**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-Q**

 

| **ý****Quarterly Report pursuant  to Section 13 or 15(d)  of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **for  the Quarterly Period Ended March 31, 2004,**                                                                                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                                                                                    |
| **or**                                                                                                                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                                                                                    |
| **o****Transition report  pursuant to Section 13 or 15(d)  Of the Exchange Act**                                                                                                                                                                                                                                                                   |
| **for  the Transition Period from                             to                          .** |

 

**No.000-25425**

**(CommissionFile Number)**

 

**MERCER INSURANCE GROUP, INC.**

(Exact name ofRegistrant as specified in its charter)

 

| **PENNSYLVANIA**                                                 |   | **23-2934601**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **10  North Highway 31, P.O. Box 278, Pennington, NJ**           |   | **08534**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

 

**(609)737-0426**

(Registrant’stelephone number, including area code)

 

(Former name,former address and former fiscal year,

if changed sincelast report)

 

Check whether theregistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the past 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

Yes  ý    Noo

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 

Yes  o    NO  ý

 

State the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 

|                         |   | **Number of Shares Outstanding  as of May 10, 2004** |
|------------------------------|--------|------------------------------------------------------|
|                         |   |                                                 |
| COMMON STOCK (No  Par Value) |   | 6,845,733                                            |
| (Title of Class              |   | (Outstanding  Shares)                                |

 

 

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**TABLEOF CONTENTS**

 
| Part I. Financial Information                                           |   |                                                                                                      |
|------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------|
|                                                                         |   | Item 1. Financial Statements.                                                                        |   |   |
|                                                                         |   | Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations. |   |   |
|                                                                         |   | Item 3. Quantitative and Qualitative  Disclosures About Market Risk.                                 |   |   |
|                                                                         |   | Item 4. Control  and Procedures.                                                                     |   |   |
|                                                                         |   |                                                                                                      |   |   |
| Part II. Other Information                                              |   |                                                                                                      |
|                                                                         |   | Item 1. Legal Proceedings.                                                                           |   |   |
|                                                                         |   | Item 2. Changes in Securities, Use of  Proceeds and Issuer Purchases of Equity Securities.           |   |   |
|                                                                         |   | Item 3. Defaults upon Senior Securities.                                                             |   |   |
|                                                                         |   | Item 4. Submission of Matters to a  Vote of Security Holders.                                        |   |   |
|                                                                         |   | Item 5. Other Information.                                                                           |   |   |
|                                                                         |   | Item 6. Exhibits and Reports on  Form 8-K.                                                      |   |   |
|                                                                         |   |                                                                                                      |   |   |
| Signatures                                                                   |   |
|                                                                         |   |                                                                                                      |   |   |
| Certification  of Chief Executive Officer pursuant to  section 302 |   |                                                                                                      |
| Certification of Chief  Financial Officer pursuant to section 302       |   |                                                                                                      |
| Certification of CEO  and CFO pursuant to section 906                   |   |                                                                                                      |
|                                                                              |        |                                                                                                           |  |  |  |

 

2

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Forward-looking Statements

 

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

 

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

 

•                  future economic conditions in theregional and national markets in which the Company competes which are lessfavorable than expected;

 

•                  the effects of weather-related andother catastrophic events;

 

•                  the concentration of insured accountsin New Jersey and Pennsylvania;

 

•                  the effect oflegislative, judicial, economic, demographic and regulatory events in the twostates in which we do business;

 

•                  the continuationof an A.M. Best rating in the Excellent category;

 

•                  the ability toenter new markets successfully and capitalize on growth opportunities eitherthrough acquisitions or the expansion of our producer network;

 

•                  financial marketconditions, including, but not limited to, changes in interest rates and thestock markets causing a reduction of investment income or investment gains, anacceleration of the amortization of deferred policy acquisition costs,reduction in the value of our investment portfolio or a reduction in the demandfor our products;

 

•                  the impact ofacts of terrorism and acts of war;

 

•                  the effects ofterrorist related insurance legislation and laws;

 

•                  inflation;

 

•                  the cost,availability and collectibility of reinsurance;

 

•                  estimates andadequacy of loss reserves and trends in losses and loss adjustment expenses;

 

•                  heightenedcompetition, including specifically the intensification of price competition,the entry of new competitors and the development of new products by new andexisting competitors;

 

•                  changes in thecoverage terms selected by insurance customers, including higher deductiblesand lower limits;

 

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

 

•                  the potentialimpact on our reported net income that could result from the adoption of futureaccounting standards issued by the Financial Accounting Standards Board orother standard-setting bodies;

 

•                  inability tocarry out marketing and sales plans, including, among others, development ofnew products or changes to existing products and acceptance of the new orrevised products in the market;

 

•                  unanticipatedchanges in industry trends and ratings assigned by nationally recognized ratingorganizations;

 

•                  adverselitigation or arbitration results;

 

•                  the ability tocarry out our business plans; and

 

•                  adverse changes in applicable laws,regulations or rules governing insurance holding companies and insurancecompanies, and environmental, tax or accounting matters including limitationson premium levels, increases in minimum capital and reserves, and otherfinancial viability requirements, and changes that affect the cost of, ordemand for our products.

 

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

 

3

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PartI – FINANCIAL INFORMATION

 

Item1 – Financial Statements

 

**MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**As of March 31, 2004 and December 31, 2003**

 

 
|                                                                                                                                        |   | **As of  March  31, 2004**  |    | **As of  December  31, 2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|-------------------------------|--------|
|                                                                                                                                        |   | **(Dollars  in thousands)** |    |
|                                                                                                                                        |   | **(Unaudited)**             |    |
| **ASSETS**                                                                                                                                  |   |                        |    |                          |   |
| Investments,  at fair value:                                                                                                                |   |                        |    |                          |   |
| Fixed  income securities, available-for-sale, at fair  value (Amortized cost of $91,001 and $46,282,  respectively)               |   | $                           | 91,472  |                          | $      | 46,277 |   |
| Equity  securities, at fair value (cost of $15,425   and $15,866, respectively)                                                        |   | 22,907                      |    | 22,656                   |   |
| Short-term  investments, at amortized cost, which   approximates fair value                                                            |   | —                      |    | 54,396                        |   |
| Total  investments                                                                                                                          |   | 114,379                     |    | 123,329                       |   |
| Cash  and cash equivalents                                                                                                                  |   | 28,028                      |    | 15,350                        |   |
| Premiums  receivable                                                                                                                        |   | 7,892                       |    | 9,096                         |   |
| Reinsurance  receivables                                                                                                                    |   | 5,191                       |    | 4,159                         |   |
| Prepaid  reinsurance premiums                                                                                                               |   | 1,499                       |    | 1,614                         |   |
| Deferred  policy acquisition costs                                                                                                          |   | 7,062                       |    | 7,387                         |   |
| Accrued  investment income                                                                                                                  |   | 699                         |    | 596                           |   |
| Property  and equipment, net                                                                                                                |   | 8,002                       |    | 6,944                         |   |
| Goodwill                                                                                                                                    |   | 4,673                       |    | 4,673                         |   |
| Other  assets                                                                                                                               |   | 2,917                       |    | 2,727                         |   |
| Total  assets                                                                                                                               |   | $                           | 180,342 |                          | $      | 175,875 |   |
|                                                                                                                                        |   |                        |    |                          |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                              |   |                        |    |                          |   |
| Liabilities:                                                                                                                                |   |                        |    |                          |   |
| Losses  and loss adjustment expenses                                                                                                        |   | $                           | 38,440  |                          | $      | 37,261 |   |
| Unearned  premiums                                                                                                                          |   | 29,271                      |    | 30,329                        |   |
| Accounts  payable and accrued expenses                                                                                                      |   | 11,303                      |    | 7,937                         |   |
| Other  reinsurance balances                                                                                                                 |   | 9                           |    | 81                            |   |
| Other  liabilities                                                                                                                          |   | 932                         |    | 1,228                    |   |
| Deferred  income taxes                                                                                                                      |   | 854                         |    | 713                           |   |
| Total  liabilities                                                                                                                          |   | 80,809                      |    | 77,549                        |   |
|                                                                                                                                        |   |                        |    |                          |   |
| Stockholders’  Equity:                                                                                                                 |   |                        |    |                          |   |
| Preferred  stock, no par value, authorized 5,000,000   shares, no shares issued and outstanding                                        |   | —                      |    | —                        |   |
| Common  stock, no par value, authorized 15,000,000   Shares, issued 6,845,733 shares, outstanding  6,297,800 and 6,282,233 shares |   | —                      |    | —                        |   |
| Additional  paid-in capital                                                                                                                 |   | 64,922                      |    | 64,871                        |   |
| Accumulated  other comprehensive income:                                                                                                    |   |                        |    |                          |   |
| Unrealized  gains in investments, net of deferred   income taxes                                                                       |   | 5,249                       |    | 4,478                         |   |
| Retained  Earnings                                                                                                                          |   | 34,841                      |    | 34,612                        |   |
| Unearned  ESOP shares                                                                                                                       |   | (5,479                      | )       | (5,635                        | )      |
| Total  stockholders’equity                                                                                                             |   | 99,533                      |    | 98,326                        |   |
| Total  liabilities and stockholders’ equity                                                                                            |   | $                           | 180,342 |                          | $      | 175,875 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS**

