**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**Quarterly Report pursuant to Section 13 or15(d)of the Securities Exchange Act of 1934**

 

**for the Quarterly Period Ended September30, 2004,**

**or**

 

**Transition report pursuant to Section 13 or15(d) Of the Exchange Act**

 

**for the Transition Period from                 to                 **

 

**No. 000-25425**

**(Commission FileNumber)**

 

**MERCER INSURANCE GROUP, INC.**

(Exact name of Registrant as specified in itscharter)

 

| **PENNSYLVANIA**                                                                    | **23-2934601**                       |
|-------------------------------------------------------------------------------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     | (I.R.S. Employer Identification No.) |
|                                                                                |                                 |
| **10 North Highway 31, P.O. Box 278,  Pennington, NJ**                              | **08534**                            |
| (Address of principal executive offices)                                            | (Zip Code)                           |
|                                                                                |                                 |
| **(609) 737-0426**                                                                  |
| (Registrant’s telephone number, including  area code)                          |
|                                                                                |                                 |
|                                                                                |                                 |
| (Former name, former address and former  fiscal year, if changed since last report) |

 

Check whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.                               Yesý       No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).                                                                                      Yesý       No  ̈

 

State the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date.

 
|                        |   | Number of Shares Outstanding as of October 15, 2004 |   |
|-----------------------------|--------|-----------------------------------------------------|--------|
| COMMON STOCK (No Par Value) |   | 6,810,733                                           |   |
| (Title of  Class)           |   | (Outstanding Shares)                                |   |

 

 

----

 

**TABLE OF 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.                                  | Controls and Procedures                                                                     |   |
|                                     |                                                                                        |   |
| PART II.  OTHER INFORMATION    |                                                                                        |
|                                     |                                                                                        |   |
| Item 1.                                  | Legal Proceedings                                                                           |   |
| Item 2.                                  | Unregistered Sales of Equity Securities and  Use of Proceeds                                |   |
| Item 3.                                  | Defaults Upon Senior Securities                                                             |   |
| Item 4.                                  | Submission of Matters to a Vote of Security  Holders                                        |   |
| Item 5.                                  | Other Information                                                                           |   |
| Item  6.                                 | Exhibits                                                                                    |   |
|                                     |                                                                                        |
| SIGNATURES                               |                                                                                        |
|                                     |                                                                                        |
| **Exhibits:**                            |                                                                                        |

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

 

i

----

 

**Forward-looking Statements**

 

Mercer Insurance Group, Inc.(the “Company”) may from time to time make written or oral “forward-lookingstatements,” including statements contained in the Company’s filings with theSecurities and Exchange Commission (including this Quarterly Report on Form10-Q and the exhibits hereto and thereto), in its reports to shareholders andin other communications by the Company, which are made in good faith by theCompany pursuant to the “safe harbor” provisions of the Private SecuritiesLitigation 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). Thewords “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,”“intend,” “plan” and similar expressions are intended to identifyforward-looking statements. The following factors, among others, could causethe Company’s financial performance to differ materially from the plans,objectives, expectations, estimates and intentions expressed in suchforward-looking statements:

 

•                  future economicconditions in the regional and national markets in which the Company competeswhich are less favorable than expected;

 

•                  the effects ofweather-related and other catastrophic events;

 

•                  theconcentration of insured accounts in 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;

 

1

----

 

•                  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 changesin applicable laws, regulations or rules governing insurance holding companiesand insurance companies, and environmental, tax or accounting matters includinglimitations on premium levels, increases in minimum capital and reserves, andother financial 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 alsocautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis only as of the date of this report.  The Company does not undertake to update anyforward-looking statement, whether written or oral, that may be made from timeto time by or on behalf of the Company.

 

2

----

 

# **Part I - FINANCIAL INFORMATION**

 

## **Item 1. Financial Statements**

 

**MERCER INSURANCE GROUP, INC. ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETSAs of September 30, 2004 and December 31, 2003**

 
| ** **                                                                                                                      | ** ** | **As of  September 30,  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 $94,897 and $46,282,  respectively)              |       | $                                   | 94,494     |                               | $          | 46,277 |   |
| Equity securities, at fair value (cost of  $16,131 and $15,866,respectively)                                                    |       | 22,953                              |       | 22,656                             |       |
| Short-term investments, at amortized cost,  which approximates fair value                                                       |       | 10,599                              |       | 54,396                             |       |
| Total investments                                                                                                               |       | 128,046                             |       | 123,329                            |       |
| Cash and cash equivalents                                                                                                       |       | 9,123                               |       | 15,350                             |       |
| Premiums receivable                                                                                                             |       | 9,173                               |       | 9,096                              |       |
| Reinsurance receivables                                                                                                         |       | 2,992                               |       | 4,159                              |       |
| Prepaid reinsurance premiums                                                                                                    |       | 1,437                               |       | 1,614                              |       |
| Deferred policy acquisition costs                                                                                               |       | 7,618                               |       | 7,387                              |       |
| Accrued investment income                                                                                                       |       | 877                                 |       | 596                                |       |
| Property and equipment, net                                                                                                     |       | 9,723                               |       | 6,944                              |       |
| Goodwill                                                                                                                        |       | 4,673                               |       | 4,673                              |       |
| Other assets                                                                                                                    |       | 2,112                               |       | 2,727                              |       |
| Total assets                                                                                                                    |       | $                                   | 175,774    |                               | $          | 175,875 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                  |       |                                |       |                               |       |
| Liabilities:                                                                                                                    |       |                                |       |                               |       |
| Losses and loss adjustment expenses                                                                                             |       | $                                   | 37,227     |                               | $          | 37,261 |   |
| Unearned premiums                                                                                                               |       | 30,728                              |       | 30,329                             |       |
| Accounts payable and accrued expenses                                                                                           |       | 7,359                               |       | 7,937                              |       |
| Other reinsurance balances                                                                                                      |       | 13                                  |       | 81                                 |       |
| Other liabilities                                                                                                               |       | 1,425                               |       | 1,228                              |       |
| Deferred income taxes                                                                                                           |       | 704                                 |       | 713                                |       |
| Total liabilities                                                                                                               |       | 77,456                              |       | 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 7,060,733 shares, outstanding 6,079,106 and  6,282,233 shares |       | —                              |       | —                             |       |
| Additional paid-in capital                                                                                                      |       | 67,608                              |       | 64,871                             |       |
| Accumulated other comprehensive income:                                                                                         |       |                                |       |                               |       |
| Unrealized gains in investments, net of  deferred income taxes                                                                  |       | 4,237                               |       | 4,478                              |       |
| Retained earnings                                                                                                               |       | 37,033                              |       | 34,612                             |       |
| Unearned restricted stock compensation                                                                                          |       | (2,419                              | )          | —                             |       |
| Unearned ESOP shares                                                                                                            |       | (5,166                              | )          | (5,635                             | )          |
| Treasury stock, at cost, 250,000 and -0-  shares                                                                                |       | (2,975                              | )          | —                             |       |
| Total stockholders’equity                                                                                                  |       | 98,318                              |       | 98,326                             |       |
| Total liabilities and stockholders’ equity                                                                                 |       | $                                   | 175,774    |                               | $          | 175,875 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

----

 

**MERCER INSURANCE GROUP, INC. ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF EARNINGSNine Months Ended September 30, 2004 and 2003**

 
| ** **                                                                                                  | ** ** | **2004**                                                      | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|----------|------------|
| ** **                                                                                                  | ** ** | **(Dollars in thousands, except  shares and per share data)** | ** ** |
| ** **                                                                                                  | ** ** | **(Unaudited)**                                               | ** ** |
| Revenue:                                                                                                    |       |                                                          |       |     |       |
| Net premiums earned                                                                                         |       | $                                                             | 41,617     |     | $          | 34,762 |   |
| Investment income, net of expenses                                                                          |       | 1,933                                                         |       | 1,221    |       |
| Net realized investment gains                                                                               |       | 439                                                           |       | 130      |       |
| Other revenue                                                                                               |       | 266                                                           |       | 292      |       |
| Total revenue                                                                                               |       | 44,255                                                        |       | 36,405   |       |
|                                                                                                        |       |                                                          |       |     |       |
| Expenses:                                                                                                   |       |                                                          |       |     |       |
| Losses and loss adjustment expenses                                                                         |       | 21,103                                                        |       | 19,600   |       |
| Amortization of deferred policy acquisition  costs (related party amounts of $1,120 and $884, respectively) |       | 11,509                                                        |       | 9,396    |       |
| Other expenses                                                                                              |       | 8,212                                                         |       | 6,587    |       |
| Stock conversion expenses                                                                                   |       | —                                                        |       | 65       |       |
| Total expenses                                                                                              |       | 40,824                                                        |       | 35,648   |       |
| Income before income taxes and minority  interest in income of subsidiary                                   |       | 3,431                                                         |       | 757      |       |
| Income taxes                                                                                                |       | 1,010                                                         |       | 188      |       |
| Income before minority interest in income  of subsidiary                                                    |       | 2,421                                                         |       | 569      |       |
| Minority interest in income of subsidiary                                                                   |       | —                                                        |       | (124     | )          |
| Net income                                                                                                  |       | $                                                             | 2,421      |     | $          | 445 |   |
| Earnings per common share:                                                                                  |       |                                                          |       |     |       |
| Basic                                                                                                       |       | $                                                             | 0.39       |     | N/A        |   |
| Diluted                                                                                                     |       | $                                                             | 0.38       |     | N/A        |   |
| Weighted average shares:                                                                                    |       |                                                          |       |     |       |
| Basic                                                                                                       |       | 6,287,602                                                     |       | N/A      |       |
| Diluted                                                                                                     |       | 6,371,562                                                     |       | N/A      |       |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

----

 

