** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**QuarterlyReport pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

 

**for the Quarterly Period Ended June 30, 2004,or**

 

**Transitionreport pursuant to Section 13 or 15(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 its charter)

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

 

Checkwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch shorter period that the Registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

Yes ý     No  ̈

 

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 August 6, 2004 |
|---------------------------------|--------|---------------------------------------------------|
| **COMMON STOCK (No Par Value)** |   | **7,060,733**                                     |
| (Title of Class)                |   | (Outstanding Shares)                              |

 

 

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**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  5.                                  | Legal Proceedings                                                                           |   |
| Item  6.                                  | Changes in  Securities, Use of Proceeds and Issuer Purchases of Equity Securities           |   |
| Item  7.                                  | Defaults Upon  Senior Securities                                                            |   |
| Item 8.                                   | Submission of  Matters to Vote of Security Holders                                          |   |
| Item  9.                                  | Other Information                                                                           |   |
| Item  10.                                 | Exhibits and  Reports on Form 8-K                                                           |   |
|                                      |                                                                                        |
| 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

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**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 economic conditions in the regional and national markets inwhich the Company competes which are less favorable than expected;

 

•                  the effects of weather-related and other catastrophic events;

 

•                  the concentration of insured accounts in New Jersey and Pennsylvania;

 

•                  the effect of legislative, judicial, economic, demographic andregulatory events in the two states in which we do business;

 

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

 

•                  the ability to enter new markets successfully and capitalize on growthopportunities either through acquisitions or the expansion of our producernetwork;

 

•                  financial market conditions, including, but not limited to, changes ininterest rates and the stock markets causing a reduction of investment incomeor investment gains, an acceleration of the amortization of deferred policyacquisition costs, reduction in the value of our investment portfolio or areduction in the demand for our products;

 

•                  the impact of acts of terrorism and acts of war;

 

•                  the effects of terrorist related insurance legislation and laws;

 

•                  inflation;

 

•                  the cost, availability and collectibility of reinsurance;

 

1

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•                  estimates and adequacy of loss reserves and trends in losses and lossadjustment expenses;

 

•                  heightened competition, including specifically the intensification ofprice competition, the entry of new competitors and the development of newproducts by new and existing competitors;

 

•                  changes in the coverage terms selected by insurance customers,including higher deductibles and lower limits;

 

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

 

•                  the potential impact on our reported net income that could result fromthe adoption of future accounting standards issued by the Financial AccountingStandards Board or other standard-setting bodies;

 

•                  inability to carry out marketing and sales plans, including, amongothers, development of new products or changes to existing products andacceptance of the new or revised products in the market;

 

•                  unanticipated changes in industry trends and ratings assigned bynationally recognized rating organizations;

 

•                  adverse litigation or arbitration results;

 

•                  the ability to carry out our business plans; and

 

•                  adverse changes in applicable laws, regulations or rules governinginsurance holding companies and insurance companies, and environmental, tax oraccounting matters including limitations on premium levels, increases inminimum capital and reserves, and other financial viability requirements, and changesthat affect the cost of, or demand 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

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# **FINANCIAL INFORMATION**

# ** **

## **Item 1**.  FinancialStatements

## ** **

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

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**As of June 30, 2004 and December 31, 2003**

** **
|                                                                                                                            |   | **As of   June 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  $90,546 and $46,282, respectively)         |   | $                               | 88,245  |                                | $      | 46,277 |   |
| Equity securities, at fair value (cost of****$15,754  and $15,866, respectively)                                                |   | 23,017                          |    | 22,656                              |   |
| Short-term investments, at amortized cost,  which approximates fair value                                                       |   | 15,795                          |    | 54,396                              |   |
| Total investments                                                                                                               |   | 127,057                         |    | 123,329                             |   |
| Cash and cash equivalents                                                                                                       |   | 9,391                           |    | 15,350                              |   |
| Premiums receivable                                                                                                             |   | 10,163                          |    | 9,096                               |   |
| Reinsurance receivables                                                                                                         |   | 2,428                           |    | 4,159                               |   |
| Prepaid reinsurance premiums                                                                                                    |   | 1,707                           |    | 1,614                               |   |
| Deferred policy acquisition costs                                                                                               |   | 7,747                           |    | 7,387                               |   |
| Accrued investment income                                                                                                       |   | 958                             |    | 596                                 |   |
| Property and equipment, net                                                                                                     |   | 9,062                           |    | 6,944                               |   |
| Goodwill                                                                                                                        |   | 4,673                           |    | 4,673                               |   |
| Other assets                                                                                                                    |   | 2,718                           |    | 2,727                               |   |
| Total assets                                                                                                                    |   | $                               | 175,904 |                                | $      | 175,875 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                   |   |                            |    |                                |   |
| Liabilities:                                                                                                                    |   |                            |    |                                |   |
| Losses and loss adjustment expenses                                                                                             |   | $                               | 37,932  |                                | $      | 37,261 |   |
| Unearned premiums                                                                                                               |   | 31,609                          |    | 30,329                              |   |
| Accounts payable and accrued expenses                                                                                           |   | 6,174                           |    | 7,937                               |   |
| Other reinsurance balances                                                                                                      |   | 47                              |    | 81                                  |   |
| Other liabilities                                                                                                               |   | 1,275                           |    | 1,228                               |   |
| Deferred income taxes                                                                                                           |   | 16                              |    | 713                                 |   |
| Total liabilities                                                                                                               |   | 77,053                          |    | 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 6,313,368 and  6,282,233 shares |   | —                          |    | —                              |   |
| Additional paid-in capital                                                                                                      |   | 67,579                          |    | 64,871                              |   |
| Accumulated other comprehensive income:                                                                                         |   |                            |    |                                |   |
| Unrealized gains in investments, net of  deferred income taxes                                                                  |   | 3,275                           |    | 4,478                               |   |
| Retained earnings                                                                                                               |   | 35,912                          |    | 34,612                              |   |
| Unearned restricted stock compensation                                                                                          |   | (2,592                          | )       | —                              |   |
| Unearned ESOP shares                                                                                                            |   | (5,323                          | )       | (5,635                              | )      |
| Total stockholders’ equity                                                                                                 |   | 98,851                          |    | 98,326                              |   |
| Total liabilities and stockholders’ equity                                                                                 |   | $                               | 175,904 |                                | $      | 175,875 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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

 

**CONDENSED CONSOLIDATED STATEMENTS OF EARNINGSSix Months Ended June 30, 2004 and 2003**

** **
|                                                                                                            |   | **2004**                                                        |   | **2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------|--------|----------|--------|
|                                                                                                            |   | **(Dollars  in thousands, except   shares and per share data)** |   |
|                                                                                                            |   | **(Unaudited)**                                                 |   |
| Revenue:                                                                                                        |   |                                                            |   |     |   |
| Net premiums earned                                                                                             |   | $                                                               | 27,585 |     | $      | 22,383 |   |
| Investment income, net of expenses                                                                              |   | 1,294                                                           |   | 821      |   |
| Net realized investment gains (losses)                                                                          |   | 99                                                              |   | (37      | )      |
| Other revenue                                                                                                   |   | 180                                                             |   | 191      |   |
| Total revenue                                                                                                   |   | 29,158                                                          |   | 23,358   |   |
|                                                                                                            |   |                                                            |   |     |   |
| Expenses:                                                                                                       |   |                                                            |   |     |   |
| Losses and loss adjustment expenses                                                                             |   | 14,930                                                          |   | 12,741   |   |
| Amortization of deferred policy acquisition  costs (related party amounts of  $663  and $579 respectively) |   | 7,642                                                           |   | 6,071    |   |
| Other expenses                                                                                                  |   | 4,839                                                           |   | 4,016    |   |
| Stock conversion expenses                                                                                       |   | —                                                          |   | 62       |   |
| Total expenses                                                                                                  |   | 27,411                                                          |   | 22,890   |   |
| Income before income taxes and minority  interest in income of subsidiary                                       |   | 1,747                                                           |   | 468      |   |
| Income taxes                                                                                                    |   | 447                                                             |   | 104      |   |
| Income before minority interest in income  of subsidiary                                                        |   | 1,300                                                           |   | 364      |   |
| Minority interest in income of subsidiary                                                                       |   | —                                                          |   | (91      | )      |
| Net income                                                                                                      |   | $                                                               | 1,300  |     | $      | 273 |   |
| Earnings per common share:                                                                                      |   |                                                            |   |     |   |
| Basic                                                                                                           |   | $                                                               | 0.21   |     | N/A    |   |
| Diluted                                                                                                         |   | $                                                               | 0.21   |     | N/A    |   |
| Weighted average shares:                                                                                        |   |                                                            |   |     |   |
| Basic                                                                                                           |   | 6,297,886                                                       |   | N/A      |   |
| Diluted                                                                                                         |   | 6,315,606                                                       |   | N/A      |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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

