is irrevocable.
      Statement 159 is effective for financial statements issued for fiscal years
      beginning after November 15, 2007. We are currently evaluating the impact of
      adopting Statement 159 on our financial statements.





**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**





Critical
      accounting estimates are defined as those estimates that are both important
      to
      the portrayal of our financial position and results of operations and that
      require us to exercise significant judgment. We use significant judgment
      concerning future results and developments in applying these critical accounting
      estimates and in preparing our consolidated financial statements. These
      judgments and estimates affect the reported amounts of assets, liabilities,
      revenues and expenses and the disclosure of material contingent assets and
      liabilities. We evaluate our estimates regularly using information that we
      believe to be relevant. These reviews include evaluating the adequacy of
      reserves for losses and loss adjustment expenses, evaluating the investment
      portfolio for other-than-temporary declines in estimated fair value, analyzing
      the recoverability of deferred tax assets and estimating the compensation
      expense associated with share-based awards. Actual results may differ materially
      from the estimates and assumptions used in preparing the consolidated financial
      statements.





**Stock
      Based Compensation**





In
      December 2004, the FASB issued Statement 123(R), which is a revision of
      Statement No. 123, *Accounting
      for Stock-Based Compensation* .
      We
      adopted Statement 123(R) using the modified prospective method on January 1,
      2006.





Prior
      to
      May 3, 2005 (the date that we filed our Form S-1 with the Securities and
      Exchange Commission), we used the Minimum Value method to calculate the pro
      forma disclosures required by Statement 123. We continue to account for the
      portion of awards granted prior to May 3, 2005 that have not been modified,
      cancelled or repurchased subsequent to that date using the intrinsic value
      method prescribed in APB Opinion No. 25 and its related interpretive guidance.
      When we adopted Statement 123(R), we began recognizing the expense associated
      with awards issued on or after May 3, 2005 and for awards modified, repurchased
      or cancelled on or after that date in the income statement over the award’s
      vesting period using the modified prospective method. Compensation expense
      amounts related to options are recognized on a straight-line basis over each
      award’s vesting period in our income statement. We recognized $275,000 and
      $238,000 of other operating expenses for stock based compensation for the three
      months ended June 30, 2007 and 2006, respectively. For the six-month periods
      ended June 30, 2007 and 2006, such amounts were $540,000 and $461,000,
      respectively. As of June 30, 2007, there was


26


$2.5
      million of estimated unrecognized compensation cost related to non-vested option
      awards expected to be charged to earnings over a weighted-average period of
      2.4
      years.





We
      use a
      Black-Scholes-Merton option pricing model in determining the fair value of
      option grants. The following table summarizes the assumptions used to estimate
      the fair value of our share-based awards issued during the six months ended
      June
      30, 2007:





Risk-free
                interest rate
            4.67%Dividend
                yield
            2.00%Expected
                stock price volatility
            35.00%Weighted-average
                expected life
            7
                years





The
      expected life is based on the midpoint between the vesting period and the
      contractual term of the award. The stock price volatility assumption is a
      significant variable in estimating the value of an option. Stock price
      volatility is a measure of the amount by which stock price has fluctuated or
      is
      expected to fluctuate in a period. In the Black-Scholes-Merton option pricing
      model, a higher volatility assumption results in a higher value for the option
      and a lower volatility assumption results in a lower option value. Stock price
      volatility is estimated based on stock price volatility data for similar
      property/casualty companies in the period following their respective initial
      public offerings since our own historical stock price information is limited
      to
      the period subsequent to our initial public offering in August 2005. The
      risk-free interest rate assumption is based on the seven-year U.S. Treasury
      rate
      at the date of the grant. The dividend yield assumption is based upon the rate
      of expected future dividend payments over the life of the options at the time
      the options were granted.





Readers
      are urged to review ‘‘Management’s Discussion and Analysis of Financial
      Condition and Results of Operations - Critical Accounting Policies and
      Estimates’’ and Note 1 to the audited consolidated financial statements
      contained in our Form 10-K for the fiscal year ended December 31, 2006 on file
      with the Securities and Exchange Commission for a more complete description
      of
      our critical accounting policies and estimates.