**MERCER INSURANCE GROUP, INC. ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF EARNINGSThree Months Ended September 30, 2004 and 2003**

 
| ** **                                                                                                | ** ** | **2004**                                                      | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|----------|------------|
| ** **                                                                                                | ** ** | **(Dollars in thousands, except  shares and per share data)** | ** ** |
| ** **                                                                                                | ** ** | **(Unaudited)**                                               | ** ** |
| Revenue:                                                                                                  |       |                                                          |       |     |       |
| Net premiums earned                                                                                       |       | $                                                             | 14,032     |     | $          | 12,379 |   |
| Investment income, net of expenses                                                                        |       | 639                                                           |       | 400      |       |
| Net realized investment gains                                                                             |       | 340                                                           |       | 167      |       |
| Other revenue                                                                                             |       | 86                                                            |       | 101      |       |
| Total revenue                                                                                             |       | 15,097                                                        |       | 13,047   |       |
|                                                                                                      |       |                                                          |       |     |       |
| Expenses:                                                                                                 |       |                                                          |       |     |       |
| Losses and loss adjustment expenses                                                                       |       | 6,173                                                         |       | 6,859    |       |
| Amortization of deferred policy acquisition  costs (related party amounts of $457 and $304, respectively) |       | 3,867                                                         |       | 3,325    |       |
| Other expenses                                                                                            |       | 3,373                                                         |       | 2,571    |       |
| Stock conversion expenses                                                                                 |       | —                                                        |       | 3        |       |
| Total expenses                                                                                            |       | 13,413                                                        |       | 12,758   |       |
| Income before income taxes and minority interest  in income of subsidiary                                 |       | 1,684                                                         |       | 289      |       |
| Income taxes                                                                                              |       | 563                                                           |       | 84       |       |
| Income before minority interest in income  of subsidiary                                                  |       | 1,121                                                         |       | 205      |       |
| Minority interest in income of subsidiary                                                                 |       | —                                                        |       | (33      | )          |
| Net income                                                                                                |       | $                                                             | 1,121      |     | $          | 172 |   |
| Earnings per common share:                                                                                |       |                                                          |       |     |       |
| Basic                                                                                                     |       | $                                                             | 0.18       |     | N/A        |   |
| Diluted                                                                                                   |       | $                                                             | 0.17       |     | N/A        |   |
| Weighted average shares:                                                                                  |       |                                                          |       |     |       |
| Basic                                                                                                     |       | 6,267,258                                                     |       | N/A      |       |
| Diluted                                                                                                   |       | 6,482,258                                                     |       | N/A      |       |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

----

 

**MERCER INSURANCE GROUP, INC. ANDSUBSIDIARIES**

 

**CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITYNine months ended September 30, 2004(Unaudited, dollars in thousands)**

 
| ** **                                                                                                       | ** ** | **Preferred  stock** | ** ** | **Common  stock** | ** ** | **Additional  paid-in  capital** | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Retained  earnings** | ** ** | **Unearned  restricted  stock  compensation** | ** ** | **Unearned  ESOP  shares** | ** ** | **Treasury  Stock** | ** ** | **Total**  | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|----------------------------|------------|---------------------|------------|------------|------------|
| ** **                                                                                                       | ** ** | ** **           | ** ** | ** **        | ** ** | ** **                       | ** ** | ** **                                    | ** ** | ** **             | ** ** | ** **                                    | ** ** | ** **                 | ** ** | ** **          | ** ** | ** ** | ** ** |
| Balance,  December 31, 2003                                                                                      |       | $                    | —     |              | —     |                             | 64,871     |                                          | 4,478      |                   | 34,612     |                                          | —     |                       | (5,635     | )                   | —     |       | $          | 98,326 |   |
| Net  income                                                                                                      |       |                 |       |              |       |                             |       |                                          |       | 2,421                  |       |                                          |       |                       |       |                |       | 2,421      |       |
| Unrealized  losses on securities:                                                                                |       |                 |       |              |       |                             |       |                                          |       |                   |       |                                          |       |                       |       |                |       |       |       |
| Unrealized  holding gains arising during period, net of related income tax expense of  ($25)                     |       |                 |       |              |       |                             |       | 49                                            |       |                   |       |                                          |       |                       |       |                |       | 49         |       |
| Less  reclassification adjustment for gains included in net income, net of related  income tax expense of ($149) |       |                 |       |              |       |                             |       | (290                                          | )          |                   |       |                                          |       |                       |       |                |       | (290       | )          |
| Other  comprehensive loss                                                                                        |       |                 |       |              |       |                             |       |                                          |       |                   |       |                                          |       |                       |       |                |       | (241       | )          |
| Comprehensive  income                                                                                            |       |                 |       |              |       |                             |       |                                          |       |                   |       |                                          |       |                       |       |                |       | 2,180      |       |
| Unearned  restricted stock compensation                                                                          |       |                 |       |              |       | 2,625                            |       |                                          |       |                   |       | (2,625                                        | )          |                       |       |                |       | —     |       |
| Amortization  of restricted stock compensation                                                                   |       |                 |       |              |       |                             |       |                                          |       |                   |       | 206                                           |       |                       |       |                |       | 206        |       |
| ESOP  shares committed                                                                                           |       |                 |       |              |       | 112                              |       |                                          |       |                   |       |                                          |       | 469                        |       |                |       | 581        |       |
| Treasury  stock purchased                                                                                        |       |                 |       |              |       |                             |       |                                          |       |                   |       |                                          |       |                       |       | (2,975              | )          | (2,975     | )          |
| Balance,  September 30, 2004                                                                                     |       | $                    | —     |              | —     |                             | 67,608     |                                          | 4,237      |                   | 37,033     |                                          | (2,419     | )                          | (5,166     | )                   | (2,975     | )          | $          | 98,318 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

6

----

 

**MERCER INSURANCE GROUP, INC. ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWSNine Months Ended September 30, 2004 and 2003**

 
| ** **                                                                         | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------|------------|
| ** **                                                                         | ** ** | **(Dollars in thousands)  (Unaudited)** | ** ** |
| Cash flows from operating activities:                                              |       |                                    |       |     |       |
| Net income                                                                         |       | $                                       | 2,421      |     | $          | 445 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                    |       |     |       |
| Depreciation and amortization of fixed  assets                                     |       | 1,087                                   |       | 974      |       |
| Net amortization of premium or (accretion  of discount)                            |       | 67                                      |       | (50      | )          |
| Amortization of restricted stock compensation                                      |       | 206                                     |       | —   |       |
| ESOP share commitment                                                              |       | 581                                     |       | —   |       |
| Net realized investment gains                                                      |       | (439                                    | )          | (130     | )          |
| Deferred income tax                                                                |       | 115                                     |       | (234     | )          |
| Change in assets and liabilities:                                                  |       |                                    |       |     |       |
| Premiums receivable                                                                |       | (77                                     | )          | (2,251   | )          |
| Reinsurance receivables                                                            |       | 1,167                                   |       | (879     | )          |
| Prepaid reinsurance premiums                                                       |       | 177                                     |       | (379     | )          |
| Deferred policy acquisition costs                                                  |       | (231                                    | )          | (963     | )          |
| Other assets                                                                       |       | 334                                     |       | (1,522   | )          |
| Losses and loss expenses                                                           |       | (34                                     | )          | 3,962    |       |
| Unearned premiums                                                                  |       | 399                                     |       | 4,849    |       |
| Other                                                                              |       | (449                                    | )          | (2,413   | )          |
| Net cash provided by operating activities                                          |       | 5,324                                   |       | 1,409    |       |
| Cash flows from investing activities:                                              |       |                                    |       |     |       |
| Purchase of fixed income securities,  available-for- sale                          |       | (74,287                                 | )          | (23,189  | )          |
| Purchase of equity securities                                                      |       | (2,532                                  | )          | (3,342   | )          |
| Sale and maturity of fixed income  securities, available-for-sale                  |       | 25,459                                  |       | 23,694   |       |
| Sale of equity securities                                                          |       | 2,857                                   |       | 4,424    |       |
| Sale of short-term investments, net                                                |       | 43,797                                  |       | —   |       |
| Purchase of property and equipment                                                 |       | (3,870                                  | )          | (1,776   | )          |
| Net cash used by investing activities                                              |       | (8,576                                  | )          | (189     | )          |
| Cash flows from financing activities:                                              |       |                                    |       |     |       |
| Purchase of treasury stock                                                         |       | (2,975                                  | )          | —   |       |
| Net cash used by financing activities                                              |       | (2,975                                  | )          | —   |       |
| Net (decrease) increase in cash and cash  equivalents                              |       | (6,227                                  | )          | 1,220    |       |
| Cash and cash equivalents at beginning of  period                                  |       | 15,350                                  |       | 7,201    |       |
| Cash and cash equivalents at end of period                                         |       | $                                       | 9,123      |     | $          | 8,421 |   |
| Cash paid during the period for:                                                   |       |                                    |       |     |       |
| Interest                                                                           |       | $                                       | 35         |     | $          | 36 |   |
| Income taxes                                                                       |       | $                                       | —     |     | $          | — |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

7

----

 

**MERCER INSURANCE GROUP, INC. ANDSUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS(Dollars in thousands)(Unaudited)**

 

### **(1) **Basis of Presentation

 

The financial informationfor the interim periods included herein is unaudited; however, such informationreflects all adjustments which are, in the opinion of management, necessary toa fair presentation of the financial position, results of operations, and cashflows for the interim periods.  Theresults of operations for interim periods are not necessarily indicative ofresults to be expected for the full year.

 

These financial statementsshould be read in conjunction with the financial statements and notes for theyear ended December 31, 2003 included in the Company’s Annual Report onForm 10-K filed with the Securities and Exchange Commission.