 

**CONDENSED CONSOLIDATED STATEMENTS OF EARNINGSThree Months Ended June 30, 2004 and 2003**

** **
|                                                                                                             |   | **2004**                                                       |   | **2003** |   |
|------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------|--------|----------|--------|
|                                                                                                             |   | **(Dollars  in thousands, except  shares and per share data)** |   |
|                                                                                                             |   | **(Unaudited)**                                                |   |
| Revenue:                                                                                                         |   |                                                           |   |     |   |
| Net premiums earned                                                                                              |   | $                                                              | 13,723 |     | $      | 11,327 |   |
| Investment income, net of expenses                                                                               |   | 626                                                            |   | 394      |   |
| Net realized investment gains (losses)                                                                           |   | 196                                                            |   | (186     | )      |
| Other revenue                                                                                                    |   | 88                                                             |   | 111      |   |
| Total revenue                                                                                                    |   | 14,633                                                         |   | 11,646   |   |
|                                                                                                             |   |                                                           |   |     |   |
| Expenses:                                                                                                        |   |                                                           |   |     |   |
| Losses and loss adjustment expenses                                                                              |   | 6,607                                                          |   | 6,227    |   |
| Amortization of deferred policy acquisition  costs (related party amounts of  $346  and $295, respectively) |   | 3,779                                                          |   | 3,098    |   |
| Other expenses                                                                                                   |   | 2,769                                                          |   | 2,167    |   |
| Stock conversion expenses                                                                                        |   | —                                                         |   | 50       |   |
| Total expenses                                                                                                   |   | 13,155                                                         |   | 11,542   |   |
| Income before income taxes and minority  interest in income of subsidiary                                        |   | 1,478                                                          |   | 104      |   |
| Income taxes                                                                                                     |   | 407                                                            |   | 16       |   |
| Income before minority interest in income  of subsidiary                                                         |   | 1,071                                                          |   | 88       |   |
| Minority interest in income of subsidiary                                                                        |   | —                                                         |   | (48      | )      |
| Net income                                                                                                       |   | $                                                              | 1,071  |     | $      | 40 |   |
| Earnings per common share:                                                                                       |   |                                                           |   |     |   |
| Basic                                                                                                            |   | $                                                              | 0.17   |     | N/A    |   |
| Diluted                                                                                                          |   | $                                                              | 0.17   |     | N/A    |   |
| Weighted average shares:                                                                                         |   |                                                           |   |     |   |
| Basic                                                                                                            |   | 6,305,669                                                      |   | N/A      |   |
| Diluted                                                                                                          |   | 6,341,109                                                      |   | N/A      |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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

 

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITYSix months ended June 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** |   | **Total** |   |
|----------------------------------------------------------------------------------------------------------------|--------|----------------------|--------|-------------------|--------|----------------------------------|--------|------------------------------------------------|--------|------------------------|--------|-----------------------------------------------|--------|----------------------------|--------|-----------|--------|
|                                                                                                           |   |                 |   |              |   |                             |   |                                           |   |                   |   |                                          |   |                       |   |      |   |
| Balance, December 31, 2003                                                                                     |   | $                    | — |              | — |                             | 64,871 |                                           | 4,478  |                   | 34,612 |                                          | — |                       | (5,635 | )         | 98,326 |   |
| Net income                                                                                                     |   |                 |   |              |   |                             |   |                                           |   | 1,300                  |   |                                          |   |                       |   | 1,300     |   |
| Unrealized losses on securities:                                                                               |   |                 |   |              |   |                             |   |                                           |   |                   |   |                                          |   |                       |   |      |   |
| Unrealized holding losses arising during  period, net of related income tax benefit of ($586)                  |   |                 |   |              |   |                             |   | (1,138                                         | )      |                   |   |                                          |   |                       |   | (1,138    | )      |
| Less reclassification adjustment for gains  included in net income, net of related income tax expense of ($34) |   |                 |   |              |   |                             |   | (65                                            | )      |                   |   |                                          |   |                       |   | (65       | )      |
| Other comprehensive loss                                                                                       |   |                 |   |              |   |                             |   |                                           |   |                   |   |                                          |   |                       |   | (1,203    | )      |
| Comprehensive income                                                                                           |   |                 |   |              |   |                             |   |                                           |   |                   |   |                                          |   |                       |   | 97        |   |
| Unearned restricted stock compensation                                                                         |   |                 |   |              |   | 2,625                            |   |                                           |   |                   |   | (2,625                                        | )      |                       |   | —    |   |
| Amortization of restricted stock  compensation                                                                 |   |                 |   |              |   |                             |   |                                           |   |                   |   | 33                                            |   |                       |   | 33        |   |
| ESOP shares committed                                                                                          |   |                 |   |              |   | 83                               |   |                                           |   |                   |   |                                          |   | 312                        |   | 395       |   |
| Balance, June 30, 2004                                                                                         |   | $                    | — |              | — |                             | 67,579 |                                           | 3,275  |                   | 35.912 |                                          | (2,592 | )                          | (5,323 | )         | 98,851 |   |
|                                                                                                                |        |                      |        |                   |        |                                  |        |                                                |        |                        |        |                                               |        |                            |        |           |        |  |  |

 

See accompanying notes tocondensed consolidated financial statements.

 

6

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

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSSix Months Ended June 30, 2004 and 2003**

** **
|                                                                               |   | **2004**                    |   | **2003** |   |
|------------------------------------------------------------------------------------|--------|-----------------------------|--------|----------|--------|
|                                                                               |   | **(Dollars  in thousands)** |   |
|                                                                               |   | **(Unaudited)**             |   |
| Cash flows from operating activities:                                              |   |                        |   |     |   |
| Net income                                                                         |   | $                           | 1,300  |     | $      | 273 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                        |   |     |   |
| Depreciation and amortization of fixed  assets                                     |   | 694                         |   | 656      |   |
| Net accretion of discount                                                          |   | (69                         | )      | (38      | )      |
| Amortization of restricted stock  compensation                                     |   | 33                          |   | —   |   |
| ESOP share commitment                                                              |   | 395                         |   | —   |   |
| Net realized investment (gains) losses                                             |   | (99                         | )      | 37       |   |
| Deferred income tax                                                                |   | (77                         | )      | (68      | )      |
| Change in assets and liabilities:                                                  |   |                        |   |     |   |
| Premiums receivable                                                                |   | (1,067                      | )      | (3,047   | )      |
| Reinsurance receivables                                                            |   | 1,731                       |   | 818      |   |
| Prepaid reinsurance premiums                                                       |   | (93                         | )      | (368     | )      |
| Deferred policy acquisition costs                                                  |   | (360                        | )      | (864     | )      |
| Other assets                                                                       |   | (353                        | )      | (623     | )      |
| Losses and loss expenses                                                           |   | 671                         |   | 2,088    |   |
| Unearned premiums                                                                  |   | 1,280                       |   | 4,166    |   |
| Other                                                                              |   | (1,751                      | )      | (1,923   | )      |
| Net cash provided by operating activities                                          |   | 2,235                       |   | 1,107    |   |
| Cash flows from investing activities:                                              |   |                        |   |     |   |
| Purchase of fixed income securities,  available-for- sale                          |   | (67,173                     | )      | (14,263  | )      |
| Purchase of equity securities                                                      |   | (1,593                      | )      | (2,805   | )      |
| Sale and maturity of fixed income  securities, available-for-sale                  |   | 22,814                      |   | 15,694   |   |
| Sale of equity securities                                                          |   | 1,973                       |   | 3,636    |   |
| Sale of short-term investments, net                                                |   | 38,601                      |   | —   |   |
| Purchase of property and equipment                                                 |   | (2,816                      | )      | (978     | )      |
| Net cash provided (used) by investing  activities                                  |   | (8,194                      | )      | 1,284    |   |
| Net (decrease) increase in cash and cash  equivalents                              |   | (5,959                      | )      | 2,391    |   |
| Cash and cash equivalents at beginning of  period                                  |   | 15,350                      |   | 7,201    |   |
| Cash and cash equivalents at end of period                                         |   | $                           | 9,391  |     | $      | 9,592 |   |
| Cash paid during the period for:                                                   |   |                        |   |     |   |
| Interest                                                                           |   | $                           | 19     |     | $      | 19 |   |
| Income taxes                                                                       |   | $                           | — |     | $      | — |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