**Three Months Ended March 31, 2004 and 2003**

 
|                                                                                                            |   | **2004**                                                          |   | **2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------|--------|----------|--------|
|                                                                                                            |   | **(Dollars  in  thousands,  except shares  and per share  data)** |   |
|                                                                                                            |   | **(Unaudited)**                                                   |   |
| Revenue:                                                                                                        |   |                                                              |   |     |   |
| Net  premiums earned                                                                                            |   | $                                                                 | 13,862 |     | $      | 11,056 |   |
| Investment  income, net of expenses                                                                             |   | 668                                                               |   | 427      |   |
| Net  realized investment gains (losses)                                                                         |   | (97                                                               | )      | 149      |   |
| Other  revenue                                                                                                  |   | 92                                                                |   | 80       |   |
| Total  revenue                                                                                                  |   | 14,525                                                            |   | 11,712   |   |
| Expenses:                                                                                                       |   |                                                              |   |     |   |
| Losses  and loss adjustment expenses                                                                            |   | 8,323                                                             |   | 6,514    |   |
| Amortization  of deferred policy acquisition costs (related  party amounts of $317 and $285, respectively) |   | 3,863                                                             |   | 2,973    |   |
| Other  expenses                                                                                                 |   | 2,070                                                             |   | 1,849    |   |
| Stock  conversion expenses                                                                                      |   | —                                                            |   | 12       |   |
| Total  expenses                                                                                                 |   | 14,256                                                            |   | 11,348   |   |
| Income  before income taxes and minority interest in income of subsidiary                                       |   | 269                                                               |   | 364      |   |
| Income  taxes                                                                                                   |   | 40                                                                |   | 88       |   |
| Income  before minority interest in income of subsidiary                                                        |   | 229                                                               |   | 276      |   |
| Minority  interest in income of subsidiary                                                                      |   | —                                                            |   | (43      | )      |
| Net  income                                                                                                     |   | $                                                                 | 229    |     | $      | 233 |   |
|                                                                                                            |   |                                                              |   |     |   |
| Earnings  per common share:                                                                                     |   |                                                              |   |     |   |
| Basic                                                                                                           |   | $                                                                 | 0.04   |     | N/A    |   |
| Diluted                                                                                                         |   | $                                                                 | 0.04   |     | N/A    |   |
| Weighted  average shares, basic and diluted                                                                     |   | 6,290,102                                                         |   | N/A      |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

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MERCERINSURANCE GROUP, Inc. AND SUBSIDIARIES

 

ConsolidatedStatement of Stockholders’  Equity

 

Threemonths ended March 31, 2004

 

(Unaudited,dollars in thousands)

 
|                                                                                                           |   | **Preferred  stock** |   | **Common  stock** |   | **Additional  paid-in  capital** |   | **Accumulated  other  comprehensive  income** |   | **Retained  Earnings** |   | **Unearned  ESOP  Shares** |   | **Total** |   |
|----------------------------------------------------------------------------------------------------------------|--------|----------------------|--------|-------------------|--------|----------------------------------|--------|-----------------------------------------------|--------|------------------------|--------|----------------------------|--------|-----------|--------|
| Balance,  December 31, 2003                                                                               |   | $                    | — |              | — |                             | 64,871 |                                          | 4,478  |                   | 34,612 |                       | (5,635 | )         | 98,326 |   |
| Net  income                                                                                                    |   |                 |   |              |   |                             |   |                                          |   | 229                    |   |                       |   | 229       |   |
| Unrealized  gains on securities:                                                                               |   |                 |   |              |   |                             |   |                                          |   |                   |   |                       |   |      |   |
| Unrealized  holding gains arising during period, net of related income tax expense of  $364                    |   |                 |   |              |   |                             |   | 707                                           |   |                   |   |                       |   | 707       |   |
| Less  reclassification adjustment for losses included in net income, net of related  income tax benefit of $33 |   |                 |   |              |   |                             |   | 64                                            |   |                   |   |                       |   | 64        |   |
| Other  comprehensive income                                                                                    |   |                 |   |              |   |                             |   |                                          |   |                   |   |                       |   | 771       |   |
| Comprehensive  income                                                                                          |   |                 |   |              |   |                             |   |                                          |   |                   |   |                       |   | 1,000     |   |
| ESOP  shares committed                                                                                         |   |                 |   |              |   | 51                               |   |                                          |   |                   |   | 156                        |   | 207       |   |
| Balance,  March 31, 2004                                                                                  |   | $                    | — |              | — |                             | 64,922 |                                          | 5,249  |                   | 34,841 |                       | (5,479 | )         | 99,533 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

6

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**MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Three Months Ended March 31, 2004 and 2003**