 

### **(2) **Segment Information

 

The Company manages itsbusiness in three segments: commercial lines insurance, personal linesinsurance, and investments.  Thecommercial lines insurance and personal lines insurance segments are managedbased on underwriting results determined in accordance with accountingprinciples generally accepted in the United States of America, and theinvestment segment is managed based on after-tax investment returns.

 

Underwriting results forcommercial lines and personal lines take into account premiums earned, incurredlosses and loss adjustment expenses, and underwriting expenses.  The investments segment is evaluated byconsideration of net investment income (investment income less investmentexpenses), and realized gains and losses.

 

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

 

8

----

 

Financial data by segment isas follows for the nine months ended September 30, 2004 and 2003:

 
| ** **                                                                | ** ** | **Nine Months Ended September 30** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| ** **                                                                | ** ** | **(In thousands)**                 | ** ** |
| Revenues:                                                                 |       |                               |       |   |   |
| Net premiums earned:                                                      |       |                               |       |   |   |
| Commercial lines                                                          |       | $                                  | 24,150     |   | $ | 18,569 |   |
| Personal lines                                                            |       | 17,467                             |       | 16,193 |   |
| Total net premiums earned                                                 |       | 41,617                             |       | 34,762 |   |
| Net investment income                                                     |       | 1,933                              |       | 1,221 |   |
| Realized investment gains                                                 |       | 439                                |       | 130 |   |
| Other                                                                     |       | 266                                |       | 292 |   |
| Total revenues                                                            |       | 44,255                             |       | 36,405 |   |
| Income before income taxes:                                               |       |                               |       |   |   |
| Underwriting income (loss):                                               |       |                               |       |   |   |
| Commercial lines                                                          |       | 5,384                              |       | 2,568 |   |
| Personal lines                                                            |       | (4,591                             | )          | (3,389 | ) |
| Total underwriting income (loss)                                          |       | 793                                |       | (821 | ) |
| Net investment income                                                     |       | 1,933                              |       | 1,221 |   |
| Realized investment gains                                                 |       | 439                                |       | 130 |   |
| Other                                                                     |       | 266                                |       | 227 |   |
| Income before income taxes and minority  interest in income of subsidiary |       | $                                  | 3,431      |   | $ | 757 |   |

 

Financial data by segment isas follows for the three months ended September 30, 2004 and 2003:

 
| ** **                                                                | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                | ** ** | **(In thousands)**                  | ** ** |
| Revenues:                                                                 |       |                                |       |   |   |
| Net premiums earned:                                                      |       |                                |       |   |   |
| Commercial lines                                                          |       | $                                   | 8,295      |   | $ | 6,881 |   |
| Personal lines                                                            |       | 5,737                               |       | 5,498 |   |
| Total net premiums earned                                                 |       | 14,032                              |       | 12,379 |   |
| Net investment income                                                     |       | 639                                 |       | 400 |   |
| Realized investment gains                                                 |       | 340                                 |       | 167 |   |
| Other                                                                     |       | 86                                  |       | 101 |   |
| Total revenues                                                            |       | 15,097                              |       | 13,047 |   |
| Income before income taxes:                                               |       |                                |       |   |   |
| Underwriting income (loss):                                               |       |                                |       |   |   |
| Commercial lines                                                          |       | 1,880                               |       | 899 |   |
| Personal lines                                                            |       | (1,261                              | )          | (1,275 | ) |
| Total underwriting income (loss)                                          |       | 619                                 |       | (376 | ) |
| Net investment income                                                     |       | 639                                 |       | 400 |   |
| Realized investment gains                                                 |       | 340                                 |       | 167 |   |
| Other                                                                     |       | 86                                  |       | 98 |   |
| Income before income taxes and minority  interest in income of subsidiary |       | $                                   | 1,684      |   | $ | 289 |   |

 

### **(3) **Reinsurance

 

Premiums earned are net ofamounts ceded of $6,377 and $7,087 for the nine months ended September 30,2004 and 2003, respectively, and $2,048 and $2,428 for the three months ended September30, 2004 and 2003, respectively. Losses and loss adjustment expenses are net ofamounts ceded of $451 and $2,122 for the nine months ended September 30,2004 and 2003, respectively, and $157 and $1,513 for the three months ended September30, 2004 and 2003, respectively.

 

9

----

 

### **(4) **Comprehensive Income

 

The Company’s comprehensive incomefor the nine month period ended September 30, 2004 and 2003 is as follows:

 
| ** **                                                                                                            | ** ** | **Nine Months ended  September 30** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| ** **                                                                                                            | ** ** | **(In thousands)**                       | ** ** |
|                                                                                                                  |       |                                     |       |   |   |
| Net income                                                                                                            |       | $                                        | 2,421      |   | $ | 445 |   |
| Other comprehensive income, net of tax:                                                                               |       |                                     |       |   |   |
| Unrealized gains on securities:                                                                                       |       |                                     |       |   |   |
| Unrealized holding gains arising during  period, net of related income tax expense of $25, and $566                   |       | 49                                       |       | 1,099 |   |
| Less reclassification adjustment for gains  included in net income, net of related income tax expense of $149 and $44 |       | (290                                     | )          | (86 | ) |
|                                                                                                                  |       | (241                                     | )          | 1,013 |   |
| Comprehensive Income                                                                                                  |       | $                                        | 2,180      |   | $ | 1,458 |   |

 

The Company’s comprehensiveincome for the three month period ended September 30, 2004 and 2003 is asfollows:

 
| ** **                                                                                                            | ** ** | **Three Months ended  September 30** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                                                                            | ** ** | **(In thousands)**                        | ** ** |
|                                                                                                                  |       |                                      |       |   |   |
| Net income                                                                                                            |       | $                                         | 1,121      |   | $ | 172 |   |
| Other comprehensive income, net of tax:                                                                               |       |                                      |       |   |   |
| Unrealized gains on securities:                                                                                       |       |                                      |       |   |   |
| Unrealized holding gains arising during  period, net of related income tax expense of $611, and $89                   |       | 1,186                                     |       | 173 |   |
| Less reclassification adjustment for gains  included in net income, net of related income tax expense of $116 and $57 |       | (224                                      | )          | (110 | ) |
|                                                                                                                  |       | 962                                       |       | 63 |   |
| Comprehensive Income                                                                                                  |       | $                                         | 2,083      |   | $ | 235 |   |

 

### **(5) **Stock-based Compensation

 

Stock-based compensationplans are accounted for under the provisions of Accounting Principles Board(APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations. Accordingly, no compensation expense is recognized for fixedstock option grants. Compensation expense would be recorded on the date of astock option grant only if the current market price of the underlying stockexceeded the exercise price. The following table illustrates the effect on netincome and earnings per share as if the provisions of Statement of FinancialAccounting Standards (SFAS) No. 123 (as amended by SFAS No. 148), “Accountingfor Stock-Based Compensation,” had been applied to all periods presented.

 

10

----

 
| ** **                                                                                                                                  | ** ** | **Nine months ended**                      | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **September 30,  2004**                    | ** ** | **September 30,  2003** | ** ** |
| ** **                                                                                                                                  | ** ** | **(In thousands,  except per share data)** | ** ** |
| Net income, as reported                                                                                                                     |       | $                                          | 2,421      |   | $ | 445 |   |
| Plus: Stock-based employee compensation  expense included in reported net income, net of related tax effects                                |       | 136                                        |       | 0 |   |
|                                                                                                                                        |       |                                       |       |   |   |
| Less: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (289                                       | )          | 0 |   |
| Pro forma net income                                                                                                                        |       | $                                          | 2,268      |   | $ | 445 |   |
| Basic earnings per share:                                                                                                                   |       |                                       |       |   |   |
| As reported                                                                                                                                 |       | $                                          | 0.39       |   | N/A |   |
| Pro forma                                                                                                                                   |       | $                                          | 0.36       |   | N/A |   |
| Diluted earnings per share:                                                                                                                 |       |                                       |       |   |   |
| As reported                                                                                                                                 |       | $                                          | 0.38       |   | N/A |   |
| Pro forma                                                                                                                                   |       | $                                          | 0.36       |   | N/A |   |

 
| ** **                                                                                                                                  | ** ** | **Quarter ended**                          | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **September 30,  2004**                    | ** ** | **September 30,  2003** | ** ** |
| ** **                                                                                                                                  | ** ** | **(In thousands,  except per share data)** | ** ** |
| Net income, as reported                                                                                                                     |       | $                                          | 1,121      |   | $ | 172 |   |
|                                                                                                                                        |       |                                       |       |   |   |
| Plus: Stock-based employee compensation  expense included in reported net income, net of related tax effects                                |       | 114                                        |       | 0 |   |
|                                                                                                                                        |       |                                       |       |   |   |
| Less: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (246                                       | )          | 0 |   |
| Pro forma net income                                                                                                                        |       | $                                          | 989        |   | $ | 172 |   |
| Basic earnings per share:                                                                                                                   |       |                                       |       |   |   |
| As reported                                                                                                                                 |       | $                                          | 0.18       |   | N/A |   |
| Pro forma                                                                                                                                   |       | $                                          | 0.16       |   | N/A |   |
| Diluted earnings per share:                                                                                                                 |       |                                       |       |   |   |
| As reported                                                                                                                                 |       | $                                          | 0.17       |   | N/A |   |
| Pro forma                                                                                                                                   |       | $                                          | 0.15       |   | N/A |   |

 

The Company adopted theMercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16,2004. Awards may be made in the form of incentive stock options, nonqualifiedstock options, restricted stock or any combination to employees andnon-employee Directors. The Plan limits to 250,000 the number of shares thatmay be awarded as restricted stock, and to 500,000 the number of shares forwhich incentive stock options may be granted. The total number of sharesauthorized in the plan is 876,555 shares, with an annual increase equal to 1%of the shares outstanding at the end of the previous year. The Plan providesthat stock options and restricted stock awards may include vesting restrictionsand performance criteria at the discretion of the Compensation Committee of theBoard of Directors. The term of options may not exceed ten years for

 

11

----

 

incentive stock options, andten years and 1 month for nonqualified stock options, and the option price maynot be less than fair market value on the date of grant. The 2004 grants havevesting periods of 3 or 5 years on restricted stock, incentive stock options,and nonqualified stock options.