7

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

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands)(Unaudited)**

 

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

 

The financial 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 lines insurance,and investments.  The commercial linesinsurance and personal lines insurance segments are managed based onunderwriting results determined in accordance with accounting principlesgenerally accepted in the United States of America, and the investment segmentis 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

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

 
|                                                                      |   | **Six Months  Ended June 30** |   |
|---------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                      |   | **2004**                      |   | **2003** |   |
|                                                                      |   | **(In  thousands)**           |   |
| Revenues:                                                                 |   |                          |   |   |   |
| Net premiums earned:                                                      |   |                          |   |   |   |
| Commercial lines                                                          |   | $                             | 15,855 |   | $ | 11,688 |   |
| Personal lines                                                            |   | 11,730                        |   | 10,695 |   |
| Total net premiums earned                                                 |   | 27,585                        |   | 22,383 |   |
| Net investment income                                                     |   | 1,294                         |   | 821 |   |
| Realized investment gains (losses)                                        |   | 99                            |   | (37 | ) |
| Other                                                                     |   | 180                           |   | 191 |   |
| Total revenues                                                            |   | 29,158                        |   | 23,358 |   |
| Income before income taxes:                                               |   |                          |   |   |   |
| Underwriting income (loss):                                               |   |                          |   |   |   |
| Commercial lines                                                          |   | 3,504                         |   | 1,669 |   |
| Personal lines                                                            |   | 3,330                         | )      | (2,114 | ) |
| Total underwriting income (loss)                                          |   | 174                           |   | (445 | ) |
| Net investment income                                                     |   | 1,294                         |   | 821 |   |
| Realized investment gains (losses)                                        |   | 99                            |   | (37 | ) |
| Other                                                                     |   | 180                           |   | 129 |   |
| Income before income taxes and minority  interest in income of subsidiary |   | $                             | 1,747  |   | $ | 468 |   |

 

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

 
|                                                                      |   | **Three  Months Ended June 30** |   |
|---------------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                                      |   | **2004**                        |   | **2003** |   |
|                                                                      |   | **(In  thousands)**             |   |
| Revenues:                                                                 |   |                            |   |   |   |
| Net premiums earned:                                                      |   |                            |   |   |   |
| Commercial lines                                                          |   | $                               | 7,830  |   | $ | 5,952 |   |
| Personal lines                                                            |   | 5,893                           |   | 5,375 |   |
| Total net premiums earned                                                 |   | 13,723                          |   | 11,327 |   |
| Net investment income                                                     |   | 626                             |   | 394 |   |
| Realized investment gains (losses)                                        |   | 196                             |   | (186 | ) |
| Other                                                                     |   | 88                              |   | 111 |   |
| Total revenues                                                            |   | 14,633                          |   | 11,646 |   |
| Income before income taxes:                                               |   |                            |   |   |   |
| Underwriting income (loss):                                               |   |                            |   |   |   |
| Commercial lines                                                          |   | 1,262                           |   | 594 |   |
| Personal lines                                                            |   | (694                            | )      | (759 | ) |
| Total underwriting income (loss)                                          |   | 568                             |   | (165 | ) |
| Net investment income                                                     |   | 626                             |   | 394 |   |
| Realized investment gains (losses)                                        |   | 196                             |   | (186 | ) |
| Other                                                                     |   | 88                              |   | 61 |   |
| Income before income taxes and minority  interest in income of subsidiary |   | $                               | 1,478  |   | $ | 104 |   |

### ** **

### **(3) **Reinsurance

### ** **

Premiums earned are net ofamounts ceded of $4,329 and $4,659 for the six months ended June 30, 2004and 2003, respectively, and $2,310 and $2,558 for the three months ended June30, 2004 and 2003, respectively. Losses and loss adjustment expenses are net ofamounts ceded of

 

9

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$294 and $609 for the six months ended June 30, 2004 and 2003,respectively, and $(89) and $7 for the three months ended June 30, 2004 and2003, respectively.

 

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

### ** **

The Company’s comprehensiveincome for the six month period ended June 30, 2004 and 2003 is as follows:

 
|                                                                                                                                       |   | **Six Months  ended  June 30** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                                                                       |   | **2004**                            |   | **2003** |   |
|                                                                                                                                       |   | **(In  thousands)**                 |   |
|                                                                                                                                       |   |                                |   |   |   |
| Net income                                                                                                                                 |   | $                                   | 1,300  |   | $ | 273 |   |
| Other comprehensive income (loss), net of  tax:                                                                                            |   |                                |   |   |   |
| Unrealized gains (losses) on securities:                                                                                                   |   |                                |   |   |   |
| Unrealized holding gains (losses) arising  during period, net of related income tax expense (benefit) of $(586), and  $477                 |   | (1,138                              | )      | 926 |   |
| Less reclassification adjustment for  (gains) losses included in net income, net of related income tax benefit  (expense) of $(34) and $13 |   | (65                                 | )      | 24 |   |
|                                                                                                                                       |   | (1,203                              | )      | 950 |   |
| Comprehensive Income                                                                                                                       |   | $                                   | 97     |   | $ | 1,223 |   |

 

The Company’s comprehensiveincome for the three month period ended June 30, 2004 and 2003 is as follows:

 
|                                                                                                                                       |   | **Three  Months ended   June 30** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|
|                                                                                                                                       |   | **2004**                                    |   | **2003** |   |
|                                                                                                                                       |   | **(In  thousands)**                         |   |
|                                                                                                                                       |   |                                        |   |   |   |
| Net income                                                                                                                                 |   | $                                           | 1,071  |   | $ | 40 |   |
| Other comprehensive income (loss), net of  tax:                                                                                            |   |                                        |   |   |   |
| Unrealized gains (losses) on securities:                                                                                                   |   |                                        |   |   |   |
| Unrealized holding gains (losses) arising  during period, net of related income tax expense (benefit) of $(950), and  $623                 |   | (1,844                                      | )      | 1,209 |   |
| Less reclassification adjustment for  (gains) losses included in net income, net of related income tax benefit  (expense) of $(67) and $64 |   | (130                                        | )      | 122 |   |
|                                                                                                                                       |   | (1,974                                      | )      | 1,331 |   |
| Comprehensive Income (loss)                                                                                                                |   | $                                           | (903   | ) | $ | 1,371 |   |