 
|                                                                               |   | **March 31,**           |   |
|------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                               |   | **2004**                     |   | **2003** |   |
|                                                                               |   | **(Dollars  in  thousands)** |   |
|                                                                               |   | **(Unaudited)**              |   |
| Cash  flows from operating activities:                                             |   |                         |   |   |   |
| Net  income                                                                        |   | $                            | 229    |   | $ | 233 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |   |                         |   |   |   |
| Depreciation  and amortization of fixed assets                                     |   | 343                          |   | 325 |   |
| Net  accretion of discount                                                         |   | (199                         | )      | (24 | ) |
| ESOP  share commitment                                                             |   | 207                          |   | — |   |
| Net  realized investment (gains) losses                                            |   | 97                           |   | (149 | ) |
| Deferred  income tax                                                               |   | (256                         | )      | (50 | ) |
| Change  in assets and liabilities:                                                 |   |                         |   |   |   |
| Premiums  receivable                                                               |   | 1,204                        |   | (153 | ) |
| Reinsurance  receivables                                                           |   | (1,032                       | )      | (271 | ) |
| Prepaid  reinsurance premiums                                                      |   | 115                          |   | 69 |   |
| Deferred  policy acquisition costs                                                 |   | 325                          |   | (22 | ) |
| Other  assets                                                                      |   | (293                         | )      | (221 | ) |
| Losses  and loss expenses                                                          |   | 1,179                        |   | 1,572 |   |
| Unearned  premiums                                                                 |   | (1,058                       | )      | 134 |   |
| Other                                                                              |   | 2,998                        |   | (3,052 | ) |
| Net  cash provided by (used in) operating activities                               |   | 3,859                        |   | (1,609 | ) |
| Cash  flows from investing activities:                                             |   |                         |   |   |   |
| Purchase  of fixed income securities, available-for- sale                          |   | (63,673                      | )      | (6,220 | ) |
| Purchase  of equity securities                                                     |   | (204                         | )      | (879 | ) |
| Sale  and maturity of fixed income securities available-for-sale                   |   | 19,045                       |   | 10,252 |   |
| Sale  of equity securities                                                         |   | 656                          |   | 2,297 |   |
| Sale  of short-term investments, net                                               |   | 54,396                       |   | — |   |
| Purchase  of property and equipment                                                |   | (1,401                       | )      | (639 | ) |
| Net  cash provided by investing activities                                         |   | 8,819                        |   | 4,811 |   |
| Net  increase in cash and cash equivalents                                         |   | 12,678                       |   | 3,202 |   |
| Cash and cash  equivalents at beginning of period                                  |   | 15,350                       |   | 7,201 |   |
| Cash and cash  equivalents at end of period                                        |   | $                            | 28,028 |   | $ | 10,403 |   |
| Cash  paid during the period for:                                                  |   |                         |   |   |   |
| Interest                                                                           |   | $                            | 10     |   | $ | 7 |   |
| Income  taxes                                                                      |   | $                            | — |   | $ | — |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

7

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**MERCER INSURANCE GROUP, Inc. AND SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Dollars in thousands)**

**(Unaudited)**

 

**(1)  Basis of Presentation**

 

The financial information for the interim periodsincluded herein is unaudited; however, such information reflects alladjustments which are, in the opinion of management, necessary to a fair presentationof the financial position, results of operations, and cash flows for theinterim periods. The results of operations for interim periods are notnecessarily indicative of results to be expected for the full year.

 

These financial statements should be read inconjunction with the financial statements and notes for the year endedDecember 31, 2003 included in the Company’s Annual Report on Form 10-Kfiled with the Securities and Exchange Commission.

 

8

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**(2)  Segment Information**

 

TheCompany manages its business in three segments: commercial lines insurance,personal lines insurance, and investments. The commercial lines insurance andpersonal lines insurance segments are managed based on underwriting resultsdetermined in accordance with accounting principles generally accepted in theUnited States of America, and the investment segment is managed based onafter-tax investment returns.

 

Underwritingresults for commercial lines and personal lines take into account premiumsearned, incurred losses and loss adjustment expenses, and underwritingexpenses. The investments segment is evaluated by consideration of netinvestment income (investment income less investment expenses), and realizedgains and losses.

 

Indetermining the results of each segment, assets are not allocated tosegments and are reviewed in the aggregate for decision-making purposes.

 

Financial data by segment is as follows for the threemonths ended March 31, 2004 and 2003:

 
|                                                                      |   | **Three  Months  Ended  March 31,** |   |
|---------------------------------------------------------------------------|--------|------------------------------------------|--------|
|                                                                      |   | **2004**                                 |   | **2003** |   |
| Revenues:                                                                 |   |                                     |   |   |   |
| Net  premiums earned:                                                     |   |                                     |   |   |   |
| Commercial  lines                                                         |   | $                                        | 8,025  |   | $ | 5,736 |   |
| Personal  lines                                                           |   | 5,837                                    |   | 5,320 |   |
| Total  net premiums earned                                                |   | 13,862                                   |   | 11,056 |   |
| Net  investment income                                                    |   | 668                                      |   | 427 |   |
| Realized  investment gains (losses)                                       |   | (97                                      | )      | 149 |   |
| Other                                                                     |   | 92                                       |   | 80 |   |
| Total  revenues                                                           |   | 14,525                                   |   | 11,712 |   |
|                                                                      |   |                                     |   |   |   |
| Income  before income taxes:                                              |   |                                     |   |   |   |
| Underwriting  income (loss):                                              |   |                                     |   |   |   |
| Commercial  lines                                                         |   | 2,242                                    |   | 1,076 |   |
| Personal  lines                                                           |   | (2,636                                   | )      | (1,356 | ) |
| Total  underwriting loss                                                  |   | (394                                     | )      | (280 | ) |
| Net  investment income                                                    |   | 668                                      |   | 427 |   |
| Realized  investment gains (losses)                                       |   | (97                                      | )      | 149 |   |
| Other                                                                     |   | 92                                       |   | 68 |   |
| Income  before income taxes and minority interest in income of subsidiary |   | $                                        | 269    |   | $ | 364 |   |

 

9

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**(3)Reinsurance**

 

Premiums earned are net of amounts ceded of $2,019 and$2,101 for the three months ended March 31, 2004 and 2003, respectively. Lossesand loss adjustment expenses are net of amounts ceded of $683 and $602 for thethree months ended March 31, 2004 and 2003.

 

**(4)Comprehensive Income**

 

The Company’s comprehensive income for the three month period endedMarch 31, 2004 and 2003 is as follows:

 

 

 

 
|                                                                                                                                       |   | **Three Months ended  March 31** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|------------|
|                                                                                                                                       |   | **2004**                         |       | **2003** |   |
|                                                                                                                                       |   |                             | ** ** |   | ** ** |
| Net income                                                                                                                                 |   | $                                | 229        |   | $ | 233 |   |
| Other comprehensive income (loss), net of tax:                                                                                             |   |                             |       |   |   |
| Unrealized gains (losses) on securities:                                                                                                   |   |                             |       |   |   |
| Unrealized holding gains (losses) arising during  period, net of related income tax expense (benefit) of $364, and $(146)                  |   | 707                              |       | (283 | ) |
|                                                                                                                                       |   |                             |       |   |   |
| Less reclassification adjustment for (gains) losses  included in net income, net of related income tax benefit (expense) of $33  and $(51) |   | 64                               |       | (98 | ) |
|                                                                                                                                       |   | 771                              |       | (381 | ) |
| Comprehensive Income                                                                                                                       |   | $                                | 1,000      |   | $ | (148 | ) |

 

Item 2

 

MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS

 

The following presents management’s discussion andanalysis of our financial condition and results of operations as of the datesand for the periods indicated. You should read this discussion in conjunctionwith the condensed consolidated financial statements and notes thereto includedin this report. This discussion contains forward-looking information thatinvolves risks and uncertainties. Actual results could differ significantlyfrom these forward-looking statements. See “Forward-Looking Statements”.

 

**Overview**

 

**THE CONVERSION TRANSACTION AND THE HOLDING COMPANY**

 

Mercer Insurance Group,Inc. (the “Company” or the “Holding Company”) is a holding company owning allof the outstanding shares of Mercer Insurance Company, the company resultingfrom the conversion of Mercer Mutual Insurance Company from the mutual to thestock form of organization on December 15,

 

10

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2003 (the “Conversion”).Prior to the Conversion, and since 1844, Mercer Mutual Insurance Company wasengaged in the business of selling property and casualty insurance.

