**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

**FORM 10-K**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**Or**

**o**                                  TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from            to           **

**Commissionfile number 000-50070**

**SAFETYINSURANCE GROUP, INC.**

**(Exact name of registrant asspecified in its charter)**

| **Delaware**                                                     |   | **13-4181699**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**20 Custom House Street,Boston, Massachusetts 02110**

(Address of principalexecutive offices including zip code)

**(617) 951-0600**

(Registrant’s telephonenumber, including area code)

**Securitiesregistered pursuant to Section 12(b) of the Act:**
| Title of each class                          | Name of each  exchange on which registered |
|----------------------------------------------|--------------------------------------------|
| **Common Shares, $0.01 par value per share** | **NASDAQ  Global Select Market**           |

 

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

Indicate by check markwhether the registrant is not required to file reports pursuant to Section 13of Section 15(d) of the Act.    Yes    o    No    x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.    Yes    x    No    o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§ 229.405 of this chapter) is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.    x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer    o    Accelerated filer    x    Non-accelerated filer    o

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

The aggregate market valueof the registrant’s voting and non-voting common equity (based on the closingsales price on NASDAQ) held by non-affiliates of the registrant as of June 30,2006, was approximately $679,472,762.

As of February 26,2007, there were 16,100,432 Common Shares with a par value of $0.01 per shareoutstanding.

**Documents Incorporated byReference**

Portionsof the registrant’s definitive proxy statement for its Annual Meeting ofShareholders to be held on May 18, 2007, which Safety Insurance Group, Inc.(the “Company”, “we”, “our”, “us”) intends to file within 120 days afterits December 31, 2006 year-end, are incorporated by reference into Part IIIhereof.

 

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**SAFETY INSURANCEGROUP, INC.Table of Contents**
|                    | ** **                                                                                           | ** ** | **Page  No.** |
|--------------------|------------------------------------------------------------------------------------------------------|------------|---------------|
| **PART I.**   |                                                                                                 |       |          |
| **Item 1.**        | **Business**                                                                                         | ** ** | ** **    | 1 | ** ** |
| **Item 1A.**       | **Risk  Factors**                                                                                    | ** ** | ** **    | 30 | ** ** |
| **Item  1B.**      | **Unresolved  Staff Comments**                                                                       | ** ** | ** **    | 35 | ** ** |
| **Item 2.**        | **Properties**                                                                                       | ** ** | ** **    | 35 | ** ** |
| **Item 3.**        | **Legal  Proceedings**                                                                               | ** ** | ** **    | 36 | ** ** |
| **Item 4.**        | **Submission of Matters to a  Vote of Security Holders**                                             | ** ** | ** **    | 36 | ** ** |
| **PART II.**  |                                                                                                 |       |          |   |   |
| **Item 5.**        | **Market for Registrant’s  Common Equity and Related Stockholder Matters**                      | ** ** | ** **    | 37 | ** ** |
| **Item  6.**       | **Selected  Financial Data**                                                                         | ** ** | ** **    | 39 | ** ** |
| **Item 7.**        | **Management’s Discussion and  Analysis of Financial Condition and Results of Operation**       | ** ** | ** **    | 42 | ** ** |
| **Item 7A.**       | **Quantitative and Qualitative  Disclosures About Market Risk**                                      | ** ** | ** **    | 69 | ** ** |
| **Item  8.**       | **Financial  Statements and Supplementary Data**                                                     | ** ** | ** **    | 70 | ** ** |
| **Item  9.**       | **Changes  in and Disagreements With Accountants on Accounting and Financial Disclosure**            | ** ** | ** **    | 98 | ** ** |
| **Item 9A.**       | **Controls and Procedures**                                                                          | ** ** | ** **    | 98 | ** ** |
| **Item 9B.**       | **Other Information**                                                                                | ** ** | ** **    | 98 | ** ** |
| **PART III.** |                                                                                                 |       |          |   |   |
| **Item  10.**      | **Directors,  Executive Officers and Corporate Governance**                                          | ** ** | ** **    | 99 | ** ** |
| **Item 11.**       | **Executive Compensation**                                                                           | ** ** | ** **    | 99 | ** ** |
| **Item  12.**      | **Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters** | ** ** | ** **    | 100 | ** ** |
| **Item  13.**      | **Certain  Relationships and Related Transactions, and Directors Independence**                      | ** ** | ** **    | 100 | ** ** |
| **Item  14.**      | **Principal  Accountant Fees and Services**                                                          | ** ** | ** **    | 100 | ** ** |
| **PART IV.**  |                                                                                                 |       |          |   |   |
| **Item  15.**      | **Exhibits,  Financial Statement Schedules**                                                         | ** ** | ** **    | 100 | ** ** |
| **SIGNATURES**     |                                                                                                 |       | 109           |   |

 

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*In this Form 10-K, all dollar amounts arepresented in thousands, except average premium, average claim and per claimdata, share, and per share data.*

**PART I.**

***ITEM 1.****                 BUSINESS*

**General**

We are a leading providerof private passenger automobile insurance in Massachusetts. In addition toprivate passenger automobile insurance (which represented 76.0% of our directwritten premiums in 2006), we offer a portfolio of property and casualtyinsurance products, including commercial automobile, homeowners, dwelling fire,umbrella and business owner policies. Operating exclusively in Massachusettsthrough our insurance subsidiaries, Safety Insurance Company (“Safety Insurance”),Safety Indemnity Insurance Company (“Safety Indemnity”) and Safety Property andCasualty Insurance Company (“Safety P&C”) which was organized in December 2006but has not yet commenced writing business (together referred to as the “InsuranceSubsidiaries”), we have established strong relationships with 652 independentinsurance agents in 760 locations throughout Massachusetts. We have used theserelationships and our extensive knowledge of the Massachusetts market to becomethe second largest private passenger automobile carrier, capturing anapproximate 11.2% share of the Massachusetts private passenger automobileinsurance market, and the third largest commercial automobile carrier, with an11.8% share of the Massachusetts commercial automobile insurance market, in2006 according to statistics compiled by Commonwealth Automobile Reinsurers (“CAR”).In addition, we were also ranked the 44th largest automobile writer in the countryaccording to A.M. Best, based on 2005 direct written premiums. We wereincorporated under the laws of Delaware in 2001, but through our predecessors,we have underwritten insurance in Massachusetts since 1979.