### ** **

### **(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

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|                                                                                                                                        |   | **Six months  ended**                       |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|
|                                                                                                                                        |   | **June 30,  2004**                          |   | **June 30,  2003** |   |
|                                                                                                                                        |   | **(In  thousands,  except per share data)** |   |
| Net income, as reported                                                                                                                     |   | $                                           | 1,300  |   | $ | 273 |   |
| Plus: Stock-based employee compensation  expense included in reported net income, net of related tax effects                                |   | 22                                          |   | 0 |   |
|                                                                                                                                        |   |                                        |   |   |   |
| Less: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (44                                         | )      | 0 |   |
| Pro forma net income                                                                                                                        |   | $                                           | 1,278  |   | $ | 273 |   |
| Basic earnings per share:                                                                                                                   |   |                                        |   |   |   |
| As reported                                                                                                                                 |   | $                                           | 0.21   |   | N/A |   |
| Pro forma                                                                                                                                   |   | $                                           | 0.20   |   | N/A |   |
| Diluted earnings per share:                                                                                                                 |   |                                        |   |   |   |
| As reported                                                                                                                                 |   | $                                           | 0.21   |   | N/A |   |
| Pro forma                                                                                                                                   |   | $                                           | 0.20   |   | N/A |   |

 
|                                                                                                                                        |   | **Quarter  ended**                          |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|
|                                                                                                                                        |   | **June 30,  2004**                          |   | **June 30,  2003** |   |
|                                                                                                                                        |   | **(In  thousands,  except per share data)** |   |
| Net income, as reported                                                                                                                     |   | $                                           | 1,071  |   | $ | 40 |   |
| Plus: Stock-based employee compensation  expense included in reported net income, net of related tax effects                                |   | 22                                          |   | 0 |   |
|                                                                                                                                        |   |                                        |   |   |   |
| Less: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (44                                         | )      | 0 |   |
| Pro forma net income                                                                                                                        |   | $                                           | 1,049  |   | $ | 40 |   |
| Basic earnings per share:                                                                                                                   |   |                                        |   |   |   |
| As reported                                                                                                                                 |   | $                                           | 0.17   |   | N/A |   |
| Pro forma                                                                                                                                   |   | $                                           | 0.17   |   | N/A |   |
| Diluted earnings per share:                                                                                                                 |   |                                        |   |   |   |
| As reported                                                                                                                                 |   | $                                           | 0.17   |   | N/A |   |
| Pro forma                                                                                                                                   |   | $                                           | 0.17   |   | 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

 

11

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criteria at the discretion of the Compensation Committee of the Boardof Directors. The term of options may not exceed ten years for incentive stockoptions, and ten years and 1 month for nonqualified stock options, and theoption price may not be less than fair market value on the date of grant. The2004 grants have vesting periods of 3 or 5 years on restricted stock, incentivestock 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                     |   | 12.21                                                          |   |
|                                        |   |                  |   |                                                           |   |
| Outstanding at June 30, 2004                |   | 537,700               |   | $                                                              | 12.21  |   |
|                                        |   |                  |   |                                                           |   |
| Exercisable at:                             |   |                  |   |                                                           |   |
| June 30, 2004                               |   | 0                     |   | $                                                              | 0.00   |   |
| Weighted-average remaining contractual life |   | 9.9 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 in 2004.  The weighted average price per share on thegrant date was $12.21 per share.

 

12

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

### ** **

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

 
|                                                                                       |   | **Six months  ended  June 30,**                         |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------------------------|--------|
|                                                                                       |   | **2004**                                                |   | **2003** |   |
|                                                                                       |   | **(Dollars  in thousands, except per share data)** |   |
| Numerator for basic and diluted earnings  per share:                                       |   |                                                    |   |   |   |
| Net income                                                                                 |   | $                                                       | 1,300  |   | N/A |   |
| Denominator for basic earnings per share  –  weighted-average shares outstanding |   | 6,297,886                                               |   | N/A |   |
| Effect of stock incentive plans                                                            |   | 17,720                                                  |   | N/A |   |
| Denominator for diluted earnings per share                                                 |   | 6,315,606                                               |   | N/A |   |
| Basic earnings per share                                                                   |   | $                                                       | 0.21   |   | N/A |   |
| Diluted earnings per share                                                                 |   | $                                                       | 0.21   |   | N/A |   |

 
|                                                                                      |   | **Quarter  Ended  June 30,**                            |   |
|-------------------------------------------------------------------------------------------|--------|---------------------------------------------------------|--------|
|                                                                                      |   | **2004**                                                |   | **2003** |   |
|                                                                                      |   | **(Dollars  in thousands, except per share data)** |   |
| Numerator for basic and diluted earnings  per share:                                      |   |                                                    |   |   |   |
| Net Income                                                                                |   | $                                                       | 1,071  |   | N/A |   |
| Denominator for basic earnings per share –  weight – average shares outstanding |   | 6,305,669                                               |   | N/A |   |
| Effect of stock incentive plans                                                           |   | 35,440                                                  |   | N/A |   |
| Denominator for diluted earnings per share                                                |   | 6,341,109                                               |   | N/A |   |
| Basic earnings per share                                                                  |   | $                                                       | 0.17   |   | 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 because the exercise price of the options was greater than theaverage market price.

 

## **Item 2**.  Management’sDiscussion and Analysis of Financial 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”.

 

13

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**Overview**

 

**THE CONVERSION TRANSACTION AND THE 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 an additional31,134 shares were committed in the first two quarters of 2004.

 

**Our Business**

 

The Company and itssubsidiaries underwrite property and casualty insurance in New Jersey andPennsylvania.  Our consolidatedoperating insurance company subsidiaries are:

 

•                  Mercer Insurance Company, a Pennsylvania property and casualty stockinsurance company offering insurance coverage to businesses and individuals inNew Jersey and Pennsylvania,

 

•                  Mercer Insurance Company of New Jersey, Inc., a New Jersey property andcasualty stock insurance company offering insurance coverage to businesses andindividuals in New Jersey and Pennsylvania; and

 

•                  Franklin Insurance Company, a property and casualty stock insurancecompany offering private passenger automobile and homeowners insurance toindividuals located in Pennsylvania.

 

The Holding Company issubject to regulation by the Pennsylvania Insurance Department and the NewJersey Department of Banking and Insurance as its primary regulators because itis the holding company for Mercer Insurance Company, and, indirectly, MercerInsurance

 

14

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Company of New Jersey, Inc. through its holding company, QueenstownHolding Company, Inc., and Franklin Holding Company, Inc. and its subsidiary,Franklin Insurance 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 ourcondensed consolidated financial statements included in this report. However,assets are not allocated to segments and are reviewed in the aggregate fordecision-making purposes.  Ourcommercial lines insurance business consists primarily of multi-peril andgeneral liability and related coverages. Our personal lines insurance business consists primarily of homeowners(in New Jersey and Pennsylvania) and private passenger automobile (inPennsylvania only) insurance coverages. We market both the commercial and personal insurance lines throughindependent 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 underwriting risks being produced by our agents, theability to retain on renewal existing good-performing accounts, competitionfrom other insurance companies, regulatory rate approvals, our reputation, andother limitations created by the marketplace or regulators.  Our underwriting costs are affected by,among other things, the amount of commission and profit-sharing we pay ouragents to produce the underwriting risks for which we receive premiums, thecost of issuing insurance policies and maintaining our customer and agent relationships,marketing costs, taxes we pay to the states in which we operate on the amountof premium we collect, and other assessments and charges imposed on ourcompanies by the regulators in the states in which we do business.  Our claim and claim settlement costs areaffected by, among other things, the quality of our underwriting accounts,severe or extreme weather in our operating region, the nature of the claim, theregulatory and legal environment in our territories, inflation in underlyingmedical and property repair costs, and the availability and cost ofreinsurance.  Our investment income andrealized gains and losses are determined by, among other things, market forces,the rates of interest and dividends paid on our investment portfolio holdings,the credit or investment quality of the issuers and the success of theirunderlying businesses, the market perception of the issuers, and other factorssuch as ratings by rating agencies and analysts.

 

**Critical Accounting Policies**

 

*General.*  The Company’s financial statements are prepared in conformitywith accounting principles generally accepted in the United States of America(GAAP). We are required to make estimates and assumptions in certaincircumstances that affect amounts reported in our consolidated financialstatements and related footnotes.  Weevaluate these estimates and assumptions on an on-going basis based onhistorical developments, market conditions, industry trends and otherinformation that we believe to be reasonable under the circumstances.  There can be no assurance that actualresults will conform to our estimates and

 

15

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assumptions, and that reported results of operations will not bematerially adversely affected by the need to make accounting adjustments toreflect changes in these estimates and assumptions from time to time.  We believe the following policies are themost sensitive to estimates and judgments.