 

Information regarding fixedstock option activity in Mercer Insurance Group’s plan is presented below:

 
| ** **                                  | ** ** | **Number  of shares** | ** ** | **Weighted Average  Exercise Price  Per Share** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------|------------|
|                                        |       |                       |       |                                                           |       |
| Outstanding at December 31, 2003       |       | 0                          |       | $                                                              | 0.00       |   |
| Granted – 2004                         |       | 537,700                    |       | 12.21                                                          |       |
| Exercised – 2004                       |       | 0                          |       | 0.00                                                           |       |
| Forfeited – 2004                       |       | 0                          |       | 0.00                                                           |       |
|                                        |       |                       |       |                                                           |       |
| Outstanding at September 30, 2004           |       | 537,700                    |       | $                                                              | 12.21      |   |
|                                        |       |                       |       |                                                           |       |
| Exercisable at:                             |       |                       |       |                                                           |       |
| September 30, 2004                          |       | 0                          |       | $                                                              | 0.00       |   |
| Weighted-average remaining contractual life |       | 9.7 years                  |       |                                                           |       |

 

The per shareweighted-average fair value of options granted during 2004 was $4.19. The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted-averageassumptions used for grants in 2004: dividend yield of 0%; expected volatilityof 20.91%; risk-free interest rate of 4.73%, and an expected life of 6.5 years.

 

Grants of 215,000 shares ofrestricted stock were awarded to employees and non-employee Directors in2004.  The weighted average price pershare on the grant date was $12.21 per share.

 

### **(6) **Earnings per Share

 

The computation of basic anddiluted earnings per share is as follows:

 
| ** **                                                                           | ** ** | **Nine months ended  September 30,**                   | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                                               | ** ** | **2003** | ** ** |
| ** **                                                                           | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Numerator for basic and diluted earnings  per share:                                 |       |                                                   |       |   |   |
| Net income                                                                           |       | $                                                      | 2,421      |   | N/A |   |
| Denominator for basic earnings per share –  weighted-average shares outstanding |       | 6,287,602                                              |       | N/A |   |
| Effect of stock incentive plans                                                      |       | 83,960                                                 |       | N/A |   |
| Denominator for diluted earnings per share                                           |       | 6,371,562                                              |       | N/A |   |
| Basic earnings per share                                                             |       | $                                                      | 0.39       |   | N/A |   |
| Diluted earnings per share                                                           |       | $                                                      | 0.38       |   | N/A |   |

 

12

----

 
| ** **                                                                                | ** ** | **Quarter Ended  September 30,**                       | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                                               | ** ** | **2003** | ** ** |
| ** **                                                                                | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Numerator for basic and diluted earnings  per share:                                      |       |                                                   |       |   |   |
| Net Income                                                                                |       | $                                                      | 1,121      |   | N/A |   |
| Denominator for basic earnings per share –  weight – average shares outstanding |       | 6,267,258                                              |       | N/A |   |
| Effect of stock incentive plans                                                           |       | 215,000                                                |       | N/A |   |
| Denominator for diluted earnings per share                                                |       | 6,482,258                                              |       | N/A |   |
| Basic earnings per share                                                                  |       | $                                                      | 0.18       |   | N/A |   |
| Diluted earnings per share                                                                |       | $                                                      | 0.17       |   | N/A |   |

 

Options to purchase 537,700shares of common stock were not included in the computation of diluted earningsper share for the 3 months and 9 months ended September 30, 2004, because theexercise price of the options was greater than the average market price.

 

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

##  

The following presentsmanagement’s discussion and analysis of our financial condition and results ofoperations as of the dates and for the periods indicated.  You should read this discussion inconjunction with the condensed consolidated financial statements and notesthereto included in this report.  Thisdiscussion contains forward-looking information that involves risks anduncertainties. Actual results could differ significantly from theseforward-looking statements. See “Forward-Looking Statements”.

 

**Overview**

 

**THE CONVERSION TRANSACTION ANDTHE HOLDING COMPANY**

 

Mercer Insurance Group, Inc.(the “Company” or the “Holding Company”) is a holding company owning all of theoutstanding shares of Mercer Insurance Company, the company resulting from theconversion of Mercer Mutual Insurance Company from the mutual to the stock formof organization on December 15, 2003 (the “Conversion”).  Prior to the Conversion, and since 1844,Mercer Mutual Insurance Company was engaged in the business of selling propertyand casualty insurance.

 

The Company had no activityprior to the Conversion, and was formed for the purpose of owning all of thestock of Mercer Mutual Insurance Company after the Conversion.  At the time of the Conversion,6,845,733 shares of Mercer Insurance Group, Inc. were issued (including502,525 shares issued immediately after the Conversion to acquire theremaining 51% of common stock as well as all manditorily redeemable preferredstock of Franklin Holding Company, Inc., of which Mercer Mutual InsuranceCompany had acquired 49% for cash in 2001) with net cash proceeds ofapproximately $53 million received by the Company in exchange forthe shares (approximately $27 million of this amount was contributedto the capital of Mercer Insurance Company after the Conversion).  Also included in the total shares are626,111 shares issued in the Conversion to the Mercer Insurance Group,Inc. Employee Stock Ownership Plan, (the “ESOP”) as to which no cash proceedswere received because the ESOP funded the purchase of these shares with aloan from the Company.  The shares heldby the ESOP will be allocated to participant accounts evenly over a ten-yearperiod.  The first annual allocationoccurred in December, 2003, in the amount of 62,611 shares, and anadditional 46,873 shares were committed in the first three quarters of2004.

 

13

----

 

**Our Business**

 

The Company and itssubsidiaries underwrite property and casualty insurance in New Jersey andPennsylvania.  Our consolidated operatinginsurance 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 offering insurance coverage to businesses and individuals in NewJersey; and

 

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

 

The Company is subject toregulation by the Pennsylvania Insurance Department and the New JerseyDepartment of Banking and Insurance as its primary regulators because it is theholding company for Mercer Insurance Company, and, indirectly, Mercer InsuranceCompany of New Jersey, Inc. through its holding company, Queenstown HoldingCompany, Inc., and Franklin Holding Company, Inc. and its subsidiary, FranklinInsurance Company.

 

We manage our business andreport our operating results in three operating segments: commercial linesinsurance, personal lines insurance 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 insurancebusiness consists primarily of multi-peril and general liability and relatedcoverages.  Our personal lines insurancebusiness consists primarily of homeowners (in New Jersey and Pennsylvania) andprivate passenger automobile (in Pennsylvania only) insurance coverages.  We market both the commercial and personalinsurance lines through independent producers.

 

Our income is principallyderived from insurance premiums received from insureds in the commercial lines(businesses insured) and personal lines (individuals insured) segments, lessthe costs of underwriting the insurance policies, the costs of settling andpaying claims reported on the policies, and from investment income reduced byinvestment expenses and gains or losses on holdings in our investmentportfolio.  Variability in our income iscaused by a variety of circumstances, some within the control of our companiesand some not within our control. Premium volume is affected by, among otherthings, the availability and regular flow to our insurance companies ofquality, properly-priced risks being produced by our agents, the ability toretain on renewal existing good-performing accounts, competition from other insurancecompanies, regulatory rate approvals, our reputation, and other limitationscreated by the marketplace or regulators. Our underwriting costs are affected by, among other things, the amountof commission and profit-sharing we pay our agents to produce the underwritingrisks for which we receive premiums, the cost of issuing insurance policies andmaintaining our customer and agent relationships, marketing costs, taxes we payto the states in which we operate on the amount of premium we collect, and otherassessments and charges imposed on our companies by the regulators in thestates in which we do business.  Ourclaim and claim settlement costs are affected by, among other things, thequality of our accounts, severe or extreme weather in our operating region, thenature of the claim, the regulatory and legal environment in our territories,inflation in underlying medical and property repair costs, and the availabilityand cost of reinsurance.  Our investmentincome and realized gains and losses are determined by, among other things,market forces, the rates of interest and dividends paid on our investmentportfolio holdings, the credit or investment quality of the issuers and thesuccess of their underlying businesses, the market perception of the issuers,and other factors such as ratings by rating agencies and analysts.

 

14

----

 

**Critical Accounting Policies**

 

*General.*  The Company’s financial statements areprepared in conformity with accounting principles generally accepted in theUnited States of America (GAAP). We are required to make estimates andassumptions in certain circumstances that affect amounts reported in ourconsolidated financial statements and related footnotes.  We evaluate these estimates and assumptionson an on-going basis based on historical developments, market conditions,industry trends and other information that we believe to be reasonable underthe circumstances.  There can be noassurance that actual results will conform to our estimates and assumptions,and that reported results of operations will not be materially adverselyaffected by the need to make accounting adjustments to reflect changes in theseestimates and assumptions from time to time. We believe the following policies are the most sensitive to estimatesand judgments.

 

*Liabilities for Loss and LossAdjustment Expenses.*  Theliability for losses and loss adjustment expenses represents estimates of theultimate unpaid cost of all losses incurred, including losses for claims thathave not yet been reported to our insurance companies.  The amount of loss reserves for reportedclaims is based primarily upon a case-by-case evaluation of the type of riskinvolved, knowledge of the circumstances surrounding each claim and the insurancepolicy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss adjustmentexpenses are determined using historical information by line of insurance asadjusted to current conditions. Inflation is implicitly provided for in the reserving function throughanalysis of costs, trends and reviews of historical reserving results overmultiple years.