**RECONCILIATION
      OF NON-GAAP MEASURES**





The
      following table reconciles the underwriting profit (loss) by individual
      insurance segment and of the whole Company to consolidated income before taxes.
      We believe that these measures are useful to investors in evaluating the
      performance of our Company and its insurance segments because our objective
      is
      to consistently earn underwriting profits. We evaluate the performance of our
      insurance segments and allocate resources based primarily on underwriting profit
      (loss) of insurance segments. Our definition of underwriting profit (loss)
      of
      insurance segments and underwriting profit (loss) may not be comparable to
      the
      definition of underwriting profit (loss) for other companies.





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006***(in
                thousands)*Underwriting
                profit (loss) of the insurance segments:Excess
                and Surplus Insurance
            
            $
            11,019
            
            $
            9,760
            
            $
            19,191
            
            $
            17,891Workers’
                Compensation Insurance
            
            
            225
            
            
            410
            
            
            3,070
            
            
            (233
            )Total
                underwriting profit of insurance segments
            
            
            11,244
            
            
            10,170
            
            
            22,261
            
            
            17,658Other
                operating expenses of the Corporate and Other
              segment(a)
            
            
            (2,870
            )
            
            (1,166
            )
            
            (3,815
            )
            
            (1,807
            )Underwriting
                profit
            
            
            8,374
            
            
            9,004
            
            
            18,446
            
            
            15,851Net
                investment income
            
            
            5,951
            
            
            4,506
            
            
            11,722
            
            
            8,499Net
                realized investment losses
            
            
            (19
            )
            
            (49
            )
            
            (27
            )
            
            (84
            )Other
                income
            
            
            68
            
            
            46
            
            
            138
            
            
            88Interest
                expense
            
            
            (1,298
            )
            
            (896
            )
            
            (2,582
            )
            
            (1,673
            )Consolidated
                income before taxes
            
            $
            13,076
            
            $
            12,611
            
            $
            27,697
            
            $
            22,681





(a)
            Includes
                $2.0 million of costs incurred in connection with the proposed transaction
                for the quarter and six months ended June 30,
                2007.


27


The
      following table reconciles underwriting profit, income before taxes, Federal
      income tax expense, net income, earnings per share and combined ratios for
      the
      Company showing the effect of the $2.0 million of costs for legal, accounting
      and investment banking services incurred to date in connection with the
      transaction. See - “Proposed Transaction”.





**Three
                Months Ende****d June 30, 2007**
            
            **Six
                Months Ended
                June 30, 2007****As
                Reported**
            
            **Transaction
                Costs**
            
            **As
                Adjusted**
            
            **As
                Reported**
            
            **Transaction
                Costs**
            
            **As
                Adjusted***(in
                thousands, except for share data)*Underwriting
                profit
            