 

*Liabilities for Loss and Loss Adjustment Expenses.*  The liability for losses and loss adjustmentexpenses represents estimates of the ultimate unpaid cost of all lossesincurred, including losses for claims that have not yet been reported to ourinsurance companies.  The amount of lossreserves for reported claims is based primarily upon a case-by-case evaluationof the type of risk involved, knowledge of the circumstances surrounding eachclaim and the insurance policy provisions relating to the type of loss.  The amounts of loss reserves for unreportedclaims and loss adjustment expenses are determined using historical informationby line of insurance as adjusted to current conditions.  Inflation is implicitly provided for in thereserving function through analysis of costs, trends and reviews of historicalreserving results over multiple 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 loss adjustment expenseratios to in-force business to derive a reserve level for each line ofbusiness.  This amount, together withreserves required by new reported claims and changes to existing case reserves,is compared to existing reserves to establish the adjustment to reserves thatis required.  In connection with thedetermination of the reserves, we also consider other specific factors such asrecent weather-related losses, trends in historical paid losses, and legal andjudicial trends with respect to theories of liability.  Because of the nature of our business, whichgenerally provides coverage for short-term risks, loss development is comparativelyrapid and historical paid losses have been a reliable predictive measure offuture 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 regardingfuture loss cost trends.  Accordingly,the ultimate liability for unpaid losses and loss settlement expenses willlikely differ from the amount recorded at June 30, 2004.  Changes in estimates or differences betweenestimates and amounts ultimately paid are reflected in current operations.  Loss reserving techniques and assumptionshave been consistently applied during the periods presented.

 

16

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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 of reasonablylikely changes was established based on a review of changes in accident yeardevelopment by line of business and applied to loss reserves as a whole.  The selected range of changes does notindicate what could be the potential best or worst case or likely scenarios:

 
| **Adjustment  Change in Loss and  Loss Adjustment  Reserves Net of    Reinsurance** |   | **Adjusted  Loss and  Loss Reserves Net  of Reinsurance as of  June 30, 2004** |   | **Percentage  Change  in Stockholders’  Equity as of  June 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                                                                                    | %      | 30,513                                                                              |   | 2.3                                                                                | %      | 29,003                                                                                              |   | 2.2                                                                                     | %      |
| -7.5                                                                                     | %      | 31,360                                                                              |   | 1.7                                                                                | %      | 29,808                                                                                              |   | 1.6                                                                                     | %      |
| -5.0                                                                                     | %      | 32,208                                                                              |   | 1.1                                                                                | %      | 30,614                                                                                              |   | 1.1                                                                                     | %      |
| -2.5                                                                                     | %      | 33,055                                                                              |   | 0.6                                                                                | %      | 31,419                                                                                              |   | 0.5                                                                                     | %      |
| Base                                                                                     |   | 33,903                                                                              |   | —                                                                             |   | 32,225                                                                                              |   | —                                                                                  |   |
| 2.5                                                                                      | %      | 34,751                                                                              |   | -0.6                                                                               | %      | 33,031                                                                                              |   | -0.5                                                                                    | %      |
| 5.0                                                                                      | %      | 35,598                                                                              |   | -1.1                                                                               | %      | 33,836                                                                                              |   | -1.1                                                                                    | %      |
| 7.5                                                                                      | %      | 36,446                                                                              |   | -1.7                                                                               | %      | 34,642                                                                                              |   | -1.6                                                                                    | %      |
| 10.0                                                                                     | %      | 37,293                                                                              |   | -2.3                                                                               | %      | 35,448                                                                                              |   | -2.2                                                                                    | %      |

 

----

### **(1) **Net of 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:

 
|                        |   | **June 30,  2004**     |   | **December 31,  2003** |   |
|-----------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                        |   | **(Dollars  in thousands)** |   |
| Commercial lines:           |   |                        |   |                        |   |
| Commercial multi-peril      |   | $                           | 5,822  |                        | $      | 6,998 |   |
| Other liability             |   | 9,051                       |   | 8,708                       |   |
| Workers’ compensation  |   | 4,934                       |   | 4,684                       |   |
| Commercial automobile       |   | 2,186                       |   | 2,251                       |   |
| Fire, allied, inland marine |   | 78                          |   | 242                         |   |
|                        |   | 22,071                      |   | 22,883                      |   |
| Personal lines:             |   |                        |   |                        |   |
| Homeowners                  |   | 10,805                      |   | 9,509                       |   |
| Personal automobile         |   | 2,768                       |   | 3,073                       |   |
| Fire, allied, inland marine |   | 399                         |   | 328                         |   |
| Other liability             |   | 1,789                       |   | 1,400                       |   |
| Workers’ compensation  |   | 100                         |   | 68                          |   |
|                        |   | 15,861                      |   | 14,378                      |   |
| Total                       |   | $                           | 37,932 |                        | $      | 37,261 |   |

 

*Investments.*  Unrealized investment gains or losses on investments carried atfair value, net of applicable income taxes, are reflected directly instockholders’ equity as a component of comprehensive income and, accordingly,have no effect on net income.  A declinein fair value of

 

17

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an investment below its cost that is deemed other than temporary ischarged to earnings as a realized loss. We monitor our investment portfolio and review investments that haveexperienced a decline in fair value below cost to evaluate whether the declineis other than temporary.  Theseevaluations involve judgment and consider the magnitude and reasons for adecline and the prospects for the fair value to recover in the near term.  In the six months ended June 30, 2004 and2003, we recorded a pre-tax charge to earnings of $0 and $445,000,respectively, and in the three months ended June 30, 2004 and 2003, we recordeda pre-tax charge to earnings of $0 and $445,000, respectively. These chargesare primarily with respect to equity securities that we determined under ourpolicy to be other than temporarily impaired. Adverse investment market conditions, or poor operating results ofunderlying investments, could result in 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 below 50% of cost orremains below 80% of cost for more than three months, a review of the financialcondition and prospects of the company is performed by the Investment Committeeof the Board of Directors to determine if the decline in fair value is otherthan temporary.  A specificdetermination is made for any such security. Other equity securities in an unrealized loss position not meeting thesequantitative thresholds are evaluated considering, among other things, themagnitude and reasons for the decline and the prospects for the fair value ofthe securities to recover in the near term. If it is determined that the decline in fair value is judged to be“other than temporary” then the cost basis of the security is written down to“realizable value” and the amount of the write down accounted for as a realizedloss.  “Realizable value” is defined asthe quoted market price of the security. Write-down to a value other than the market price requires objectiveevidence 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 maturity security generally is written down if we areunable to hold it or otherwise intend to sell a security with an unrealizedloss, or if it is probable that we will be unable to collect all amounts dueaccording to the contract terms of a debt security not impaired at acquisition.

 

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

 

•                  A review of the financial condition and prospects of the issuerperformed by the Investment Committee indicates that the security should beevaluated.

 

•                  Moody’s or Standard & Poors rate the security below investmentgrade.

 

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•                  The security has a fair value below 70% of amortized cost at quarterend due to deterioration in credit quality.

 

*Policy Acquisition Costs. *We defer policy acquisition costs, such as commissions, premium taxesand certain other underwriting expenses that vary with and are directly relatedto the production of business.  Thesecosts are amortized over the effective period of the related insurancepolicies.  The method followed incomputing deferred policy acquisition costs limits the amount of deferred coststo their estimated realizable value, which gives effect to the premium to beearned, related investment income, loss and loss adjustment expenses, andcertain other costs expected to be incurred as the premium is earned.  Future changes in estimates, the mostsignificant of which is expected loss and loss adjustment expenses, may requireacceleration of the amortization of deferred policy acquisition costs.

 

*Reinsurance.*  Amounts recoverable from property and casualty reinsurers areestimated in a manner consistent with the claim liability associated with thereinsured policy.  Amounts paid forreinsurance contracts are expensed over the contract period during whichinsured events are covered by the reinsurance contracts.

 

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 of accounting for incometaxes. Deferred income taxes arise from the recognition of temporarydifferences between financial statement carrying amounts and the tax bases ofour assets and liabilities.  A valuationallowance is provided when it is more likely than not that some portion of thedeferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of theenactment 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 priced personaland commercial lines business.  Ourpolicy is to maintain our disciplined underwriting and pricing standards duringsoft markets, even at the expense of premium growth. For more than three years,the industry has enjoyed a

 

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hard market with pricing power, however pricing competition hasre-appeared in the market, particularly in lines of business which arepredominantly property exposures.  Thecyclicality of the market is difficult to anticipate, and pricing has leveledoff consistent with the latter stages of a hard market.