 

Reserves are closelymonitored and are recomputed periodically using the most recent information onreported claims and a variety of statistical techniques.  Specifically, on a quarterly basis, wereview, by line of business, existing reserves, new claims, changes to existingcase reserves, and paid losses with respect to the current and prior accidentyears.  We use historical paid andincurred losses and accident year data to derive expected ultimate loss andloss adjustment expense ratios by line of business.  We then apply these expected loss and lossadjustment expense ratios to in-force business to derive a reserve level foreach 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 connectionwith the determination of the reserves, we also consider other specific factorssuch as recent weather-related losses, trends in historical paid losses, andlegal and judicial trends with respect 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 areestimates because there are uncertainties inherent in the determination ofultimate losses.  Court decisions,regulatory changes and economic conditions can affect the ultimate cost ofclaims that occurred in the past as well as create uncertainties regarding futureloss cost trends.  Accordingly, theultimate liability for unpaid losses and loss settlement expenses will likelydiffer from the amount recorded at September 30, 2004.  Changes in estimates or differences betweenestimates and amounts ultimately paid are reflected in current operations.  Loss reserving techniques and assumptions havebeen consistently applied during the periods presented.

 

15

----

 

The table below summarizesthe effect on net loss reserves and equity in the event of reasonably likelychanges in the variables considered in establishing loss and loss adjustmentexpense reserves.  The range ofreasonably 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 changesdoes not indicate what could be the potential best or worst case or likelyscenarios:

 
| **Adjustment  Change in Loss and  Loss Adjustment  Reserves Net of  Reinsurance** | ** ** | **Adjusted Loss and  Loss Reserves Net of  Reinsurance as of  September 30,  2004** | ** ** | **Percentage Change  in Stockholders’  Equity as of  September 30,  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                                                                             | %          | 30,047                                                                                   |       | 2.2                                                                                     | %          | 29,003                                                                                             |       | 2.2                                                                                    | %          |
| -7.5                                                                              | %          | 30,882                                                                                   |       | 1.7                                                                                     | %          | 29,808                                                                                             |       | 1.6                                                                                    | %          |
| -5.0                                                                              | %          | 31,717                                                                                   |       | 1.1                                                                                     | %          | 30,614                                                                                             |       | 1.1                                                                                    | %          |
| -2.5                                                                              | %          | 32,551                                                                                   |       | 0.6                                                                                     | %          | 31,419                                                                                             |       | 0.5                                                                                    | %          |
| Base                                                                              |       | 33,386                                                                                   |       | —                                                                                  |       | 32,225                                                                                             |       | —                                                                                 |       |
| 2.5                                                                               | %          | 34,221                                                                                   |       | -0.6                                                                                    | %          | 33,031                                                                                             |       | -0.5                                                                                   | %          |
| 5.0                                                                               | %          | 35,055                                                                                   |       | -1.1                                                                                    | %          | 33,836                                                                                             |       | -1.1                                                                                   | %          |
| 7.5                                                                               | %          | 35,890                                                                                   |       | -1.7                                                                                    | %          | 34,642                                                                                             |       | -1.6                                                                                   | %          |
| 10.0                                                                              | %          | 36,725                                                                                   |       | -2.2                                                                                    | %          | 35,448                                                                                             |       | -2.2                                                                                   | %          |

 

----

### **(1)  Netof Tax**

 

The property and casualtyindustry has incurred substantial aggregate losses from claims related toasbestos-related illnesses, environmental remediation, product and constructiondefect liability, mold, and other uncertain exposures.  We have not experienced significant lossesfrom these types of claims.

 

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

 
| ** **                  | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **(Dollars in thousands)**  | ** ** |
| Commercial lines:           |       |                        |       |                       |       |
| Commercial multi-peril      |       | $                           | 5,651      |                       | $          | 6,998 |   |
| Other liability             |       | 8,613                       |       | 8,708                      |       |
| Workers’ compensation  |       | 4,716                       |       | 4,684                      |       |
| Commercial automobile       |       | 2,112                       |       | 2,251                      |       |
| Fire, allied, inland marine |       | 586                         |       | 242                        |       |
|                        |       | 21,678                      |       | 22,883                     |       |
| Personal lines:             |       |                        |       |                       |       |
| Homeowners                  |       | 10,372                      |       | 9,509                      |       |
| Personal automobile         |       | 2,923                       |       | 3,073                      |       |
| Fire, allied, inland marine |       | 268                         |       | 328                        |       |
| Other liability             |       | 1,885                       |       | 1,400                      |       |
| Workers’ compensation  |       | 101                         |       | 68                         |       |
|                        |       | 15,549                      |       | 14,378                     |       |
| Total                       |       | $                           | 37,227     |                       | $          | 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 value of an investmentbelow its cost that is deemed other than temporary is charged to earnings as arealized loss.  We monitor our investmentportfolio and review investments that have experienced a decline in fair valuebelow cost to evaluate whether the decline is other than temporary.  These evaluations involve judgment andconsider the magnitude and reasons for a decline and the prospects for the fairvalue to recover in the near term.  Inthe nine months ended September 30, 2004 and 2003, we recorded a pre-tax chargeto earnings of $0 and $445,000, respectively, and no charges in

 

16

----

 

the quarters ended September30, 2004 and 2003. These charges are primarily with respect to equitysecurities that we determined under our policy to be other than temporarilyimpaired.  Adverse investment marketconditions, or poor operating results of underlying investments, could resultin impairment charges in the future.

 

We generally apply thefollowing standards in determining whether the decline in fair value of aninvestment is other than temporary:

 

*Equities.*  If an equity security has a fair value below50% of cost or remains below 80% of cost for more than three months, a reviewof the financial condition and prospects of the company is performed by theInvestment Committee of the Board of Directors to determine if the decline infair value is other than temporary.  Aspecific determination is made for any such security.  Other equity securities in an unrealized lossposition not meeting these quantitative thresholds are evaluated considering,among other things, the magnitude and reasons for the decline and the prospectsfor the fair value of the securities to recover in the near term.  If it is determined that the decline in fairvalue is judged to be “other than temporary” then the cost basis of thesecurity is written down to “realizable value” and the amount of the write downaccounted for as a realized loss.  “Realizablevalue” is defined as the quoted market price of the security.  Write-down to a value other than the marketprice requires objective evidence in support of that value.

 

We have one significantnon-traded equity security, a non-voting common stock in Excess ReinsuranceCompany, which is carried at $1.2 million. Its fair value is estimated atthe statutory book value as reported to the National Association of InsuranceCommissioners (NAIC).  Other non-tradedsecurities, which are not material in the aggregate, are carried at cost.

 

*Fixed Income Securities.*  A**fixed maturitysecurity generally is written down if we are unable to hold it or otherwiseintend to sell a security with an unrealized loss, or if it is probable that wewill be unable to collect all amounts due according to the contract terms of adebt security not impaired at acquisition.

 

A fixed maturity securityreview for collectibility is done if any of the following situations occur:

 

•                  A review of thefinancial condition and prospects of the issuer performed by the InvestmentCommittee indicates that the security should be evaluated.

 

•                  Moody’s orStandard & Poors rate the security below investment grade.

 

•                  The security hasa fair value below 70% of amortized cost at quarter end due to deterioration incredit quality.

 

*Policy Acquisition Costs. *We defer policy acquisitioncosts, such as commissions, premium taxes and certain other underwritingexpenses that vary with and are directly related to the production ofbusiness.  These costs are amortized overthe effective period of the 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 significantof which is expected loss and loss adjustment expenses, may requireacceleration of the amortization of deferred policy acquisition costs.

 

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

 

17

----

 

Ceded unearned premiums andreinsurance balances recoverable on paid and unpaid loss and loss adjustmentexpenses are reported separately as assets, instead of being netted with theappropriate liabilities, because reinsurance does not relieve us of our legalliability to our policyholders. Reinsurance balances recoverable are subject to credit risk associatedwith the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaidloss and loss adjustment expenses affect the estimates for the ceded portion ofthese liabilities.

 

We continually monitor thefinancial condition of our reinsurers.

 

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

 

**Results of Operations**

 

Our results of operationsare influenced by factors affecting the property and casualty insuranceindustry in general.  The operatingresults of the United States property and casualty insurance industry aresubject 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 andunderwriting results have been, and continue to be, influenced by marketconditions.  Pricing in the property andcasualty insurance industry historically has been cyclical.  During a soft market cycle, price competitionis prevalent and makes it difficult to write and retain properly pricedpersonal and commercial lines business. Our policy is to maintain our disciplined underwriting and pricingstandards during soft markets, even at the expense of premium growth. For morethan three years, the industry has enjoyed a hard market with pricing power,however pricing competition has re-appeared in the market, particularly inlines of business which are predominantly property exposures, and pricing powerhas diminished accordingly.  The cyclicalityof the market is difficult to anticipate, and pricing has leveled offconsistent with the late stages of a hard market, resulting in slower overallrevenue growth than the Company has enjoyed in the last three years.

 

***Nine months and threemonths ended September 30, 2004, compared to nine months and three monthsended September 30, 2003***

 

For the nine months ended September30, 2004, the Company had net income of $2.4 million compared to $445,000 forthe same period in 2003.  Theunderwriting gain from our commercial lines segment for the nine months of 2004increased to $5.4 million from the prior year amount of $2.6 million,but our personal lines segment incurred an underwriting loss of $4.6 million,an increased loss from the loss of $3.4 million in the prior comparableperiod.  In our investment segment, netinvestment income increased 58% in the first nine months of 2004 to $1.9million from $1.2 million, and net realized gains for the first nine months of2004 were $439,000, as compared to net realized gains of $130,000 for the 2003period.