            $
            8,374
            
            $
            2,014
            
            $
            10,388
            
            $
            18,446
            
            $
            2,014
            
            $
            20,460Income
                before taxes
            
            $
            13,076
            
            $
            2,014
            
            $
            15,090
            
            $
            27,697
            
            $
            2,014
            
            $
            29,711Federal
                income tax expense
            
            
            3,920
            
            
            705
            
            
            4,625
            
            
            8,414
            
            
            705
            
            
            9,119Net
                income
            
            $
            9,156
            
            $
            1,309
            
            $
            10,465
            
            $
            19,283
            
            $
            1,309
            
            $
            20,592Earnings
                per share:Basic
            
            $
            0.60
            
            $
            0.09
            
            $
            0.69
            
            $
            1.27
            
            $
            0.09
            
            $
            1.36Diluted
            
            $
            0.56
            
            $
            0.08
            
            $
            0.64
            
            $
            1.19
            
            $
            0.08
            
            $
            1.27Ratios:Loss
                ratio
            
            
            58.7
            %
            
            -
            
            
            58.7
            %
            
            57.8
            %
            
            -
            
            
            57.8
            %Expense
                ratio
            
            
            28.0
            %
            
            3.2
            %
            
            24.8
            %
            
            27.2
            %
            
            1.6
            %
            
            25.6
            %Combined
                ratio
            
            
            86.7
            %
            
            3.2
            %
            
            83.5
            %
            
            85.0
            %
            
            1.6
            %
            
            83.4
            %




Management
      believes that the presentation of underwriting profit, income statement,
      earnings per share amounts and combined ratio information both before and after
      the effects of the transaction costs incurred to date relating to a proposed
      transaction allow for better comparisons to prior periods. Management considers
      results both before and after the effects of the transaction costs in assessing
      performance. Management does not anticipate that additional costs for legal,
      accounting and investment banking services for such a transaction will be
      incurred in subsequent fiscal years. Assuming all of the conditions to closing
      are met, the Company expects the transaction to close in the fourth quarter
      of
      2007.





**PROPOSED
      TRANSACTION**





On
      June
      11, 2007, the Company entered into an Agreement and Plan of Merger (the Merger
      Agreement), with Franklin Holdings (Bermuda), Ltd., a Bermuda company (Parent)
      and Franklin Acquisition Corp, a Delaware corporation and a wholly-owned direct
      subsidiary of Parent (Merger Sub). Under the terms of the Merger Agreement,
      Merger Sub will be merged with and into the Company, and as a result the Company
      will continue as the surviving corporation and a wholly owned subsidiary of
      Parent (the Merger). Parent is a Bermuda-based holding company and member of
      the
      D. E. Shaw group, a global investment management firm. We are
      permitted, under the terms of the Merger Agreement, to continue to pay regular
      quarterly cash dividends until the consummation of the Merger, such amount
      not
      to exceed $0.15 per share per quarter.





Subject
      to the terms and conditions set forth in the Merger Agreement, at the effective
      time of the Merger, each outstanding share of Common Stock, other than shares
      as
      to which appraisal rights under Delaware law may have been perfected, will
      be
      canceled and converted into the right to receive $34.50 in cash per share,
      without interest (the Merger Consideration). In addition, at the effective
      time
      of the Merger, (a) each outstanding option to purchase Common Stock (vested
      or
      unvested) will be canceled and the holder will be entitled to receive an amount
      of cash equal to the difference between the Merger Consideration and the
      exercise price of the applicable stock option without interest and less any
      required withholding taxes and (b) each outstanding warrant to purchase Common
      Stock will be converted into the right to receive, upon exercise of such warrant the
      Merger Consideration the
      holder of such warrant would
      have been entitled to receive upon consummation of the Merger if such holder
      had
      been, immediately prior to the Merger, the holder of the number of shares of
      Common Stock then issuable upon exercise in full of
      such
      warrant or, if the holder and the Company agree, canceled and extinguished,
      and
      the holder thereof will be entitled to receive, following exercise or
      cancellation, as the case may be, an amount in cash equal to the excess (if
      any)
      of (a) the product of (x) the number of shares of Common Stock subject to the
      warrant and (y) the Merger Consideration, minus (b) the aggregate exercise
      price
      of the warrant, without interest and less any required withholding
      taxes.


28





The
      closing of the Merger is expected to occur in the fourth quarter of 2007,
      subject to the receipt of stockholder approval and regulatory approvals and
      satisfaction or waiver of other customary closing conditions. The Company and
      Parent filed notification and report forms relating to the Merger under the
      Hart-Scott-Rodino Act (the HSR Act) with the Federal Trade Commission (the
      FTC)
      and the Department of Justice. On July 20, 2007, the FTC granted early
      termination of the waiting period under the HSR Act with respect to the Merger.
      Parent made the required filings relating to the Merger with the insurance
      commissioners of North Carolina and Ohio, the states in which our insurance
      subsidiaries are domiciled, on July 11, 2007. The Merger is not subject to
      a
      financing condition and equity commitments for the full amount of the Merger
      Consideration plus funds sufficient to pay all related fees and expenses
      required to be paid or funded as of or prior to the consummation of the Merger
      have been received by Parent from affiliates of the D.E. Shaw group.