 

The Company had noactivity prior to the Conversion, and was formed for the purpose of owning allof the stock of the Mercer Mutual Insurance Company after the Conversion. Atthe time of the Conversion, 6,845,733 shares of Mercer Insurance Group, Inc.were issued (including 502,525 shares issued immediately after the Conversionto acquire the remaining 51% of common stock as well as all manditorily redeemablepreferred stock of Franklin Holding Company, Inc., of which Mercer MutualInsurance Company had acquired 49% for cash in 2001) with net cash proceeds ofapproximately $53 million received by the Company in exchange for the shares(approximately $27 million was contributed to the capital of Mercer InsuranceCompany after the Conversion). Also included in the total shares are 626,111shares issued in the Conversion to the Mercer Insurance Group, Inc. EmployeeStock Ownership Plan, (the “ESOP”) as to which no cash proceeds were receivedbecause the ESOP funded the purchase of these shares with a loan from theCompany.  The shares held by the ESOPwill be allocated to participant accounts evenly over a ten-year period. Thefirst annual allocation occurred in December, 2003, in the amount of 62,611shares, and an additional 15,567 shares were committed in the first quarter of2004.

 

**OurBusiness**

 

The Company and its subsidiaries underwrite propertyand casualty insurance in New Jersey and Pennsylvania. Our consolidatedoperating insurance company subsidiaries are:

 

•                  Mercer InsuranceCompany, a Pennsylvania property and casualty stock insurance company offeringinsurance coverage to businesses and individuals in New Jersey andPennsylvania,

•                  Mercer InsuranceCompany of New Jersey, Inc., a New Jersey property and casualty stock insurancecompany that currently offers only workers’ compensation insurance tobusinesses located in New Jersey; and

•                  FranklinInsurance Company, a property and casualty stock insurance company offeringprivate passenger automobile and homeowners insurance to individuals located inPennsylvania.

 

The Holding Company is subject to regulation by thePennsylvania Insurance Department and the New Jersey Department of Banking andInsurance as its primary regulators because it is the holding company forMercer Insurance Company, and, indirectly, Mercer Insurance Company of NewJersey, Inc. and its holding company, Queenstown Holding Company, Inc., andFranklin Holding Company, Inc. and its subsidiary, Franklin Insurance Company.

 

We manage our business and report our operatingresults in three operating segments: commercial lines insurance, personal linesinsurance and the investment function. See Note 2 of the notes to our condensedconsolidated financial statements included in this report. However, assets arenot allocated to segments and are reviewed in the aggregate for decision-makingpurposes. Our commercial lines insurance business consists primarily ofmulti-peril and general liability and related coverages. Our personal linesinsurance business consists primarily of homeowners and private passengerautomobile insurance coverages. We market both the commercial and personalinsurance lines through independent producers.

 

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Our income is principally derived from insurancepremiums received from insureds in the commercial lines (businesses insured)and personal lines (individuals insured) segments, less the costs ofunderwriting the insurance policies, the costs of settling and paying claimsreported on the policies, and from investment income reduced by investmentexpenses and gains or losses on holdings in our investment portfolio.Variability in our income is caused by a variety of circumstances, some withinthe control of our companies and some not within their control. Premium volumeis affected by, among other things, the availability of quality,properly-priced underwriting risks being produced by our agents, the ability toretain on renewal existing good-performing accounts, competition from otherinsurance companies, regulatory rate approvals, our reputation, and otherlimitations created by the marketplace or regulators. Our underwriting costsare affected by, among other things, the amount of commission andprofit-sharing we pay our agents to produce the underwriting risks we receivepremiums for, the cost of issuing insurance policies and maintaining ourcustomer and agent relationships, marketing costs, taxes we pay to the stateswe operate in on the amount of premium we collect, and other assessments andcharges imposed on our companies by the regulators in the states in which we dobusiness. Our claim and claim settlement costs are affected by, among otherthings, the quality of our underwriting accounts, severe weather in ouroperating region, the nature of the claim, the regulatory and legal environmentin our territories, inflation in underlying medical and property repair costs,and the availability and cost of reinsurance. Our investment income andrealized gains and losses are determined by, among other things, market forces,the rates of interest and dividends paid on our investment portfolio holdings,the credit or investment quality of the issuer and the success of its underlyingbusiness, the market perception of the company invested in, and other factorssuch as ratings by rating agencies and analysts.

 

**Critical Accounting Policies**

 

*General.*  We are required to make estimates andassumptions in certain circumstances that affect amounts reported in ourconsolidated financial statements and related footnotes. We evaluate theseestimates and assumptions on an on-going basis based on historicaldevelopments, market conditions, industry trends and other information that webelieve to be reasonable under the circumstances. There can be no assurancethat actual results will conform to our estimates and assumptions, and thatreported results of operations will not be materially adversely affected by theneed to make accounting adjustments to reflect changes in these estimates andassumptions from time to time. We believe the following policies are the mostsensitive to estimates and judgments.

 

*Liabilitiesfor Loss and Loss Adjustment Expenses.*  The liability for losses and loss adjustmentexpenses represents estimates of the ultimate unpaid cost of all lossesincurred, including losses for claims that have not yet been reported to ourinsurance companies. The amount of loss reserves for reported claims is basedprimarily upon a case-by-case evaluation of the type of risk involved,knowledge of the circumstances surrounding each claim and the insurance policyprovisions relating to the type of loss. The amounts of loss reserves forunreported claims and loss adjustment expenses are determined using historicalinformation by line of insurance as adjusted to current conditions. Inflationis implicitly provided for in the reserving function through analysis of costs,trends and reviews of historical reserving results over multiple years.

 

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Reserves are closely monitored and are recomputedperiodically using the most recent information on reported claims and a varietyof statistical techniques. Specifically, on a quarterly basis, we review, by lineof business, existing reserves, new claims, changes to existing case reserves,and paid losses with respect to the current and prior accident years. We usehistorical paid and incurred losses and accident year data to derive expectedultimate loss and loss adjustment expense ratios by line of business. We thenapply these expected loss and loss adjustment expense ratios to in-forcebusiness to derive a reserve level for each line of business. This amount,together with reserves required by new reported claims and changes to existingcase reserves, is compared to existing reserves to establish the adjustment toreserves that is required. In connection with the determination of thereserves, we also consider other specific factors such as recent weather-relatedlosses, trends in historical paid losses, and legal and judicial trends withrespect to theories of liability. Because of the nature of our business, whichgenerally provides coverage for short-term risks, loss development iscomparatively rapid and historical paid losses have been a reliable predictivemeasure of future losses.

 

Nevertheless, reserves are estimates because there areuncertainties inherent in the determination of ultimate losses. Courtdecisions, regulatory changes and economic conditions can affect the ultimatecost of claims that occurred in the past as well as create uncertaintiesregarding future loss cost trends. Accordingly, the ultimate liability forunpaid losses and loss settlement expenses will likely differ from the amount recordedat March 31, 2004. Changes in estimates or differences between estimates andamounts ultimately paid are reflected in current operations. Loss reservingtechniques and assumptions have been consistently applied during the periodspresented.