 

For the three months ended September30, 2004, the Company had net income of $1.1 million compared to $172,000 forthe same period in 2003.  Theunderwriting gain from our commercial lines segment for the third quarter of2004 increased to $1.9 million from the prior year amount of $899,000. Thepersonal lines segment incurred an underwriting loss of $1.3 million inthe third quarter of 2004, compared to a loss of $1.3 million in the prioryear period.  In our investment segment,net investment income increased 60% in the

 

18

----

 

third quarter of 2004 to $639,000from $400,000, and we had a net realized gain for the third quarter of 2004 of$340,000, as compared to a net realized gain of $167,000 for the 2003 period.

 

Total revenues for the firstnine months of 2004 were $44.3 million, which was 22% greater than 2003revenues of $36.4 million.  Thisincrease was due to a $6.9 million, or 20%,  increase in net premiums earned in the first ninemonths of 2004, an increase in net investment income of $712,000, or 58%, aswell as to a realized gain on investments of $439,000 in 2004 as compared to arealized gain of $130,000 in 2003.

 

Total revenues for the thirdquarter of 2004 were $15.1 million, which was 16% greater than revenues of$13.0 million during the comparable 2003 period.  This increase was due to a $1.7 million,or 13%,  increase in net premiums earnedin the third quarter of 2004, an increase in net investment income of $239,000,or 60%, as well as to a realized gain on investments of $340,000 in 2004 ascompared to a realized gain of $167,000 during the comparable 2003 period.

 

Direct premiums writtenincreased 3% to $46.9 million in the first nine months of 2004 whencompared to 2003, and consisted of $28.1 million of commercial linespremiums, a 6% increase, and $18.8 million of personal lines premiums, a 2%decrease.  Net premiums earned increasedby 20% to $41.6 million for the first nine months of 2004 as compared to $34.8 millionfor the prior year period.  Commerciallines net premiums earned increased 30% to $24.2 million in the first ninemonths of 2004, and personal lines net premiums earned increased 8% to $17.4 millionin 2004.  The overall increases in directpremiums written and net premiums earned are generally attributable to theCompany’s focus on growth in our commercial lines business, and a reduction inthe amount of reinsurance utilized by the Company.

 

Direct premiums written forthe third quarter of 2004 decreased 3% to $14.6 million when compared to2003, and consisted of $8.0 million of commercial lines premiums, a 1% decrease,and $6.6 million of personal lines premiums, a 5% decrease.  Direct premiums written decreased in thequarter as compared to the same period in 2003 due to increasing competition inthe marketplace, particularly in the case of property exposures. Net premiumsearned increased by 13% to $14.0 million for the third quarter of 2004 ascompared to $12.4 million for the prior year period.  Commercial lines net premiums earnedincreased 21% to $8.3 million in the third quarter, and personal lines netpremiums earned increased 4% to $5.7 million.

 

Consistent with our goal ofincreasing our commercial lines business, we increased commercial lines directpremiums written in the first nine months of 2004 to 60% of our business, ascompared to 58% in the prior year period. Similarly, commercial lines netpremium earned increased to 58% of our business, as compared to 53% in the 2003period. Our direct commercial multi-peril premiums written, the largestcomponent of our commercial lines segment, increased by 6% to $14.3 millionin the first nine months of 2004, compared to $13.4 million for the 2003period. Commercial multi-peril net premiums earned increased by 33% to $12.1 millionin 2004, as compared to $9.1 million for the prior year period.  We expect this trend of increasing commercialwritings to continue as we target growth in certain types of risks and withselected producers.

 

For the first nine months of2004, net premiums earned for our homeowners insurance, the largest componentof our personal lines segment, increased 9% to $10.1 million, compared to$9.3 million for the 2003 period, while homeowners direct premiums writtenremained flat at $11.0 million for both periods. The growth in homeownersinsurance net premiums earned primarily reflects the reduction in reinsuranceutilization initiated by the Company at the beginning of 2004.

 

Personal automobile directwritten premiums for the first nine months of 2004, written exclusively inPennsylvania, decreased 3% to $5.8 million from $6.0 million for the 2003period.  Net premiums earned for personalautomobile increased in the first nine months of 2004 by 7% to $5.4 million,from $5.1 million for the

 

19

----

 

comparable period in2003.  Despite the increases in personallines net premiums earned, our focus is principally on our commercial linesgrowth.

 

Net investment incomeincreased $712,000, or 58%, to $1.9 million in the first nine months of 2004,as compared to the same period in 2003, due primarily to higher averageinvested assets.  Net realized gains forthe same period in 2004 were $439,000, as compared to a net realized gain of $130,000in the comparable period in 2003.  In2004, net realized gains of $439,000 included gains on securities sales of $904,000,and losses on securities sales of $461,000. The losses from securities sales were comprised of $283,000 from thesale of bonds and $178,000 from the sale of equities.  The following table summarizes the period oftime that the equity securities sold at a loss during 2004 had been in acontinuous unrealized loss position:

 
| **PERIOD  OF TIME IN AN  UNREALIZED LOSS POSITION** | ** ** | **Fair Value on Sale Date** | ** ** | **Realized Loss** | ** ** |
|-----------------------------------------------------|------------|-----------------------------|------------|-------------------|------------|
| ** **                                          | ** ** | **(In thousands)**          | ** ** |
|                                                |       |                        |       |              |       |
| 0-6 months                                          |       | $                           | 347        |              | $          | 46 |   |
| 7-12 months                                         |       | 276                         |       | 4                 |       |
| More than 12 months                                 |       | 122                         |       | 128               |       |
| Total                                               |       | $                           | 745        |              | $          | 178 |   |

 

The equity securities soldat a loss had been expected to appreciate in value but after reevaluation weresold so that sale proceeds could be reinvested. The equity securities described above as having been in an unrealizedloss position for more than 12 months were part of a larger block of shares ina single issuer, which, taken in the aggregate, were in an unrealized gainposition as of June 30, 2004. The equity securities were sold as part of ournormal review process intended to reduce exposure to certain issuers andindustries, to recognize changing economic conditions, and to facilitate taxplanning objectives.

 

The following tablesummarizes the length of time equity securities with unrealized losses held at September 30,2004 have been in an unrealized 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 |       | $                  | 2,304      |                    | $          | 133                           |       | $ | 105 |   | $ | 28 |   | $ | 0 |   |
| Less than 80% of cost |       | 57                 |       | 29                      |       | 29                            |       | — |   | — |   |
| Total                 |       | $                  | 2,361      |                    | $          | 162                           |       | $ | 134 |   | $ | 28 |   | $ | 0 |   |
|                       |            |                    |            |                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |

 

The estimated fair value andunrealized loss for securities in a temporary unrealized loss position as of September30, 2004 are as follows : 

 
| ** **                                                                             | ** ** | **Less than 12 Months**   | ** ** | **12 Months or Longer** | ** ** | **Total**                 | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|---------------------------|------------|
| ** **                                                                             | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses**  | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                                                             | ** ** | **(In thousands)**        | ** ** |
| U.S. Treasury securities and obligations of  U.S. government corporations and agencies |       | $                         | 7,040      |                    | $          | 58                        |       | $ | 5,618 |   | $ | 165 |   | $ | 12,658 |   | $ | 223 |   |
|                                                                                   |       |                      |       |                    |       |                      |       |   |   |   |   |   |   |
| Obligations of states and political  subdivisions                                      |       | 19,395                    |       | 149                     |       | $                         | 288        |   | $ | 10 |   | 19,683 |   | 159 |   |
|                                                                                   |       |                      |       |                    |       |                      |       |   |   |   |   |   |   |
| Corporate securities                                                                   |       | 9,407                     |       | 111                     |       | —                    |       | — |   | 9,407 |   | 111 |   |
|                                                                                   |       |                      |       |                    |       |                      |       |   |   |   |   |   |   |
| Mortgage-backed securities                                                             |       | 18,017                    |       | 225                     |       | —                    |       | — |   | 18,017 |   | 225 |   |
|                                                                                   |       |                      |       |                    |       |                      |       |   |   |   |   |   |   |
| Total fixed maturities                                                                 |       | 53,859                    |       | 543                     |       | 5,906                     |       | 175 |   | 59,765 |   | 718 |   |
|                                                                                   |       |                      |       |                    |       |                      |       |   |   |   |   |   |   |
| Total equity securities                                                                |       | 2,361                     |       | 162                     |       | —                    |       | — |   | 2,361 |   | 162 |   |
|                                                                                   |       |                      |       |                    |       |                      |       |   |   |   |   |   |   |
| Total securities in a temporary unrealized  loss position                              |       | $                         | 56,220     |                    | $          | 705                       |       | $ | 5,906 |   | $ | 175 |   | $ | 62,126 |   | $ | 880 |   |

 

20

----

 

The unrealized losses onfixed maturity investments with unrealized losses for less than twelve monthswere primarily due to changes in the interest rate environment.  The Company has 17 fixed maturity securitieswith unrealized losses for more than twelve months.  All of the 17 fixed maturity securities withunrealized losses greater than twelve months have fair values greater than 94%of cost.  The Company believes thesedeclines are temporary.

 

There are 13 equitysecurities that are in an unrealized loss position on September 30, 2004. Elevenof these securities have been in an unrealized loss position for less than sixmonths.  The other 2 equity securitieshave been in an unrealized loss position for less than twelve months.  The Company believes these declines aretemporary.