The
      Company and Parent each have certain termination rights under the terms of
      the
      Merger Agreement, including the right by either party to terminate the Merger
      Agreement if the Merger has not been consummated on or before December 15,
      2007.
      In the event that the Merger Agreement is terminated under certain circumstances
      set forth in the Merger Agreement, we will be required to pay a fee of
      approximately $11.5 million to Parent and reimburse Parent for an amount not
      to
      exceed approximately $3.6 million for transaction fees and expenses incurred
      by
      Parent and its affiliates.





On
      August
      3, 2007, the Company filed a preliminary proxy statement with the Securities
      and
      Exchange Commission containing information about the Merger and a special
      meeting of stockholders, to be called, at which the Company’s stockholders will
      be asked to vote on a proposal to approve the Merger Agreement. The definitive
      proxy statement, when filed, will include the date of the special meeting of
      stockholders and the record date for the special meeting. On August 5, 2007,
      the
      Company’s right to solicit competing proposals ended under the terms of the
      Merger Agreement. The Company did not receive any competing proposals during
      the
      solicitation period.


29





**SUBSEQUENT
      EVENT**





On
      July
      2, 2007, the Company completed an acquisition of 100% of the stock of Align
      Financial Group, a wholesale and retail insurance agency, with principal offices
      in San Diego, California. Terms of the transaction were not
      disclosed.





*“SAFE
      HARBOR” STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
      1995: This Form 10-Q contains ‘‘forward-looking’’ statements within the meaning
      of the Securities Litigation Reform Act of 1995, including among others those
      concerning: expectations regarding our business and growth strategies; the
      basis
      for our reserve estimates; the adequacy of our reserves; our expected cost
      associated with a catastrophe loss; our belief that our reinsurance recoverables
      are collectible; expectations regarding lawsuits and expectations regarding
      the
      Merger. Such statements involve certain risks and uncertainties that could
      cause
      actual results to differ materially from those in the forward-looking
      statements. Potential risks and uncertainties include such factors as: effects
      of increased competition; effects of the cyclical nature of our business;
      effects of developments in the financial or capital markets; changes in
      availability, cost or quality of reinsurance; losses of key personnel or the
      inability to recruit qualified personnel; payment of claims by reinsurers on
      time or at all; effects of severe weather conditions and other catastrophes;
      effects of war or terrorism; changes in relationships with agencies, brokers
      and
      agents; changes in rating agency policies or practices; declines in financial
      ratings; changes in regulations or laws applicable to our insurance
      subsidiaries; changes in legal theories of liability under our insurance
      policies; accuracy of assumptions underlying our reserves for losses and loss
      adjustment expenses and our catastrophe model; actual losses incurred by
      policyholders as a result of hurricanes; regulatory approvals necessary for
      the
      Merger may not be obtained, or required regulatory approvals may delay the
      Merger or result in the imposition of conditions that could have a material
      adverse effect on the Company or cause the parties not to complete the
      transaction; conditions to the closing of the Merger may not be satisfied or
      waived; the outcome of any legal proceedings initiated against the Company
      and
      others following the announcement of the Merger cannot be predicted and could
      delay or prevent the Merger and could have a material adverse effect on the
      Company’s result of operations; the business of the Company may suffer as a
      result of uncertainty surrounding the Merger; the amount of the costs, fees,
      expenses and charges related to the Merger (including if we are required to
      pay
      Parent a termination fee or reimburse Parent’s transaction expenses under the
      terms of the Merger Agreement); and risks described in our filings with the
      Securities and Exchange Commission, including our Form 10-K for the fiscal
      year
      ended December 31, 2006.*





**Item
      3.**  **Quantitative
      and Qualitative Disclosures About Market Risk.**





Market
      risk is the potential economic loss principally arising from adverse changes
      in
      the fair value of financial instruments. The major components of market risk
      affecting us are credit risk and interest rate risk. Our market risks at June
      30, 2007 have not materially changed from those identified in our Form 10-K
      for
      the fiscal year ended December 31, 2006.