 

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

 
| **Change in  Loss and Loss  Adjustment  Reserves Net  of Reinsurance** |   | **Adjusted Loss  and Loss  Adjustment  Reserves Net  of Reinsurance  as of  March 31,  2004** |   | **Percentage  Change in  Stockholders’  Equity as of  March 31,  2004(1)** |   | **Adjusted Loss  and Loss  Adjustment  Reserves Net  of  Reinsurance as  of  December 31,  2003** |   | **Percentage  Change in  Stockholders’  Equity as of  December 31,  2003(1)** |   |
|------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|
| **(Dollars in thousands)**                                             |   |
| –10.0%                                                            |   | 30,814                                                                                        |   | 2.3                                                                             | %      | $                                                                                                 | 29,003 |                                                                               | 2.2    | % |
| –7.5%                                                             |   | 31,670                                                                                        |   | 1.7                                                                             | %      | 29,808                                                                                            |   | 1.6                                                                                | %      |
| –5.0%                                                             |   | 32,526                                                                                        |   | 1.1                                                                             | %      | 30,614                                                                                            |   | 1.1                                                                                | %      |
| –2.5%                                                             |   | 33,382                                                                                        |   | 0.6                                                                             | %      | 31,419                                                                                            |   | 0.5                                                                                | %      |
| Base                                                                   |   | 34,238                                                                                        |   | —                                                                          |   | 32,225                                                                                            |   | —                                                                             |   |
| 2.5%                                                                   |   | 35,094                                                                                        |   | -0.6                                                                            | %      | 33,031                                                                                            |   | –0.5                                                                          | %      |
| 5.0%                                                                   |   | 35,950                                                                                        |   | -1.1                                                                            | %      | 33,836                                                                                            |   | –1.1                                                                          | %      |
| 7.5%                                                                   |   | 36,806                                                                                        |   | -1.7                                                                            | %      | 34,642                                                                                            |   | –1.6                                                                          | %      |
| 10.0%                                                                  |   | 37,662                                                                                        |   | -2.3                                                                            | %      | 35,448                                                                                            |   | –2.2                                                                          | %      |
|                                                                        |        |                                                                                               |        |                                                                                 |        |                                                                                                   |        |                                                                                    |        |  |  |

 

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(1)                                  Netof Tax

 

The property and casualty industry has incurredsubstantial aggregate losses from claims related to asbestos-related illnesses,environmental remediation, product and construction defect liability, mold, andother uncertain exposures. We have not experienced significant losses fromthese types of claims.

 

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

 
|                        |   | **March 31,  2004**        |   | **December 31,  2003** |   |
|-----------------------------|--------|----------------------------|--------|------------------------|--------|
|                        |   | **(Dollars In thousands)** |   |
| Commercial lines:           |   |                       |   |                   |   |
| Commercial multi-peril      |   | $                          | 6,152  |                   | $      | 6,998 |   |
| Other liability             |   | 8,713                      |   | 8,708                  |   |
| Workers’ compensation  |   | 4,698                      |   | 4,684                  |   |
| Commercial automobile       |   | 2,082                      |   | 2,251                  |   |
| Fire, allied, inland marine |   | 97                         |   | 242                    |   |
|                        |   | 21,742                     |   | 22,883                 |   |
| Personal lines:             |   |                       |   |                   |   |
| Homeowners                  |   | 11,472                     |   | 9,509                  |   |
| Personal automobile         |   | 3,220                      |   | 3,073                  |   |
| Fire, allied, inland marine |   | 394                        |   | 328                    |   |
| Other liability             |   | 1,524                      |   | 1,400                  |   |
| Workers’ compensation  |   | 88                         |   | 68                     |   |
|                        |   | 16,698                     |   | 14,378                 |   |
| Total                       |   | $                          | 38,440 |                   | $      | 37,261 |   |

 

*Investments.*  Unrealized investment gains or losses oninvestments carried at fair value, net of applicable income taxes, arereflected directly in stockholders’’ equity as a component of comprehensiveincome and, accordingly, have no effect on net income. A decline in fair valueof an investment below its cost that is deemed other than temporary is chargedto earnings as a realized loss. We monitor our investment portfolio and reviewinvestments that have experienced a decline in fair value below cost toevaluate whether the decline is other than temporary. These evaluations involvejudgment and consider the magnitude and reasons for a decline and the prospectsfor the fair value to recover in the near term. For the three months endedMarch 31, 2004 and 2003, we did not have any investments in our portfolio witha decline in value determined to be other than temporary. Adverse investmentmarket conditions, or poor operating results of underlying investments, couldresult in impairment charges in the future.

 

We generally apply the following standards indetermining whether the decline in fair value of an investment is other thantemporary:

 

*Equities*– If an equity security has a fair value below 50% of cost or remains below 80%of cost for more than three months, a review of the financial condition andprospects of the company is performed by the Investment Committee of the Boardof Directors to determine if the decline in fair value is other than temporary.A specific determination is made for any

 

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such security. Other equity securities in anunrealized loss position not meeting these quantitative thresholds areevaluated considering, among other things, the magnitude and reasons for thedecline and the prospects for the fair value of the securities to recover inthe near term. If it is determined that the decline in fair value is judged tobe “other than temporary” then the cost basis of the security is written downto “realizable value” and the amount of the write down accounted for as arealized loss. “Realizable value” is defined as the quoted market price of thesecurity. Write-down to a value other than the market price requires objectiveevidence in support of that value.

 

We have one significant non-traded equity security, anon-voting common stock in Excess Reinsurance Company, which is carried at $1.2million. Its fair value is estimated at the statutory book value as reported tothe National Association of Insurance Commissioners (NAIC). Other non-tradedsecurities, which are not material in the aggregate, are carried at cost.

 

*FixedIncome Securities* – A fixed maturity security generally iswritten down if we are unable to hold it or otherwise intend to sell a securitywith an unrealized loss, or if it is probable that we will be unable to collectall amounts due according to the contract terms of a debt security not impairedat acquisition.

 

A fixed maturity security review for collectibility isdone if any of the following situations occur:

 

•             A review of the financial condition andprospects of the company performed by the Investment Committee indicates thatthe security should be evaluated.

 

•             Moody’s or Standard & Poors rate thesecurity below investment grade.

 

•             The security has a fair value below 70% ofamortized cost at quarter end due to deterioration in credit quality.

 

*PolicyAcquisition Costs.*  Wedefer policy acquisition costs, such as commissions, premium taxes and certainother underwriting expenses that vary with and are directly related to theproduction of business. These costs are amortized over the effective period ofthe related insurance policies. The method followed in computing deferredpolicy acquisition costs limits the amount of deferred costs to their estimatedrealizable value, which gives effect to the premium to be earned, relatedinvestment income, loss and loss adjustment expenses, and certain other costsexpected to be incurred as the premium is earned. Future changes in estimates,the most significant of which is expected loss and loss adjustment expenses,may require acceleration of the amortization of deferred policy acquisitioncosts.

 

*Reinsurance.*  Amounts recoverable from property andcasualty reinsurers are estimated in a manner consistent with the claimliability associated with the reinsured policy. Amounts paid for reinsurancecontracts are expensed over the contract period during which insured events arecovered by the reinsurance contracts.

 

Ceded unearned premiums and reinsurance balancesrecoverable on paid and unpaid loss and loss adjustment expenses are reportedseparately as assets,

 

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instead of being netted with the appropriateliabilities, because reinsurance does not relieve us of our legal liability toour policyholders. Reinsurance balances recoverable are subject to credit riskassociated with the particular reinsurer. Additionally, the same uncertaintiesassociated with estimating unpaid loss and loss adjustment expenses affect theestimates for the ceded portion of these liabilities.

 

We continually monitor the financial condition of ourreinsurers.

 

*IncomeTaxes.*  We use theasset and liability method of accounting for income taxes. Deferred incometaxes arise from the recognition of temporary differences between financialstatement carrying amounts and the tax bases of our assets and liabilities. Avaluation allowance is provided when it is more likely than not that someportion of the deferred tax asset will not be realized. The effect of a changein tax rates is recognized in the period of the enactment date.

 

**Results of Operations**

 

Our results of operations are influenced by factorsaffecting the property and casualty insurance industry in general. Theoperating results of the United States property and casualty insurance industryare subject to significant variations due to competition, weather, catastrophicevents, regulation, general economic conditions, judicial trends, fluctuationsin interest rates and other changes in the investment environment.