 

For the first nine months of2004, we had a GAAP combined ratio (the “combined ratio” is an industrymeasurement of a company’s underwriting success, and is the sum of the ratiosof a company’s loss and loss adjustment expense, and underwriting expenses tonet earned premium.  A combined ratio ofless than 100% means a company is making an underwriting profit) of 98.1%. Thecombined ratio for the first nine months of 2004 consisted of a loss and lossadjustment expense ratio of 50.7% and an underwriting expense ratio of 47.4%,compared to a GAAP combined ratio of 102.4%, a loss and loss adjustment expenseratio of 56.4% and an underwriting expense ratio of 46.0% for the same periodin 2003. In the third quarter of 2004, we had a GAAP combined ratio of 95.6%, aloss and loss adjustment expense ratio of 44.0% and an underwriting expenseratio of 51.6%, compared to a GAAP combined ratio of 103.0%, a loss and lossadjustment expense ratio of 55.4% and an underwriting expense ratio of 47.6%for the 2003 period.

 

In the commercial linessegment for the first nine months of 2004, we had an underwriting gain of $5.4 million,a combined ratio of 77.7%, a loss and loss adjustment expense ratio of 28.3%and an underwriting expense ratio of 49.4%, compared to an underwriting gain of$2.6 million, a combined ratio of 86.2%, a loss and loss adjustment expense ratioof 37.2% and an underwriting expense ratio of 49.0% for 2003. For the thirdquarter of 2004, in our commercial lines segment we had an underwriting gain of$1.9 million, a combined ratio of 77.3%, a loss and loss adjustmentexpense ratio of 25.7% and an underwriting expense ratio of 51.6%, compared toan underwriting gain of $0.9 million, a combined ratio of 86.9%, a lossand loss adjustment expense ratio of 39.2% and an underwriting expense ratio of47.7% for the 2003 period.

 

In the personal lines segmentfor the first nine months of 2004, we had an underwriting loss of $4.6 million,a combined ratio of 126.3%, a loss and loss adjustment expense ratio of 81.7%and an underwriting expense ratio of 44.6%, compared to an underwriting loss of$3.4 million, a combined ratio of 120.9%, a loss and loss adjustmentexpense ratio of 78.4% and an underwriting expense ratio of 42.5% for 2003. Forthe third quarter of 2004, in our personal lines segment we had an underwritingloss of $1.3 million, a combined ratio of 122.0%, a loss and lossadjustment expense ratio of 70.5% and an underwriting expense ratio of 51.5%,compared to an underwriting loss of $1.3 million, a combined ratio of 123.2%,a loss and loss adjustment expense ratio of 75.7% and an underwriting expenseratio of 47.5% for the 2003 period.

 

21

----

 

For the first nine months of2004, net loss and loss adjustment expenses incurred increased overall by $1.5 million,or 8%, to $21.1 million from the 2003 period.  The increase in loss and loss adjustmentexpenses reflects the increase in commercial and personal lines volume and anincrease in the frequency of personal lines losses in the first quarter of2004. The first quarter’s increase in personal lines losses is attributable toharsher weather conditions as compared to 2003, resulting principally fromextremely cold temperatures.  Theseconditions lead to losses from frozen pipes, structural collapses, morefrequent automobile losses and slip-and-fall accidents.  In the third quarter of 2004, net loss andloss adjustment expenses incurred decreased by $686,000, or 10% to $6.2 millionfrom 2003. This decrease in losses and loss adjustment expenses in the quarterreflects favorable claims frequency and severity during the quarter, ascompared to the prior year, offset by losses resulting from increased exposuresrelative to increased premium volume. The favorable claims frequency andseverity is due in part to the moderate weather experienced in our operatingterritory during the second and third quarters of 2004.

 

Underwriting expensesincreased by $3.7 million in the first nine months of 2004, or 23%, to $19.7 millionfrom 2003.  This increase was principallyattributable to an increase in expenses due to higher amortization of deferredpolicy acquisition costs resulting from higher premium volume, which includes acharge of $648,000 associated with the commitment of shares to employeeparticipants in the ESOP for 2004, and other expenses, including $206,000 forgrants of restricted stock compensation made during 2004, and $150,000 for thecost of professional services incurred in 2004 in connection with Sarbanes /Oxley compliance. No expense was included in the comparable 2003 period forESOP expense, or for restricted stock compensation or Sarbanes / Oxleycompliance. We are currently in the process of converting our informationsystem.  When completed, we expect somecosts to moderate as conversion costs and costs associated with operating dualsystems will no longer be incurred. These reduced costs will be offset by some higher staffing costs, but wealso should be positioned to expand premium volume without material incrementallabor and facility costs in the near term because of increased processingcapacity.

 

The Company maintains AgencyProfit Sharing plans, which, in addition to base commissions,  annually rewards agents for the growth andprofitability of the business they produce while representing the Company. Theadditional commission is computed only on the aggregate growth andprofitability of the book of business they produce each year. The Company doesnot have any marketing services agreements, placement services agreements, orsimilar arrangements. The Agency Profit Sharing plan expense accrued for 2004at September 30, 2004 is $2.0 million, as compared to $1.3 million for the sameperiod in 2003.

 

In the second quarter webegan writing new New Jersey accounts in Mercer Insurance Company of New Jerseyinstead of Mercer Insurance Company, and in the third quarter we began renewingthe New Jersey accounts of Mercer Insurance Company in Mercer Insurance Companyof New Jersey. By doing so, we will reduce the premium taxes we pay by reducingthe New Jersey retaliatory premium tax Mercer Insurance Company has been accruingon its New Jersey accounts since it redomesticated to Pennsylvania in 1997.Mercer Insurance Company of New Jersey will not be subject to the retaliatorytax on its New Jersey business. We had not previously taken this step because onlypolicyholders of Mercer Insurance Company, domiciled in Pennsylvania, hadsubscription and voting rights in the Conversion. We were examined by the NewJersey Division of Taxation on this issue, and it has billed us for all priorretaliatory tax and related interest, and these amounts have been paid in full.The amounts have been paid under protest, preserving our right to seek arecovery if the retaliatory tax is successfully challenged while the statute oflimitations remains open for any refund claim by us.  We are not challenging New Jersey’s position,however other companies have brought similar claims. It is unclear whether anychallenge will be successful. After paying the disputed retaliatory taxes toNew Jersey for prior periods, an accrual of $300,000 for estimated retaliatorytaxes remained which was reversed during the first quarter of 2004 and servedto reduce premium tax expense accordingly. The 2003 retaliatory tax wasapproximately $750,000.

 

22

----

 

Federal income tax expensewas $1.0 million for the first nine months of 2004, an effective rate of 29.4%,compared to $188,000, an effective rate of 24.8%, in 2003.  The increase in the effective tax rate in2004 is attributable to higher levels of operating profit, offset in part byhigher levels of tax-exempt securities holdings.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Our insurance companiesgenerate sufficient funds from their operations and maintain a high degree ofliquidity in their investment portfolios. The primary source of funds to meet the demands of claim settlements andoperating expenses are premium collections, investment earnings and maturinginvestments.  Mercer Insurance Company recentlycompleted an expansion of its existing facilities in Pennington, New Jersey, ata cost of $2.8 million for the structure. We are also in the process of building an information system platformthat will allow our producers the choice of conducting their business throughthe Internet or through the method they have historically used.  As of September 30, 2004, we have spent $2.9 million****on the development of this platform, which includes licensefees for software used in the platform. It is anticipated to be completed in late 2005 or early 2006, at anadditional cost of between $0.6 million and $1.0 million.  Mercer Insurance Company possesses sufficientresources for these future expenditures without incurring any debt.

 

Our insurance companiesmaintain investment and reinsurance programs that are intended to providesufficient funds to meet their obligations without forced sales ofinvestments.  They maintain a portion oftheir investment portfolio in relatively short-term and highly liquid assets toensure the availability of funds.

 

The principal source ofliquidity for Mercer Insurance Group, Inc. is the net proceeds it retained fromthe Conversion of approximately $25 million, and dividend payments andother fees received from Mercer Insurance Company.  Approximately $3 million of the retainedconversion proceeds were used by Mercer Insurance Group, Inc. to complete astock repurchase of 250,000 shares during the quarter ended September 30, 2004.For a period of three years after the Conversion, Mercer Insurance Company maynot declare or pay any dividend to Mercer Insurance Group without the approvalof the Pennsylvania Insurance Department. After this three-year period, Mercer Insurance Company will berestricted by the insurance laws of Pennsylvania as to the amount of dividendsor other distributions it may pay to its holding company.  Under Pennsylvania law, there is a maximumamount that may be paid by Mercer Insurance Company during any twelve monthperiod after notice to, but without prior approval of, the PennsylvaniaInsurance Department.  This limit is thegreater of 10% of Mercer Insurance Company’s statutory surplus as reported onits most recent annual statement filed with the Pennsylvania InsuranceDepartment, or the net income of Mercer Insurance Company for the periodcovered by such annual statement.

 

If the dividend restrictionsimposed on Mercer Insurance Company related to the Conversion were not ineffect, then as of December 31, 2003, the amounts available for payment ofdividends from Mercer Insurance Company in 2004, without the prior approval ofthe Pennsylvania Insurance Department would have been approximately$5.8 million.  Similar statutorylimitations are imposed on the dividends which may be paid to Mercer InsuranceCompany by its insurance subsidiaries, and, based on their December 31,2003 surplus positions, allowable dividends would be restricted toapproximately $2 million in the aggregate.

 

Total assets at September 30,2004 remained approximately equal to total assets at December 31,2003.  Premium volume increases drove an increasein premium receivables of $77,000, or 1%, and deferred policy acquisition costsof $231,000, or 3%, compared to December 31, 2003.  Reinsurance recoverable on losses and lossexpenses decreased $1.2 million, or 28%, due to a higher retention underthe Company’s reinsurance agreements. Investments increased $4.7 million,or 4%, to $128.0 million, and cash balances decreased $6.2 million,or 40%, to $9.1 million.  The movementbetween investments and cash and cash equivalents is due to the nature of the investmentvehicles in which cash proceeds of the Conversion were invested while awaiting

 

23

----

 

longer-term investment, andtheir classification for financial statement purposes. Accrued investmentincome increased $281,000, a 47% increase from December 31, 2003, due principallyto higher levels of invested assets following receipt of the Conversionproceeds.