**Credit
      Risk**





Credit
      risk is the potential economic loss principally arising from adverse changes
      in
      the financial condition of a specific debt issuer or a reinsurer.





We
      address the risk associated with debt issuers by investing in fixed maturity
      securities that are investment grade, which are those securities rated “BBB-” or
      higher by Standard & Poor’s, or an equivalent rating by another nationally
      recognized rating agency. We monitor the financial condition of all of the
      issuers of fixed maturity securities in our portfolio. Our outside investment
      managers assist us in this process. We utilize a ratings changes report, a
      security watch list and a schedule of securities in unrealized loss positions
      as
      part of this process. If a security is rated investment grade at the time that
      we purchase it and then is downgraded to below investment grade while we hold
      it, we evaluate the security for impairment, and after discussing the security
      with our investment managers, make a decision to either dispose of the security
      or continue to hold it. Finally, we employ stringent diversification rules
      that
      limit our credit exposure to any single issuer or business sector.





At
      June
      30, 2007, the Company held $4.6 million in par value of securitizations of
      alternative-A and sub-prime mortgages, all of which are rated “AAA” by the
      established ratings agencies.


30





We
      address the risk associated with reinsurers by generally targeting reinsurers
      with A.M. Best financial strength ratings of “A-” (Excellent) or better. In an
      effort to minimize our exposure to the insolvency of our reinsurers, our
      Security Committee, consisting of our Chief Financial Officer and our corporate
      actuary, evaluates the acceptability and reviews the financial condition of
      each
      reinsurer annually. In addition, our Security Committee continually monitors
      rating downgrades involving any of our reinsurers. At June 30, 2007, all but
      $2.9 million of our reinsurance recoverables are either from companies with
      A.M.
      Best ratings of “A-” (Excellent) or better, or are collateralized.





**Interest
      Rate Risk**





Interest
      rate risk is the risk that we may incur economic losses due to adverse changes
      in interest rates. The primary market risk to the investment portfolio is
      interest rate risk associated with investments in fixed maturity securities.
      Fluctuations in interest rates have a direct impact on the market valuation
      of
      these securities. We manage our exposure to interest rate risk through an
      asset/liability matching process. In the management of this risk, the
      characteristics of duration, credit and variability of cash flows are critical
      elements. These risks are assessed regularly and balanced within the context
      of
      our liability and capital position. Our outside investment managers assist
      us in
      this process. We also have interest rate risk relating to our senior debt and
      junior subordinated debt, since interest accrues at a floating
      rate.





**Item
      4.**  **Controls
      and Procedures.**





*Evaluation
      of Disclosure Controls and Procedures*





We
      carried out an evaluation as of the end of the period covered by this report,
      under the supervision and with the participation of our management, including
      our Chief Executive Officer and Chief Financial Officer, of the effectiveness
      of
      the design and operation of our disclosure controls and procedures, as defined
      in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934,
      as
      amended (the Exchange Act), as of the end of the period covered by this report.
      Based upon that evaluation, our Chief Executive Officer and Chief Financial
      Officer concluded that our disclosure controls and procedures were effective
      as
      of that date. Disclosure controls and procedures are designed to ensure that
      information required to be disclosed in reports filed or submitted by us under
      the Exchange Act is recorded, processed, summarized and reported within the
      time
      periods specified in the Securities and Exchange Commission’s rules and
      forms.





*Changes
      in Internal Control Over Financial Reporting*





There
      has
      been no change in our internal control over financial reporting (as defined
      in
      Rule 13a-15(f) under the Exchange Act) that occurred during the period
      covered by this report that has materially affected or is reasonably likely
      to
      materially affect our internal control over financial
      reporting.