 

Our growth in premiums and underwriting results havebeen, and continue to be, influenced by market conditions. Pricing in theproperty and casualty insurance industry historically has been cyclical. Duringa soft market cycle, price competition is prevalent and makes it difficult towrite and retain properly priced personal and commercial lines business. Ourpolicy is to maintain our disciplined underwriting and pricing standards duringsoft markets, even at the expense of premium growth. The insurance industry iscurrently experiencing a hard market cycle during which price competition isless significant than during a soft market cycle. The hard market cycleallowing higher premium rates has been ongoing now for more than three years,and some pricing competition is re-appearing in the market, particularly inlines of business which are predominantly property exposures. The cyclicalityof the market is difficult to anticipate, and while pricing competitiveness hasrecently become more apparent in the market, today’s pricing remains generallyconsistent with a continuing hard market.

 

***Three months Ended March 31, 2004 Compared to three monthsEnded March 31, 2003***

 

For the three months ended March 31, 2004, the Companyhad net income of $229,000 compared to $233,000 for the same period in 2003. Althoughthe underwriting gain from our commercial lines segment for 2004 increased to$2.2 million from the prior year amount of $1.1 million, our personal linessegment incurred an underwriting loss of $2.6 million in 2004, an increase fromthe loss of $1.4 million in the prior comparable period. In our investmentsegment, net investment income increased 56% in 2004 to $668,000 from $427,000,and realized losses for 2004 were $97,000, as compared to a net realized gainof $149,000 for 2003.

 

Total revenues for the first quarter of 2004 were$14.5 million, which was 24% greater than 2003 revenues of $11.7 million. Thisincrease was due

 

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primarily to a $2.8 million increase in net premiumsearned in 2004, and to an increase in net investment income of $241,000 ascompared to 2003, offset by a realized investment loss of $97,000 in 2004 ascompared to a realized investment gain of $149,000 in 2003.

 

Direct premiums written increased 10% to $14.3 millionin 2004 when compared to 2003, and consisted of $8.6 million of commerciallines premiums, a 17% increase, and $5.7 million of personal lines premiums, a1% increase. Net premiums earned increased by 25% to $13.9 million for 2004 ascompared to $11.1 million for the prior year. Commercial lines net premiumsearned increased 40% to $8.0 million in 2004, and personal lines net premiumsearned increased 10% to $5.8 million in 2004. The overall increases in directpremiums written and net premiums earned are generally attributable to firmerpricing and continued strong growth, particularly in our commercial linesbusiness.

 

Consistent with our goal of increasing commercialbusiness, we increased direct commercial multi-peril premiums written, thelargest component of our commercial lines segment, by 18% to $4.3 million in2004, compared to $3.6 million for 2003, and increased commercial multi-perilnet premiums earned by 41% to $4.0 million in 2004, as compared to $2.8million for 2003. We expect this trend of increasing commercial writings tocontinue by targeting certain types of risks with selected producers.

 

For the same comparative periods, net premiums earnedfor our homeowners insurance, the largest component of our personal linessegment, increased 10% to $3.4 million for 2004, compared to $3.1 million for2003, while homeowners direct premiums written increased 2% to $3.1 million in2004 from $3.0 million in 2003. The growth rate for homeowners insuranceprimarily reflects the reclassification of certain homeowners risks from ourpreferred program to our standard program, resulting in a higher premium, aspart of a general review of the homeowners program which is substantiallycomplete. Premiums are higher for the standard program compared to thepreferred program.

 

Personal automobile direct written premiums, writtenexclusively in Pennsylvania**,** increased 1% to $2.0 million in 2004. Netearned premiums for personal automobile increased by 13% to $1.8 million for2004, from $1.6 million for 2003. Despite the increases in personal lines netearned premiums, our focus is principally on our commercial lines growth. Ourpersonal auto premium is currently being evaluated to determine whether we willseek an appropriate rate increase where possible.

 

Net investment income increased $241,000, or 56%, to$668,000 in 2004, due primarily to higher average invested assets. Net realizedlosses were $97,000 in 2004, compared to a realized gain of $149,000 in 2003.In 2004, realized investment losses of $97,000 were comprised of gains onsecurities sales of $130,000, offset by losses on securities sales of $227,000.The losses from securities sales were comprised of $223,000 from the sale ofbonds and $4,000 from the sale of equities. The following table summarizes theperiod of time that equity securities sold at a loss during 2004 had been in acontinuous unrealized loss position:

 

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| **PERIOD OF TIME IN AN  UNREALIZED LOSS POSITION** |   | **Fair  Value on  Sale  Date** |   | **Realized  Loss** |   |
|----------------------------------------------------|--------|--------------------------------|--------|--------------------|--------|
|                                               |   | **(In thousands)**             |   |
| 0-6  months                                        |   | $                              | — |               | $      | — |   |
| 7-12  months                                       |   | 276                            |   | 4                  |   |
| More  than 12 months                               |   | —                         |   | —             |   |
| Total                                              |   | $                              | 276    |               | $      | 4 |   |

 

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

 

The following table summarizes the length of timeequity securities with unrealized losses at March 31, 2004 have been in anunrealized loss position:

 
|                   |   |                |   |                   |   | **Length of  Unrealized Loss** |   |
|------------------------|--------|---------------------|--------|------------------------|--------|--------------------------------|--------|
|                   |   | **Fair  Value**     |   | **Unrealized  Losses** |   | **Less  than  6 months**       |   | **6 to 12  Months** |   | **Over 12  Months** |   |
|                   |   | **(In  thousands)** |   |
| Equity  securities     |   |                |   |                   |   |                           |   |   |   |   |   |
| More  than 80% of cost |   | $                   | 1,685  |                   | $      | 55                             |   | $ | 55 |   | $ | 0 |   | $ | 0 |   |
| Less  than 80% of cost |   | —              |   | —                 |   | —                         |   | — |   | — |   |
| Total                  |   | $                   | 1,685  |                   | $      | 55                             |   | $ | 55 |   | $ | 0 |   | $ | 0 |   |

 

For 2004, we had a GAAP combined ratio (the “combinedratio” is an industry measurement of a company’s underwriting success, and isthe sum of the ratios of a company’s loss and loss adjustment expense, andunderwriting expenses to net earned premium. A combined ratio of less than 100%means a company is making an underwriting profit)of 102.8%, a loss and lossadjustment expense ratio of 60.0% and an underwriting expense ratio of 42.8%,compared to a GAAP combined ratio of 102.5%, a loss and loss adjustment expenseratio of 58.9% and an underwriting expense ratio of 43.6% for 2003.

 

In the commercial lines segment for 2004, we had anunderwriting gain of $2.2 million, a combined ratio of 72.1%, a loss and lossadjustment expense ratio of 28.0% and an underwriting expense ratio of 44.1%,compared to an underwriting gain of $1.1 million, a combined ratio of 81.3%, aloss and loss adjustment expense ratio of 34.1% and an underwriting expenseratio of 47.2% for 2003.

 

In the personal lines segment for 2004, we had anunderwriting loss of $2.6 million, a combined ratio of 145.2%, a loss and lossadjustment expense ratio of 104.1% and an underwriting expense ratio of 41.1%,compared to an underwriting loss of $1.4 million, a combined ratio of 125.5%, aloss and loss adjustment expense ratio of 85.7% and an underwriting expenseratio of 39.8% for 2003.