 

***Six months and three months ended June 30, 2004, compared to sixmonths and three months ended June 30, 2003***

 

For the six months endedJune 30, 2004, the Company had net income of $1,300,000 compared to $273,000for the same period in 2003.  Theunderwriting gain from our commercial lines segment for the six months of 2004increased to $3.5 million from the prior year amount of $1.7 million,but our personal lines segment incurred an underwriting loss of$3.3 million, an increased loss from the loss of $2.1 million in theprior comparable period.  In ourinvestment segment, net investment income increased 58% in the first six monthsof 2004 to $1,294,000 from $821,000, and net realized gains for the first sixmonths of 2004 were $99,000, as compared to a net realized loss of $37,000 forthe 2003 period.

 

For the three months endedJune 30, 2004, the Company had net income of $1,071,000 compared to $40,000 forthe same period in 2003.  Theunderwriting gain from our commercial lines segment for the second quarter of2004 increased to $1.3 million from the prior year amount of$0.6 million. The personal lines segment incurred an underwriting loss of$0.7 million in the second quarter of 2004, compared to a loss of$0.8 million in the prior year period. In our investment segment, net investment income increased 59% in thesecond quarter of 2004 to $626,000 from $394,000, and we had a net realizedgain for the second quarter of 2004 of $196,000, as compared to a net realizedloss of $186,000 for the 2003 period.

 

Total revenues for the firstsix months of 2004 were $29.2 million, which was 25% greater than 2003revenues of $23.4 million.  Thisincrease was due to a $5.2 million, or 23%,  increase in net premiums earned in the first six months of 2004,an increase in net investment income of $473,000, or 58%, as well as to arealized investment gain of $99,000 in 2004 as compared to a realized investmentloss of $37,000 in 2003.

 

Total revenues for thesecond quarter of 2004 were $14.6 million, which was 26% greater thanrevenues of $11.6 million during the comparable 2003 period.  This increase was due to a$2.4 million, or 21%,  increase innet premiums earned in the second quarter of 2004, an increase in netinvestment income of $232,000, or 59%, as well as to a realized investment gainof $196,000 in 2004 as compared to a realized investment loss of $186,000during the comparable 2003 period.

 

Direct premiums writtenincreased 6% to $32.2 million in the first six months of 2004 whencompared to 2003, and consisted of $20.1 million of commercial linespremiums, a 9% increase, and $12.1 million of personal lines premiums, a0.3% increase.  Net premiums earnedincreased by 23% to $27.6 million for the first six months of 2004 ascompared to $22.4 million for the prior year period.  Commercial lines net premiums earnedincreased 36% to $15.9 million in the first six months of 2004, andpersonal lines net premiums earned increased 10% to $11.7 million in2004.  The overall increases in directpremiums written and net

 

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premiums earned are generally attributable to attractive pricing andcontinued strong growth in our commercial lines business.

 

Direct premiums written forthe second quarter of 2004 increased 2% to $17.9 million when compared to2003, and consisted of $11.4 million of commercial lines premiums, a 4%increase, and $6.5 million of personal lines premiums, a 0.1% increase.  Net premiums earned increased by 21% to$13.7 million for the second quarter of 2004 as compared to$11.3 million for the prior year period. Commercial lines net premiums earned increased 32% to $7.8 millionin the second quarter, and personal lines net premiums earned increased 10% to$5.9 million.

 

Consistent with our goal ofincreasing our commercial lines business, we increased commercial lines directpremiums written in the first six months of 2004 to 62.4% of our business, ascompared to 60.2% in the prior year period. Similarly, commercial lines netpremium earned increased to 57.5% of our business, as compared to 52.2% in the2003 period. Our direct commercial multi-peril premiums written, the largestcomponent of our commercial lines segment, increased by 11% to$10.0 million in the first six months of 2004, compared to$9.1 million for the 2003 period. Commercial multi-peril net premiumsearned increased by 40% to $7.9 million in 2004, as compared to$5.7 million for the prior year period. We expect this trend of increasing commercial writings to continue bytargeting certain types of risks with selected producers.

 

For the first six months of2004, net premiums earned for our homeowners insurance, the largest componentof our personal lines segment, increased 10% to $6.7 million, compared to$6.2 million for the 2003 period, while homeowners direct premiums writtenincreased 2% to $7.0 million from $6.9 million in the 2003period.  The growth in homeownersinsurance primarily reflects the reclassification of certain homeowners risksfrom our preferred program to our standard program, resulting in a higherpremium, as part of a general review of the homeowners program. Premiums arehigher for the standard program compared to the preferred program.

 

Personal automobile directwritten premiums for the first six months of 2004, written exclusively inPennsylvania, remained flat with the 2003 period at $3.9 million.  Net premiums earned for personal automobileincreased in the first six months of 2004 by 9% to $3.6 million, from$3.3 million for the comparable period in 2003.  Despite the increases in personal lines net premiums earned, ourfocus is principally on our commercial lines growth.  Our personal auto book is currently being reviewed for rateincrease opportunities.

 

Net investment incomeincreased $473,000, or 58%, to $1,294,000 in the first six months of 2004, ascompared to the same period in 2003, due primarily to higher average investedassets.  Net realized gains for the sameperiod in 2004 were $99,000, as compared to a net realized loss of $37,000 inthe comparable period in 2003.  In 2004,net realized losses of $99,000 included gains on securities sales of $412,000,and losses on securities sales of $308,000. The losses from securities sales were comprised of $279,000 from thesale of bonds and $29,000 from the sale of equities.  The following table summarizes the period of time that the equitysecurities sold at a loss during 2004 had been in a continuous unrealized lossposition:

 

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| **PERIOD OF TIME IN AN  UNREALIZED LOSS POSITION** |   | **Fair Value  on Sale Date** |   | **Realized  Loss** |   |
|----------------------------------------------------|--------|------------------------------|--------|--------------------|--------|
|                                               |   | **(In  thousands)**          |   |
|                                               |   |                         |   |               |   |
| 0-6 months                                         |   | $                            | 186    |               | $      | 25 |   |
| 7-12 months                                        |   | 276                          |   | 4                  |   |
| More than 12 months                                |   | —                       |   | —             |   |
| Total                                              |   | $                            | 462    |               | $      | 29 |   |

 

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 were sold as part of our normal reviewprocess intended to reduce exposure to certain issuers and industries or torecognize changing economic conditions.

 

The following tablesummarizes the length of time equity securities with unrealized losses held atJune 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 |   | $                  | 1,031  |                   | $      | 74                             |   | $ | 41 |   | $ | 33 |   | $ | 0 |   |
| Less than 80% of cost |   | —             |   | —                 |   | —                         |   | — |   | — |   |
| Total                 |   | $                  | 1,031  |                   | $      | 74                             |   | $ | 41 |   | $ | 33 |   | $ | 0 |   |

 

The estimated fair value andunrealized loss for securities in a temporary unrealized loss position as ofJune 30, 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 |   | $                         | 13,782 |                     | $      | 385                       |   | $ | 2,817 |   | $ | 195 |   | $ | 16,599 |   | $ | 580 |   |
|                                                                                   |   |                      |   |                     |   |                      |   |   |   |   |   |   |   |
| Obligations of states and political  subdivisions                                      |   | 28,600                    |   | 979                      |   | $                         | 463    |   | $ | 35 |   | 29,063 |   | 1,014 |   |
|                                                                                   |   |                      |   |                     |   |                      |   |   |   |   |   |   |   |
| Corporate securities                                                                   |   | 12,668                    |   | 334                      |   | —                    |   | — |   | 12,668 |   | 334 |   |
|                                                                                   |   |                      |   |                     |   |                      |   |   |   |   |   |   |   |
| Mortgage-backed securities                                                             |   | 20,828                    |   | 504                      |   | —                    |   | — |   | 20,828 |   | 504 |   |
|                                                                                   |   |                      |   |                     |   |                      |   |   |   |   |   |   |   |
| Total fixed maturities                                                                 |   | 75,878                    |   | 2,202                    |   | 3,280                     |   | 230 |   | 79,158 |   | 2,432 |   |
|                                                                                   |   |                      |   |                     |   |                      |   |   |   |   |   |   |   |
| Total equity securities                                                                |   | 1,031                     |   | 74                       |   | —                    |   | — |   | 1,031 |   | 74 |   |
|                                                                                   |   |                      |   |                     |   |                      |   |   |   |   |   |   |   |
| Total securities in a temporary unrealized  loss position                              |   | $                         | 76,909 |                     | $      | 2,276                     |   | $ | 3,280 |   | $ | 230 |   | $ | 80,189 |   | $ | 2,506 |   |

 

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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 nine fixed maturitysecurities with unrealized losses for more than twelve months.  All of the nine fixed maturity securitieswith unrealized losses greater than twelve months have fair values greater than92% of cost.  The Company believes thesedeclines are temporary.