31


**PART
      II** - **OTHER
      INFORMATION**





**Item
      1.**  **Legal
      Proceedings.**





We
      are
      aware of one lawsuit filed in connection with the proposed Merger of the Company
      with members of the D. E. Shaw group. On June 13, 2007, Levy
      Investments filed a purported class action complaint (the Levy complaint) in
      the
      Superior Court for Orange County, North Carolina against the Company, all of
      the
      directors of the Company and the D. E. Shaw group. The Levy complaint
      alleges, among other things, that our directors breached their fiduciary duties
      to our stockholders in approving the Merger Agreement and that the negotiation
      and structure of the proposed Merger are the result of an unfair process. The
      Levy complaint seeks, among other things, class certification and an injunction
      preventing the completion of the Merger, and a declaration that the directors
      breached their fiduciary duties. We believe the Levy complaint is without merit
      and plan to defend it vigorously.





**Item
      1A.**  **Risk
      Factors.**





There
      have been no material changes in our risk factors from the risk factors
      disclosed in our Form10-K for the year ended December 31, 2006, except for
      risks
      related to the Merger with a member of the D. E. Shaw group, a global
      investment management firm, as described in Note 2 to the unaudited condensed
      consolidated financial statements.  We are subject to several risks
      relating to the Merger, including the following:





·
            the
                occurrence of any event, change or other circumstance that could
                give rise
                to the termination of the Merger Agreement in which case we may be
                obligated to pay (a) a termination fee of approximately $11.5 million
                and
                (b) an expense reimbursement of up to approximately $3.6
                million;·
            if
                the proposed Merger is not completed, the share price of our Common
                Stock
                may change to the extent that the current market price of our Common
                Stock
                reflects an assumption that the proposed Merger will be
                completed;·
            the
                outcome of any legal proceedings, including the Levy complaint, that
                have
                been or may be instituted against us and others relating to the Merger
                cannot be determined and may have a material adverse effect on our
                results
                of operations or may prevent or delay the Merger;·
            failure
                to obtain stockholder approval or the failure to satisfy other conditions,
                including regulatory approvals, may prevent or delay the closing
                of the
                Merger;·
            the
                failure of the Merger to be completed for any reason;·
            the
                risk that the Merger disrupts current plans and operations and that
                our
                management and employees’ attention may be diverted from day-to-day
                operations;·
            the
                potential difficulties in employee retention as a result of the
                Merger;·
            the
                effect of the announcement of the Merger on our agency and broker
                relationships, operating results and business
                generally;·
            the
                amount of the costs, fees, expenses and charges related to the Merger,
                including the fees for legal, accounting and investment banking services,
                is significant and will continue and will adversely affect our results
                of
                operations; and·
            the
                failure of the Merger to be completed for any reason may result in
                unfavorable publicity and/or a negative impression of us in the investment
                community.





Additional
      risks and uncertainties not currently known to us or that we currently deem
      to
      be immaterial also may adversely affect our business, financial condition or
      operating results.


32





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


*(b)* *Use
      of Proceeds from Initial Public Offering*





On
      May 3, 2005, we filed a registration statement on Form S-1 with the
      Securities Exchange Commission for an initial public offering of common stock.
      The offering was made through an underwriting syndicate led by Keefe, Bruyette
      & Woods, Inc., and co-managers Bear, Stearns & Co., Inc., Friedman,
      Billings, Ramsey & Co., Inc. and Wachovia Capital Markets, LLC. Our
      registration statement was declared effective on August 8, 2005. On August
      9,
      2005, we affected a ten-for-one split of our Common Stock to shareholders of
      record on that date. Immediately prior to the closing of the initial public
      offering on August 12, 2005, all of our outstanding Series A Convertible
      Preferred Stock and Series B Convertible Preferred Stock, including shares
      representing accrued but unpaid dividends, were converted into 9,956,413 shares
      of Common Stock. In addition, on that date we amended and restated our
      certificate of incorporation to increase the number of authorized shares of
      Common Stock to 100,000,000 and decrease the number of authorized shares of
      preferred stock to 5,000,000. Gross proceeds from the sale of 4,444,000 shares
      of Common Stock, at an initial public offering price per share of $18.00,
      totaled $80.0 million. Costs associated with the initial public offering
      included $5.6 million of underwriting costs and $995,000 of other issuance
      costs, resulting in net proceeds from the sale of $73.4 million.