 

Net loss and loss adjustment expenses incurredincreased overall by $1.8 million, or 28%, to $8.3 million for 2004 from 2003.The increase in loss and loss adjustment expenses reflects the increase incommercial and personal lines volume and an increase in the frequency ofpersonal lines losses. The increase in personal lines losses is attributable toharsher weather conditions for 2004 compared to 2003, particularly extremelycold temperatures in the first half of the quarter in 2004. In addition, therewas a considerable amount of snow during the first quarter of 2004. Theseconditions lead to losses from frozen pipes, structural collapses, more

 

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frequent automobile losses and slip-and-fallaccidents. The increase in these losses is evidenced by the increase in thehomeowners loss and loss expense ratio to 122.4% for 2004, compared to 88.2%for 2003, and an increase in the personal automobile loss and loss expenseratio to 84.8% for 2004, compared to 78.9% for 2003. Our claims frequencyacross the entire book increased in January 2004 by approximately 50% over theaverage number of claims reported in that month in the two prior years, and inFebruary 2004 by approximately 25% over the average of the two prior years.

 

Underwriting expenses increased by $1.1 million in2004, or 23%, to $5.9 million from 2003. This increase was principallyattributable to an increase in expenses due to higher amortization of deferredpolicy acquisition costs resulting from higher premium volume, and a charge of$207,000 (pre-tax) associated with the commitment of shares to employeeparticipants in the ESOP for 2004. We are currently in the process ofconverting our information system. When completed, we expect some costs tomoderate as conversion costs and costs associated with operating dual systemswill no longer be incurred. These reduced costs will be offset by some higherstaffing costs, but we also should be positioned to expand premium volumewithout material incremental labor and facility costs because of increasedprocessing capacity.

 

We also expect underwriting expenses to moderate infuture periods because we intend to significantly reduce the amount of businesswritten in Mercer Insurance Company, the New Jersey business of which becamesubject to New Jersey’s retaliatory premium tax when it redomesticated toPennsylvania in 1997. We plan to do this by writing new policies, beginning inthe 3rd quarter of 2004, and renewing existing policies (afterregulatory approval is received, which has been applied for) for New Jerseyaccounts in Mercer Insurance Company of New Jersey, Inc., our New Jerseydomestic insurer that is not subject to this retaliatory tax. We had notpreviously renewed policies in our New Jersey subsidiary because onlypolicyholders of Mercer Insurance Company, domiciled in Pennsylvania, hadsubscription and voting rights in the Conversion. Therefore, renewing policiesin the New Jersey subsidiary before completion of the Conversion would havedenied subscription rights to Mercer Insurance Company’s policyholders anddisenfranchised them. The New Jersey Division of Taxation has billed us for allprior retaliatory tax and related interest, and these amounts have been paid infull, although under protest, thereby preserving our right to a recovery if theretaliatory tax is successfully challenged while the statute of limitationsremains open for any refund claim by us. It is unclear whether any suchchallenge will be successful. Until the business is moved to Mercer InsuranceCompany of New Jersey, Mercer Insurance Company will continue to accrue and paycurrent retaliatory taxes. After paying the disputed retaliatory taxes to NewJersey for prior periods, an accrual of $300,000 for estimated retaliatorytaxes remained which was reversed during the first quarter of 2004 and reducedpremium tax expense accordingly.

 

Federal income tax expense was $40,000 for 2004, aneffective rate of 14.9%, compared to $88,000, an effective rate of 24.2%, in2003. The decrease in the effective tax rate in 2004 is attributable to tax-exemptinvestment income being a larger percentage of net income than in the prioryear.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Our insurance companies generate sufficient funds fromtheir operations and maintain a high degree of liquidity in their investmentportfolios. The

 

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primary source of funds to meet the demands of claimsettlements and operating expenses are premium collections, investment earningsand maturing investments. Mercer Insurance Company is expanding its existingfacilities in Pennington, New Jersey, at a cost estimated at $2.8 million as ofMarch 31, 2004. We are also in the process of building an informationsystem platform that will allow our producers to conduct their business throughthe Internet or through the method they have historically used. As ofMarch 31, 2004, we have spent $2.5 million on the development of thisplatform, which includes license fees for software used in the platform. It isanticipated to be completed after mid-year 2005, at an additional cost of $0.8million. Mercer Insurance Company possesses sufficient resources for thesefuture expenditures without incurring any debt.

 

Our insurance companies maintain investment andreinsurance programs that are intended to provide sufficient funds to meettheir obligations without forced sales of investments. They maintain a portionof their investment portfolio in relatively short-term and highly liquid assetsto ensure the availability of funds.

 

The principal source of liquidity for Mercer InsuranceGroup will be the net proceeds it retained from the Conversion stock offeringof approximately $25 million, and dividend payments and other fees receivedfrom Mercer Insurance Company. For a period of three years after the Conversion,Mercer Insurance Company may not declare or pay any dividend to MercerInsurance Group without the approval of the Pennsylvania Insurance Department.After this three-year period, Mercer Insurance Company will be restricted bythe insurance laws of Pennsylvania as to the amount of dividends or otherdistributions it may pay to its holding company. Under Pennsylvania law, thereis a maximum amount that may be paid by Mercer Insurance Company during anytwelve-month period after notice to, but without prior approval of, thePennsylvania Insurance Department. This limit is the greater of 10% of MercerInsurance Company’s statutory surplus as reported on its most recent annualstatement filed with the Pennsylvania Insurance Department, or the net income ofMercer Insurance Company for the period covered by such annual statement.

 

If the dividend restrictions imposed on MercerInsurance Company related to the Conversion were not in effect, then as ofDecember 31, 2003, the amounts available for payment of dividends fromMercer Insurance Company in 2004, without the prior approval of thePennsylvania Insurance Department would have been approximately $5.8 million.Similar statutory limitations are imposed on the dividends which may be paid toMercer Insurance Company by its insurance subsidiaries, and, based on theirDecember 31, 2003 surplus positions, allowable dividends would be restricted toapproximately $2 million in the aggregate.

 

Total assets increased 3%, or $4.5 million to $180.3million, at March 31, 2004 from December 31, 2003. A premium volumedecrease as compared to the fourth quarter of 2003 drove decreases in premiumreceivables of $1.2 million, or 13%, and deferred policy acquisition costs of$0.3 million, or 4%. Reinsurance recoverable on losses and loss expensesincreased $1 million, or 25%, due to loss activity above the Company’s lossretention under its reinsurance agreements. Investments decreased $9.0 million,or 7%, to $114.4 million, and cash balances increased $12.7 million, or 83%. Themovement between investments and cash and cash equivalents is due to the natureof the investment vehicles in which cash proceeds of the Conversion which awaitlonger-term investment have been held, and their classification for financialstatement purposes.

 

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Contemporaneous with the Conversion, the Company andits subsidiaries engaged a new manager for its fixed income portfolio. Themanager will invest the proceeds of the Conversion and reallocate most otherfixed maturity securities with a view to achieving an appropriate duration,targeted at approximately 4 years, and proportionately higher yields. Given thelarge amount of new capital to invest, the need to reallocate some existinginvestment funds, and a bond market presenting investment challenges, somefunds are being maintained in very short term investments or money market fundswhile they await investment in fixed income securities appropriate to theCompany’s investment goals. It is anticipated that these amounts will be fullyinvested in accordance with the Company’s investment goals and policy in thesecond quarter of 2004, with a related increase in investment income resultingfrom such placement.

 

Total liabilities increased 4%, or $3.3 million, in2004, to $80.8 million. Decreased premium volume in the first quarter of 2004,as compared to the fourth quarter of 2003, is primarily responsible for thedecrease in unearned premium reserves of $1.1 million, or 3%. Loss and lossexpense reserves increased $1.2 million, or 3%, as a result of earned premiumincreases and the related increases in losses, and the higher level of lossesexperienced in 2004. Accounts payable increased 42% to $11.3 million primarilydue to payables relating to unsettled securities transactions at March 31,2004.