 

There are seven equitysecurities that are in an unrealized loss position on June 30, 2004.  Five of these securities have been in anunrealized loss position for less than six months.  The other two equity securities have been in an unrealized lossposition for less than twelve months. The Company believes these declines are temporary.

 

For the first six 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 99.4%, aloss and loss adjustment expense ratio of 54.1% and an underwriting expenseratio of 45.3%, compared to a GAAP combined ratio of 102.0%, a loss and lossadjustment expense ratio of 56.9% and an underwriting expense ratio of 45.1%for the same period in 2003. In the second quarter of 2004, we had a GAAPcombined ratio of 95.9%, a loss and loss adjustment expense ratio of 48.2% andan underwriting expense ratio of 47.7%, compared to a GAAP combined ratio of101.5%, a loss and loss adjustment expense ratio of 55.0% and an underwritingexpense ratio of 46.5% for the 2003 period.

 

In the commercial linessegment for the first six months of 2004, we had an underwriting gain of$3.5 million, a combined ratio of 77.9%, a loss and loss adjustmentexpense ratio of 29.6% and an underwriting expense ratio of 48.3%, compared toan underwriting gain of $1.7 million, a combined ratio of 85.7%, a lossand loss adjustment expense ratio of 36.0% and an underwriting expense ratio of49.7% for 2003. For the second quarter of 2004, in our commercial lines segmentwe had an underwriting gain of $1.3 million, a combined ratio of 83.9%, aloss and loss adjustment expense ratio of 31.3% and an underwriting expenseratio of 52.6%, compared to an underwriting gain of $0.6 million, acombined ratio of 90.0%, a loss and loss adjustment expense ratio of 37.9% andan underwriting expense ratio of 52.1% for the 2003 period.

 

In the personal linessegment for the first six months of 2004, we had an underwriting loss of$3.3 million, a combined ratio of 128.4%, a loss and loss adjustmentexpense ratio of 87.2% and an underwriting expense ratio of 41.2%, compared toan underwriting loss of $2.1 million, a combined ratio of 119.8%, a lossand loss adjustment expense ratio of 79.8% and an underwriting expense ratio of40.0% for 2003. For the second quarter of 2004, in our personal lines segmentwe had an underwriting loss of $0.7 million, a combined ratio of 111.8%, aloss and loss adjustment expense ratio of 70.5% and an underwriting expenseratio of 41.3%, compared to an underwriting loss of $0.8 million, acombined ratio of 114.1%, a loss and loss adjustment expense ratio of 73.9% andan underwriting expense ratio of 40.2% for the 2003 period.

 

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For the first six months of2004, net loss and loss adjustment expenses incurred increased overall by$2.2 million, or 17%, to $14.9 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 second quarter of 2004, net loss andloss adjustment expenses incurred increased overall by $0.4 million, or 6% to$6.6 million from 2003. Growth in losses and loss adjustment expenses in thequarter reflects the overall increase in premium volume, with claims frequencyduring the quarter reduced from the elevated levels of the first quarter to themore normal frequency levels associated with the moderate weather experiencedin our operating territory during the second quarter.

 

Underwriting expensesincreased by $2.4 million in the first six months of 2004, or 24%, to$12.5 million from 2003.  Thisincrease was principally attributable to an increase in expenses due to higheramortization of deferred policy acquisition costs resulting from higher premiumvolume, and a charge of $394,000 (pre-tax) associated with the commitmentof shares to employee participants in the ESOP for 2004, and $33,000(pre-tax) associated with grants of restricted stock compensation made duringthe second quarter.  We are currently inthe process of converting our information system.  When completed, we expect some costs to moderate as conversioncosts and costs associated with operating dual systems will no longer beincurred.  These reduced costs will beoffset by some higher staffing costs, but we also should be positioned toexpand premium volume without material incremental labor and facility costs inthe near term because of increased processing capacity.

 

We also expect underwritingexpenses to moderate in future periods because we intend to significantlyreduce the amount of New Jersey business written in Mercer Insurance Company,which became subject to New Jersey’s retaliatory premium tax when itredomesticated to Pennsylvania in 1997. We plan to do this by writing newpolicies, beginning in the 3rd quarter of 2004, and renewing existingpolicies for New Jersey accounts in Mercer Insurance Company of New Jersey,Inc., our New Jersey domestic insurer that is not subject to this retaliatorytax.  We had not previously renewedpolicies in our New Jersey subsidiary because only policyholders of MercerInsurance Company, domiciled in Pennsylvania, had subscription and votingrights in the Conversion.  Therefore,renewing policies in the New Jersey subsidiary before completion of theConversion would have denied subscription rights to Mercer Insurance Company’spolicyholders.  The New Jersey Divisionof Taxation has billed us for all prior retaliatory tax and related interest,and these amounts have been paid in full, although under protest, therebypreserving our right to a recovery if the retaliatory tax is successfullychallenged while the statute of limitations remains open for any refund claimby us.  It is unclear whether any suchchallenge will be successful.  Until thebusiness is moved to Mercer Insurance Company of New Jersey, Mercer InsuranceCompany will continue to accrue and pay current retaliatory taxes.  After paying the disputed retaliatory taxesto New Jersey for prior periods, an accrual of $300,000 for estimatedretaliatory taxes remained which was reversed during the first quarter of 2004and served to reduce premium tax expense accordingly. The 2003 retaliatory taxwas approximately $750,000.

 

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Federal income tax expensewas $447,000 for the first six months of 2004, an effective rate of 25.6%,compared to $104,000, an effective rate of 22.2%, in 2003.  The increase in the effective tax rate in2004 is attributable to higher levels of operating profit.

 

**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 Companyis expanding its existing facilities in Pennington, New Jersey, at a costestimated at $2.8 million as of June 30, 2004.  We are also in the process of building an information system platformthat will allow our producers to conduct their business through the Internet orthrough the method they have historically used.  As of June 30, 2004, we have spent $2.7 million on thedevelopment of this platform, which includes license fees for software used inthe platform.  It is anticipated to becompleted in late 2005 or early 2006, at an additional cost of between$0.6 million and $1.0 million. Mercer Insurance Company possesses sufficient resources for these futureexpenditures 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 is the net proceeds it retained from theConversion of approximately $25 million, and dividend payments and otherfees received from Mercer Insurance Company. For a period of three years after the Conversion, Mercer InsuranceCompany may not declare or pay any dividend to Mercer Insurance Group withoutthe approval of the Pennsylvania Insurance Department.  After this three-year period, MercerInsurance Company will be restricted by the insurance laws of Pennsylvania asto the amount of dividends or other distributions it may pay to its holdingcompany.  Under Pennsylvania law, thereis a maximum amount that may be paid by Mercer Insurance Company during anytwelve month period after notice to, but without prior approval of, thePennsylvania Insurance Department.  Thislimit is the greater of 10% of Mercer Insurance Company’s statutory surplus asreported on its most recent annual statement filed with the PennsylvaniaInsurance Department, or the net income of Mercer Insurance Company for theperiod covered 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 statutory limitations are imposed onthe dividends which may be paid to Mercer Insurance Company by its insurancesubsidiaries, and, based on their December 31, 2003 surplus positions,allowable dividends would be restricted to approximately $2 million in theaggregate.

 

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Total assets at June 30,2004 remained approximately equal to total assets at December 31,2003.  Premium volume increases as wellas the renewal of a significant account in June drove increases in premiumreceivables of $1.1 million, or 12%, and deferred policy acquisition costsof $0.4 million, or 5%, compared to December 31, 2003.  Reinsurance recoverable on losses and lossexpenses decreased $1.7 million, or 42%, due to the absence of lossactivity above the Company’s loss retention under its reinsurance agreements.Investments increased $3.7 million, or 3%, to $127.1 million, andcash balances decreased $6 million, or 39%.  The movement between investments and cash and cash equivalents isdue to the nature of the investment vehicles in which cash proceeds of theConversion are invested while awaiting longer-term investment, and theirclassification for financial statement purposes. Accrued investment incomeincreased $0.4 million, a 61% increase from December 31, 2003, due in part tohigher levels of invested assets following receipt of the Conversion proceeds.