On
      August
      26, 2005, the underwriters of the initial public offering exercised their
      over-allotment option in which an additional 666,600 shares of Common Stock
      were
      issued and sold at the $18.00 initial public offering price per share. Gross
      proceeds from this transaction were $12.0 million and underwriting costs were
      $840,000, resulting in net proceeds from the sale of $11.2 million and bringing
      the total net proceeds of the offering to $84.6 million.





Through
      December 31, 2006, we contributed $77.5 million of the proceeds from the
      offering to the capital of our insurance subsidiaries, and we used an additional
      $5.6 million for the payment of interest on our senior debt and trust preferred
      securities. During the quarter ended March 31, 2007, we used an additional
      $1.3
      million for the payment of interest on our senior debt and trust preferred
      securities. During the quarter ended June 30, 2007, we used the remaining $0.2
      million of proceeds from the offering for the payment of interest on our senior
      debt and trust preferred securities.





**Item
      4.**  **Submission
      of Matters to a Vote of Security Holders.**





The
      Company’s Annual Meeting of Stockholders was held on May 17, 2007. Stockholders
      elected two Class II directors for the ensuing three-year period and ratified
      the appointment of Ernst & Young LLP as the Company’s independent registered
      public accounting firm for fiscal year 2007. Results were as
      follows:





*Election
      of Directors:*





**For**
            
            **Withheld**Matthew
                Bronfman
            12,637,879
            
            1,485,764John
                T. Sinnott
            14,084,837
            
            38,806





Continuing
      directors of the Company were: J. Adam Abram, Richard W. Wright, Joel L.
      Fleishman and James L. Zech, whose terms expire in 2008 and Alan N. Colner,
      Dallas W. Luby, A. Wellford Tabor and Nicolas D. Zerbib, whose terms expire
      in
      2009.





*Ratification
      of appointment of Ernst & Young LLP as the independent registered public
      accounting firm for fiscal year 2007:*





**For**
            
            **Against**
            
            **Abstain**
            
            **Broker
                Non-Votes**14,123,440
            
            134
            
            69
            
            0


33


**Item
      6.**  **Exhibits.**





**Number**
            
            **Exhibit**2.1
            
            Agreement
                and Plan of Merger dated as of June 11, 2007 among Franklin Holdings
                (Bermuda), Ltd., Franklin Acquisition Corp. and James River Group,
                Inc.
                (incorporated by reference to the Company’s Current Report on Form 8-K
                dated June 12, 2007 (File No. 000-51480)).3.1
            
            Third
                Amended and Restated Certificate of Incorporation (incorporated herein
                by
                reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K dated
                August 12, 2005 (File No. 000-51480)).3.2
            
            Form
                of Third Amended and Restated By-Laws (incorporated herein by reference
                to
                Exhibit 3.2 to the Company’s Current Report on Form 8-K dated August 12,
                2005 (File No. 000-51480)).4.1
            
            Specimen
                Stock Certificate, representing James River Group, Inc. common stock,
                par
                value $0.0l per share (incorporated by reference to Exhibit 4.1 to
                the
                Company’s Registration Statement on Form S-1 (File No.
                333-124605)).4.2
            
            Form
                of Warrant relating to Series B Convertible Preferred Stock (incorporated
                by reference to Exhibit 4.2 to the Company’s Registration Statement on
                Form S-1 (File No. 333-124605)).4.3
            
            Registration
                Rights Agreement dated January 21, 2003, by and among James River
                Group,
                Inc. and certain stockholders as named therein (incorporated by reference
                to Exhibit 4.6 to the Company’s Registration Statement on Form S-1 (File
                No. 333-124605)).4.4
            
            Indenture
                dated as of May 26, 2004, by and between James River Group, Inc.
                and
                Wilmington Trust Company, as Trustee, relating to Floating Rate Senior
                Debentures Due 2034 (incorporated by reference to Exhibit 4.8 to
                the
                Company’s Registration Statement on Form S-1 (File No.
                333-124605)).4.5
            