 

Total stockholders’ equity increased by $1.2 million,or 1%, due principally to net income and unrealized gains on the investmentportfolio in the first quarter of 2004. Unrealized gains on the investment portfolioincreased $0.8 million (after tax), or 17% in 2004 due principally to thestrong equities market performance.

 

In connection with the Conversion, the ESOP wasestablished, and purchased 626,111 shares from the Company in return for a notebearing interest at 4% on the principal amount of $6,261,110. Mercer InsuranceCompany will make annual employee benefit contributions to the ESOP sufficientto repay that loan to the Company. It is anticipated that the loan will berepaid in 10 equal annual installments, and that, in proportion to annualprincipal and interest payments, approximately 10% of the original ESOP shareswill be allocated annually to employee participants of the ESOP. An expensecharge will be booked ratably during each year for the shares committed to beallocated to participants that year, determined with reference to the fairmarket value of the Company’s stock at the time the commitment to allocate theshares is accrued and recognized. The issuance of the shares to the ESOP wasfully recognized in the Additional Paid-in Capital account at Conversion, witha contra account entitled Unearned ESOP Shares established in the Shareholders’Equity section of the balance sheet for the unallocated shares at anamount equal to their original per-share purchase price.

 

Mercer Insurance Group expects to adopt a stock-basedincentive plan, subject to the approval of its shareholders at Mercer InsuranceGroup’s 2004 annual meeting of shareholders. Pursuant to that plan, Mercer Insurance Group may issue a total numberof shares equal to 14% of the shares of common stock that were issued in theConversion. Of this amount, an amount equal to 4% of the shares of common stockissued in the Conversion may be used to make restricted stock awards under thestock-based incentive plan. If the stock-based incentive plan is approved in2004, the Company may purchase shares of its common stock in the open marketand contribute those shares to the stock-based incentive plan for use in makingrestricted stock awards under that

 

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plan. Any such purchase will require the priorapproval of the Pennsylvania Insurance Department. The fair market value of anycommon stock used for restricted stock awards will initially represent unearnedcompensation. As Mercer Insurance Group accrues compensation expense to reflectthe vesting of such shares, unearned compensation will be reduced accordingly.This compensation expense will be deductible for federal income tax purposesupon vesting.

 

**IMPACT OF INFLATION**

 

Inflation increases an insured’s need for property andcasualty insurance coverage. Inflation also increases claims incurred byproperty and casualty insurers as property repairs, replacements and medicalexpenses increase. These cost increases reduce profit margins to the extentthat rate increases are not implemented on an adequate and timely basis. Weestablish property and casualty insurance premiums levels before the amount oflosses and loss expenses, or the extent to which inflation may affect theseexpenses, are known. Therefore, our insurance companies attempt to anticipatethe potential impact of inflation when establishing rates. Because inflationhas remained relatively low in recent years, financial results have not beensignificantly affected by inflation.

 

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

 

**OFF BALANCE SHEET COMMITMENTS AND CONTRACTUAL OBLIGATIONS**

 

The Company was not a party to any unconsolidatedarrangement or financial instrument with special purpose entities or othervehicles at March 31, 2004 which would give rise to previously undisclosedmarket, credit or financing risk.

 

The Company and its subsidiaries have no significantcontractual obligations at March 31, 2004.

 

Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk

 

*General.*  Market risk is the risk that we will incurlosses due to adverse changes in market rates and prices. We have exposure tothree principal types of market risk through our investment activities: interestrate risk, credit risk and equity risk. Our primary market risk exposure is tochanges in interest rates. We have not entered, and do not plan to enter, intoany derivative financial instruments for hedging, trading or speculativepurposes.

 

*InterestRate Risk.*  Interestrate risk is the risk that we will incur economic losses due to adverse changesin interest rates. Our exposure to interest rate changes primarily results fromour significant holdings of fixed rate investments. Fluctuations in interestrates have a direct impact on the market valuation of these securities.

 

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*EquityRisk.*  Equity pricerisk is the risk that we will incur economic losses due to adverse changes inequity prices. Our exposure to changes in equity prices primarily results fromour holdings of common stocks, mutual funds and other equities. Our portfolioof equity securities is carried on the balance sheet at fair value. Therefore,an adverse change in market prices of these securities would result in losses.

 

There have been nomaterial changes in Market Risk from the end of the most recent fiscal yearended December 31, 2003, and the information disclosed in connection therewith.

 

Item 4. Controls and Procedures

 

The Company, under the supervision and with theparticipation of the Company’s management, including the Chief ExecutiveOfficer and the Chief Financial Officer, has evaluated the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures.  Based on that evaluation, the Company’sChief Executive Officer and Chief Financial Officer conclude that the Company’sdisclosure controls and procedures are effective as of March 31, 2004.  There has been no change in the Company’sinternal control over financial reporting that occurred during the quarterended March 31, 2004 that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

Securities and Exchange Commission rules define“disclosure controls and procedures” as controls and other procedures of anissuer that are designed to ensure that information required to be disclosed bythe issuer in the reports that it files or submits under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported within thetime specified in the Commission’s rules and forms.  Disclosure controls and procedures include, without limitation,controls and procedures designed to ensure that such information is accumulatedand communicated to the issuer’s management, including its principal executiveofficer and principal financial officer, as appropriate to allow timelydecisions regarding required disclosure.

 

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PART II- OTHER INFORMATION

 

Item 1.            Legal Proceedings - None

 

Item 2.            Changes in Securities, Use of Proceeds and Issuer Purchases ofEquity Securities - None

 

Item 3.            Defaults Upon Senior Securities – None

 

Item 4.            Submission of Matters to Vote of Security Holders -

None

 

Item 5.            Other Information- None

 

Item 6.    Exhibits and Reports on Form 8-K

 

(a)  Exhibits

 
| **Exhibit No.** |   | **Title**                                                                                                                                                  |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1            |   | Certification of  Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley  Act of 2002, (filed herewith)                              |
|            |   |                                                                                                                                                       |
| 31.2            |   | Certification of  Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley  Act of 2002, (filed herewith)                              |
|            |   |                                                                                                                                                       |
| 32.1            |   | Certifications of  Chief Executive Officer and Chief Financial Officer in accordance with  Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith) |

 
|   |   |   (b)         Reports on  Form 8-K |
|--------|--------|--------------------------------------------------------------------------------------|

 
|   |   | In a report on Form 8-K dated and filed on February  25, 2004, the Company reported a press release, dated February 25,  2004, announcing its earnings for the three month and twelve month periods  ended December 31, 2003, which is incorporated herein by reference. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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SIGNATURES

 

In accordance with therequirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                |   | MERCER  INSURANCE GROUP, INC. |
|---------------------|--------|-------------------------------|
|                |   |                          |  (Registrant) |
|                |   |                          |   |
| Dated: May 14, 2004 |   | By                            | /s/Andrew R. Speaker |   |
|                |   |                          | Andrew  R. Speaker |
|                |   |                          |   | President and Chief |
|                |   |                          |   | Executive Officer |
|                     |        |                               |  |  |  |

 

 
| Dated: May 14, 2004 |   | By     | /s/ David B. Merclean |                    |
|---------------------|--------|--------|-----------------------|-------------------------|
|                |   |   |                  | David  B. Merclean      |
|                |   |   |                  | Chief Financial Officer |
|                     |        |        |                       |                         |  |

 

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