 

Contemporaneous with theConversion, the Company and its subsidiaries engaged a new manager for its fixedincome portfolio.  The manager has investedthe proceeds of the Conversion and reallocated some portfolio assets with aview to achieving an appropriate duration, targeted at approximately4 years, and proportionately higher yields, while working to minimizeinterest rate risk associated with a generally rising interest rate environment.  The manager has retained approximately $10.6million of the Conversion proceeds in short-term investments at September 30,2004, which are available for investment in fixed income securities asopportunities arise.

 

Total liabilities atSeptember 30, 2004, were flat with December 31, 2003 at $77.5 million.  An increase of $399,000 in Unearned premiumwas offset by a decrease in accrued premium taxes of $615,000, as well as adecrease in payables for unsettled securities transactions.

 

Total stockholders’ equity atSeptember 30, 2004, remained flat with December 31, 2003, with net income of $2.4million and changes in Unearned ESOP shares of $469,000 and Unearned restrictedstock compensation of $206,000 being offset by purchases of Treasury stockaggregating $3.0 million.

 

In connection with theConversion, the ESOP was established, and purchased 626,111 shares fromthe Company in return for a note bearing interest at 4% on the principal amountof $6.3 million.  Mercer InsuranceCompany will make annual employee benefit contributions to the ESOP sufficientto repay that loan to the Company.  It isanticipated that the loan will be repaid in 10 equal annual installments,and that, in proportion to annual principal and interest payments,approximately 10% of the original ESOP shares will be allocated annually toemployee participants of the ESOP.  Anexpense charge will be booked ratably during each year for the sharescommitted to be allocated to participants that year, determined with referenceto the fair market value of the Company’s stock at the time the commitment toallocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in theAdditional Paid-in Capital account at Conversion, with a contra accountentitled Unearned ESOP Shares established in the Stockholders’ Equity sectionof the balance sheet for the unallocated shares at an amount equal totheir original per-share purchase price.

 

Mercer Insurance Groupadopted a stock-based incentive plan on June 16, 2004, after shareholderapproval of the plan at the annual shareholders meeting.  Pursuant to the plan, Mercer Insurance Groupmay issue 876,555 shares, in the form of incentive stock options, non-qualifiedstock options or grants of restricted stock. No more than 250,000 of the sharesmay be issued as grants of restricted stock. In June 2004, the Board ofDirectors awarded 537,700 incentive stock and non-qualified stock options and215,000 shares of restricted stock. As of September 30, 2004, the pre-taxexpense recognized in the income statement for the current year with respect torestricted stock grants was $206,000.

 

The Board of Directorsauthorized the Company on June 16, 2004 to repurchase up to 250,000 shares ofthe Company’s common stock in the open market. The repurchases were to be madefrom time to time in open market or privately negotiated transactions as, inmanagement’s sole opinion, market conditions warranted. As of September 30,2004, all 250,000 shares had been repurchased for a total of $3.0 million, oran average of $11.90 per share, a price accretive to the Company’s book value.On October 20, 2004, the Board authorized the repurchase of an additional250,000 shares. The program will continue until October 20, 2005 or until250,000 shares are repurchased, whichever occurs first, unless Mercer InsuranceGroup extends or expands the program. The repurchased shares will be held astreasury shares available for issuance in connection with

 

24

----

 

Mercer Insurance Group’s2004 Stock Incentive Plan. Any such stock buyback will be made with funds fromthe Company, which has adequate resources for such purpose.

 

**IMPACT OF INFLATION**

 

Inflation increases aninsured’s need for property and casualty insurance coverage.  Inflation also increases the cost of claimsincurred by property and casualty insurers as property repairs, replacementsand medical expenses increase.  Thesecost increases reduce profit margins to the extent that rate increases are notimplemented on an adequate and timely basis. We establish property and casualty insurance premiums levels before theamount of losses and loss expenses, or the extent to which inflation may affectthese expenses, are known.  Therefore,our insurance companies attempt to anticipate the potential impact of inflationwhen establishing rates.  Becauseinflation has remained relatively low in recent years, financial resultshave not been significantly affected by inflation.

 

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

 

**OFF BALANCE SHEET COMMITMENTS ANDCONTRACTUAL OBLIGATIONS**

 

The Company was not a partyto any unconsolidated arrangement or financial instrument with variableinterest entities or other vehicles at September 30, 2004 which would give riseto previously undisclosed market, credit or financing risk.

 

The Company and itssubsidiaries have no significant contractual obligations at September 30, 2004.

 

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

 

*General.*  Market risk is the risk that we will incurlosses due to adverse changes in market rates and prices.  We have exposure to three principal types ofmarket risk through our investment activities: interest rate 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, into any derivative financial instruments forhedging, trading or speculative purposes.

 

*Interest Rate Risk.*  Interest rate risk is the risk that we willincur economic losses due to adverse changes in interest rates.  Our exposure to interest rate changesprimarily results from our significant holdings of fixed rate investments.  Fluctuations in interest rates have a directimpact on the market valuation of these securities. Our available-for-saleportfolio of fixed-income securities is carried on the balance sheet at fairvalue.  Therefore, an adverse change inmarket prices of these securities would result in losses reflected in thebalance sheet.

 

*CreditRisk. *The quality of ourinterest-bearing investments is generally good. Our fixed maturity securitiesat September 30, 2004 are all rated BAA or above, with an average rating of AA.

 

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

 

25

----

 

There have been no materialchanges in market risk from the end of the most recent fiscal year endedDecember 31, 2003, and the information disclosed in connection therewith.

 

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

 

The Company, under thesupervision and with the participation of the Company’s management, includingthe Chief Executive Officer and the Chief Financial Officer, has evaluated theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures. Based on that evaluation, the Company’s Chief Executive Officerand Chief Financial Officer conclude that the Company’s disclosure controls andprocedures are effective as of September 30, 2004.  There has been no change in the Company’sinternal control over financial reporting that occurred during the quarterended September 30, 2004 that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

Securities and ExchangeCommission rules define “disclosure controls and procedures” as controls andother procedures of an issuer that are designed to ensure that informationrequired to be disclosed by the issuer in the reports that it files or submitsunder the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported within the time specified in the Commission’s rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that such information is accumulated and communicated to the issuer’smanagement, including its principal executive officer and principal financialofficer, as appropriate to allow timely decisions regarding requireddisclosure.

 

# **Part II - OTHER INFORMATION**

 

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

 

None

 

## **Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds.**

 
| **Period**           | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of Shares  Purchased as Part of Publicly  Announced Plans or Programs  (Notes 1 and 2)** | ** ** | **Maximum Number of Shares  That May Yet Be Purchased  Under The Plans or Programs  (Notes 1 and 2)** |
|----------------------|------------|----------------------------------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|
|                 |       |                                   |       |                               |       |                                                                                                    |       |                                                                                                  |
| July 1-31, 2004      |       | None                                   |       | N/A                                |       | None                                                                                                    |       | 250,000                                                                                               |
|                 |       |                                   |       |                               |       |                                                                                                    |       |                                                                                                  |   |
| August 1-31, 2004    |       | 10,100                                 |       | $                                  | 11.94      |                                                                                                    | 10,100     |                                                                                                  | 239,900 |
|                 |       |                                   |       |                               |       |                                                                                                    |       |                                                                                                  |   |
| September 1-30, 2004 |       | 239,900                                |       | $                                  | 11.90      |                                                                                                    | 239,900    |                                                                                                  | None |
|                 |       |                                   |       |                               |       |                                                                                                    |       |                                                                                                  |   |
| Total                |       | 250,000                                |       | $                                  | 11.90      |                                                                                                    | 250,000    |                                                                                                  | None |

 

Note 1 – On June 16, 2004, the Company’s Board of Directors authorized the repurchase of up to 250,000 shares of its common stock, to be made from time to time in the open market or in privately negotiated

 

26

----

 

transactions as, in management’s sole opinion, market conditions warranted. The repurchased shares are to be held as treasury shares available for issuance in connection with Mercer Insurance Group’s 2004 Stock Incentive Plan. As of September 30, 2004, 250,000 shares had been repurchased under this authorization, the details of which are shown in the table above.

 

Note 2 – On October 20, 2004, the Company’s Board of Directorsauthorized the repurchase of up to 250,000 shares of its common stock, inaddition to the June 16, 2004 authorization, and under the same terms andconditions. The program will continue until October 20, 2005 or until 250,000shares are repurchased, whichever occurs first, unless Mercer Insurance Group extendsor expands the program. The repurchased shares will be held as treasury sharesavailable for issuance in connection with Mercer Insurance Group’s 2004 StockIncentive Plan. This repurchase authorization is not reflected in the tableabove.

 

## **Item 3. Defaults Upon Senior Securities**

 

None

 

## **Item 4. Submission of Matters to Vote ofSecurity Holders**

 

None

 

## **Item 5. Other Information**

 

None

 

## **Item 6. Exhibits**

 

#### **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) |

 

27

----

 

**SIGNATURES**

 

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

 

 
|                     | MERCER INSURANCE GROUP, INC. (Registrant) |
|--------------------------|-------------------------------------------|
|                     |                                      |
| Dated: November 12, 2004 | By:                                       | /s/Andrew R. Speaker |   |
|                     |                                      |  Andrew R. Speaker, |
|                     |                                      |  President and Chief Executive Officer |
|                     |                                      |
|                     |                                      |
| Dated: November 12, 2004 | By:                                       | /s/David B. Merclean |   |
|                     |                                      |  David B. Merclean, |
|                     |                                      |  Chief Financial Officer |

 

28

----