            Indenture
                dated as of May 26, 2004, by and between James River Group, Inc.
                and
                Wilmington Trust Company, as Trustee, relating to Floating Rate Junior
                Subordinated Debentures Due 2034 (incorporated by reference to Exhibit
                4.9
                to the Company’s Registration Statement on Form S-1 (File No.
                333-124605)).4.6
            
            Amended
                and Restated Declaration of Trust of James River Capital Trust I
                dated as
                of May 26, 2004, by and among James River Group, Inc., the Trustees
                (as defined therein) and the holders, from time to time, of undivided
                beneficial interests in James River Capital Trust I (incorporated
                by
                reference to Exhibit 4.10 to the Company’s Registration Statement on Form
                S-1 (File No. 333-124605)).4.7
            
            Preferred
                Securities Guarantee Agreement dated as of May 26, 2004, by James
                River
                Group, Inc., as Guarantor, and Wilmington Trust Company, as Preferred
                Guarantee Trustee, for the benefit of the Holders (as defined therein)
                of
                James River Capital Trust I (incorporated by reference to Exhibit
                4.11 to
                the Company’s Registration Statement on Form S-1 (File No.
                333-124605)).4.8
            
            Indenture
                dated December 15, 2004, by and between James River Group, Inc. and
                Wilmington Trust Company, as Trustee, relating to Floating Rate Junior
                Subordinated Deferrable Interest Debentures Due 2034 (incorporated
                by
                reference to Exhibit 4.12 to the Company’s Registration Statement on Form
                S-1 (File No. 333-124605)).4.9
            
            Amended
                and Restated Declaration of Trust of James River Capital Trust II
                dated as
                of December 15, 2004, by and among James River Group, Inc., the Trustees
                (as defined therein), the Administrators (as named therein), and
                the
                holders, from time to time, of undivided beneficial interests in
                the James
                River Capital Trust II (incorporated by reference to Exhibit 4.13
                to the
                Company’s Registration Statement on Form S-1 (File No.
                333-124605)).4.10
            
            Guarantee
                Agreement dated as of December 15, 2004, by James River Group, Inc.,
                as
                Guarantor, and Wilmington Trust Company, as Guarantee Trustee, for
                the
                benefit of the Holders (as defined therein) from time to time of
                the
                capital securities of James River Capital Trust II (incorporated
                by
                reference to Exhibit 4.14 to the Company’s Registration Statement on Form
                S-1 (File No. 333-124605)).




34




**Number**
            
            **Exhibit**4.11
            
            Indenture
                dated June 15, 2006, by and between James River Group, Inc. and Wilmington
                Trust Company, as Trustee, relating to Floating Rate Junior Subordinated
                Deferrable Interest Debentures Due 2036.**4.12
            
            Amended
                and Restated Declaration of Trust of James River Capital Trust III
                dated
                as of June 15, 2006, by and among James River Group, Inc., the Trustees
                (as defined therein), the Administrators (as named therein) and the
                holders, from time to time, of undivided beneficial interests in
                the James
                River Capital Trust III.**4.13
            
            Guarantee
                Agreement dated as of June 15, 2006, by James River Group, Inc.,
                as
                Guarantor, and Wilmington Trust Company, as Guarantee Trustee, for
                the
                benefit of the Holders (as defined therein) from time to time of
                the
                capital securities of James River Capital Trust III.**11
            
            Statement
                re computation of per share earnings is included in Note 4 to the
                Condensed Consolidated Financial Statements in Item 1, “Financial
                Statements”, of this report on Form 10-Q.31.1
            
            Certification
                of the Chief Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.31.2
            
            Certification
                of the Chief Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.32.1
            
            Certification
                of the Chief Executive Officer pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.32.2
            
            Certification
                of the Chief Financial Officer pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.




**
            Exhibit
                not included pursuant to Item 601 (b)(4)(iii) and (v) of Regulation
                S-K.
                The Company will provide a copy to the Securities and Exchange Commission
                upon request.




35


**SIGNATURES**





Pursuant
      to the requirements 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.








James
      River Group, Inc.





August
                6, 2007
            
            /s/
                Gregg T. DavisGregg
                T. Davis
              Executive
                Vice President -Finance and
                Treasurer




36