 

Contemporaneous with theConversion, the Company and its subsidiaries engaged a new manager for itsfixed income portfolio.  The managerwill invest the proceeds of the Conversion and reallocate most other fixedmaturity securities with a view to achieving an appropriate duration, targetedat approximately 4 years, and proportionately higher yields.  Given the large amount of new capital toinvest, the need to reallocate some existing investment funds, and a bondmarket presenting investment challenges, some funds are being maintained invery short term investments or money market funds while they await investmentin fixed income securities appropriate to the Company’s investment goals.  This is reflected in the $15.8 millionshort-term investment balance and the $9.4 million cash and cash equivalentsbalance on the Consolidated Balance Sheet as of June 30, 2004. It is anticipatedthat these amounts will be substantially invested in accordance with theCompany’s investment goals and policy in the balance of 2004, with a relatedincrease in investment income resulting from such placement.

 

Total liabilities decreased0.6%, or $0.5 million, in 2004, to $77.1 million.  Decreased commissions payable, reflected inthe $1.8 million, or 22%, decrease in accounts payable and accrued expenses to$6.2 million, offset growth in losses and loss adjustment expenses and unearnedpremiums which resulted from increasing premium volume in the first six monthsof 2004. The decrease in commissions referred to above relates to the paymentof commissions and contingent commissions accrued but unpaid at December 31,2003.

 

Total stockholders’ equity increasedby less than 1%, due principally to net income of $1.3 million offset byunrealized losses, net of tax, of $1.2 million in the first six months of 2004.The unrealized losses were in the fixed income portfolio, and relate to theincrease in the general level of interest rates in the latter part of thesecond quarter of 2004.

 

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.  Itis anticipated that the loan will be repaid in 10 equal annualinstallments, and that, in proportion to annual principal and interestpayments, approximately 10% of the original ESOP shares will be allocatedannually to employee participants of the ESOP. An expense 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

 

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is accrued and recognized.  Theissuance of the shares to the ESOP was fully recognized in the AdditionalPaid-in Capital account at Conversion, with a contra account entitled UnearnedESOP Shares established in the Stockholders’ Equity section of the balancesheet for the unallocated shares at an amount equal to their originalper-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.

 

The Board of Directors hasalso authorized the Company to repurchase up to 250,000 shares of the Company’scommon stock in the open market. The repurchases are authorized to be made fromtime to time in open market or privately negotiated transactions as, inmanagement’s sole opinion, market conditions warrant. The program will continueuntil June 16, 2005 or until 250,000 shares are repurchased, whichever occursfirst, unless Mercer Insurance Group extends or expands the program. Therepurchased shares will be held as treasury shares available for issuance inconnection with Mercer Insurance Group’s 2004 Stock Incentive Plan.

 

Any such stock buyback willbe made with funds from the Company, which has adequate resources for suchpurpose. As of June 30, 2004, there have been no repurchases of the Company’scommon stock under the authorization.

 

**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 AND CONTRACTUAL OBLIGATIONS**

 

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

 

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

 

## **Item 3**.  Quantitativeand Qualitative Disclosures About Market Risk

## ** **

*General.*  Market risk is the risk that we will incur losses due to adversechanges in market rates and prices.  Wehave exposure to three principal types of market risk through our investmentactivities:  interest rate risk, creditrisk and equity risk.  Our primarymarket risk exposure is to changes in interest rates.  We have not entered, and do not plan to enter, into anyderivative financial instruments for hedging, trading or speculative purposes.

 

*Interest Rate Risk.*  Interest rate risk is the risk that we will incur economic lossesdue to adverse changes in interest rates. Our exposure to interest rate changes primarily results from oursignificant holdings of fixed rate investments.  Fluctuations in interest rates have a direct impact on the marketvaluation of these securities. Our available-for-sale portfolio of fixed-incomesecurities is carried on the balance sheet at fair value.  Therefore, an adverse change in marketprices of these securities would result in losses reflected in the balancesheet.

 

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

 

*Equity Risk.*  Equity price risk is the risk that we will incur economic lossesdue to adverse changes in equity prices. Our exposure to changes in equity prices primarily results from ourholdings of common stocks, mutual funds and other equities.  Our portfolio of equity securities iscarried on the balance sheet at fair value. Therefore, an adverse change in market prices of these securities wouldresult in losses reflected in the balance sheet.

 

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 andProcedures

## ** **

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 June 30, 2004.  There has been no change in the Company’s internal control overfinancial reporting that occurred during the quarter ended June 30, 2004that has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

Securities and ExchangeCommission rules define “disclosure controls and procedures” as controls andother procedures of an issuer that are designed to ensure that information requiredto be disclosed by the issuer in the reports that it files or submits under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time specified in the Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that suchinformation is accumulated and

 

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communicated to the issuer’s management, including its principalexecutive officer and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

 

# **OTHER INFORMATIO**N

# ** **

## **Item 5. **Legal Proceedings

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None

 

## **Item 6. **Changes in Securities,Use of Proceeds and Issuer Purchases of Equity Securities

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None

 

## **Item 7. **Defaults Upon SeniorSecurities

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None

 

## **Item 8. **Submission of Matters toVote of Security Holders

## ** **

The Company’s Annual Meetingof Shareholders was held on June 16, 2004.  At the Annual Meeting, AndrewR. Speaker, George T. Hornyak, Jr. and Samuel J. Malizia were elected as ClassI directors to serve for a term of three years, expiring at the 2007 AnnualMeeting of Shareholders or until their successors are duly elected andqualified.  Votes cast for and withheld on the election of directors wereas follows:

 
|                   |   | **Votes for** |   | **Votes  withheld** |   |
|------------------------|--------|---------------|--------|---------------------|--------|
| Andrew R. Speaker      |   | 6,372,386     |   | 87,928              |   |
|                   |   |          |   |                |   |
| George T. Hornyak, Jr. |   | 6,372,861     |   | 87,453              |   |
|                   |   |          |   |                |   |
| Samuel J. Malizia      |   | 6,381,486     |   | 78,828              |   |

 

The existing Class II andClass III directors whose terms of office continued after the Annual Meetingare Roland D. Boehm, H. Thomas Davis, Jr., William V.R. Fogler, Wiliam C. Hart,Richard C. Niedt, and Richard B. Van Noy, Chairman.

 

The Shareholders alsoapproved and adopted the Mercer Insurance Group, Inc. 2004 Stock IncentivePlan, with 3,578,715 shares voted for, 797,829 shares voted against, and 9,576shares voting to abstain.

 

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## **Item 9. **Other Information

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None

 

## **Item 10. **Exhibits and Reports onForm 8-K

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#### **(a) **Exhibits

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

#### ** **

#### **(b) **Reports on Form 8-K

#### ** **

Ina report on Form 8-K dated and filed on May 12, 2004, the Company reporteda press release, dated May 11, 2004, announcing its earnings for thethree month period ended March 31, 2004, which is incorporated herein byreference.

 

In a report on Form 8-Kdated and filed on June 10, 2004, the Company reported a presentation by AndrewR. Speaker,Chief Executive Officer of Mercer Insurance Group, Inc. (the “Company”) at theSandler O’Neill & Partners, L.P.  Financial Services Conference, onJune 10 2004, in New York. The Company furnished a copy of the slidepresentation used by Mr. Speaker in his presentation, which is incorporatedherein by reference.

 

In a report on Form 8-Kdated and filed on June 23, 2004, the Company reported a press release ofMercer Insurance Group, Inc., dated June 23, 2004, announcing the authorizationof an open market stock repurchase program, which is incorporated herein byreference.

 

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**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: August 13, 2004 | By:                                         | /s/Andrew R. Speaker |
|                   |                                        | Andrew  R. Speaker, |
|                   |                                        | President  and Chief Executive Officer |
|                   |                                        |
|                   |                                        |
| Dated: August 13, 2004 | By:                                         | /s/David B. Merclean |
|                   |                                        | David  B. Merclean, |
|                   |                                        | Chief  Financial Officer |

 

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