We have maintainedprofitability in part by managing our cost structure through, for example, theuse of technology. Our share of the Massachusetts private passenger automobileinsurance market has grown from 10.4% in 2001 to 11.2% in 2006 and we havecontinued to expand our product offerings. Our direct written premiums haveincreased by 33.4% between 2001 and 2006, from $471,866 to $629,511. However,our direct written premiums decreased by 3.0% between 2005 and 2006 as a resultof a state mandated private passenger automobile rate decrease of 8.7%effective January 1, 2006. On December 15, 2006 the Commissioner ofInsurance further reduced the private passenger automobile rates 11.7%effective April 1, 2007. As a result, we anticipate a further reduction inprivate passenger automobile direct written premiums for 2007.

**Website Access to Information**

The Internet address forour website is *www.SafetyInsurance.com*.All of our press releases and United States Securities and ExchangeCommission (‘SEC”) reports are available for viewing or download at ourwebsite. These documents are made available on our website as soon asreasonably practicable after each press release is made and SEC report is filedwith, or furnished to, the SEC. Copies of any current public information aboutour company are available without charge upon written, telephone, faxed ore-mailed request to the Office of Investor Relations, Safety Insurance Group, Inc.,20 Custom House Street, Boston, MA 02110, Tel: 877-951-2522,Fax: 617-603-4837, or e-mail: *InvestorRelations@SafetyInsurance.com*.The materials on our website are not part of this report on Form 10-Knor are they incorporated by reference into this report and the URL above isintended to be an inactive textual reference only.

**Our Competitive Strengths**

*We Have StrongRelationships with Independent Agents.*   In 2005, independent agentsaccounted for approximately 78.2% of the Massachusetts automobile insurancemarket measured by direct written 

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premiums ascompared to only about 40.9% nationwide, according to A.M. Best. For thatreason, our strategy is centered around, and we sell exclusively through, anetwork of 652 independent agents (of which 157 are Exclusive RepresentativeProducers (“ERPs”)) in 760 locations throughout Massachusetts. In order tosupport our independent agents and enhance our relationships with them, we:

·       Provideour agents with a portfolio of property and casualty insurance products atcompetitive prices to help our agents address effectively the insurance needsof their clients;

·       Provideour agents with a variety of technological resources which enable us to deliversuperior service and support to them; and

·       Offerour agents competitive commission schedules and profit sharing programs.

Through these measures, westrive to become the preferred provider of the independent agents in our agencynetwork and capture a growing share of the total insurance business written bythese agents in Massachusetts. We must compete with other insurance carriersfor the business of independent agents.

*We Have an UninterruptedRecord of Profitable Operations.*   In every year since ourinception in 1979, we have been profitable. We have achieved our profitablegrowth by, among other things:

·       Increasingby 9.0% the number of private passenger automobile exposures we underwrite from427,000 in 2001 to 465,416 in 2006 and the average premium we receive perautomobile exposure from $918 to $1,019.

·       Maintaininga statutory combined ratio (refer to page 41 for a definition of statutorycombined ratio) that is consistently below industry averages;

·       Takingadvantage of the institutional knowledge our management has amassed during ourlong operating history in the unique Massachusetts market;

·       Introducingnew lines of insurance products, such as homeowners, which unlike privatepassenger automobile do not have state-established maximum premium rates;

·       Investingin technology to simplify internal processes and enhance our relationships withour agents; and

·       Maintaininga high-quality investment portfolio.

*We Are a TechnologicalLeader.*   Wehave dedicated significant human and financial resources to the development ofadvanced information systems. Our technology efforts have benefited us in twodistinct ways. First, we continue to develop technology that empowers ourindependent agent customers to make it easier for them to transact businesswith their clients and with the Insurance Subsidiaries. In our largest businessline, private passenger automobile insurance, our agents now submitapproximately 98% of all applications for new policies or endorsements forexisting policies to us electronically through our proprietary informationportal, the Agents Virtual Community (“AVC”). Second, our investment intechnology has allowed us to re-engineer internal back office processes toprovide more efficient service at lower cost. Our adjusted statutory expenseratios have been below the average industry statutory expense ratio in each ofthe past five years. Our systems have also improved our overall productivity,as evidenced by our direct written premiums per employee increasing to $1,087in 2006 from $929 in 2001.

*We Have an Experienced,Committed and Knowledgeable Management Team.*   Our senior management teamowns approximately 7% of the common stock of Safety Insurance Group, Inc.on a fully diluted basis. Our senior management team, led by our President,Chief Executive Officer and Chairman of the Board, David F. Brussard, has an averageof over 27 years of industry experience per executive, as well as anaverage of over 25 years of experience with Safety. The team hasdemonstrated an ability to operate successfully within the regulatedMassachusetts private passenger automobile insurance market.

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**Our Strategy**

Toachieve our goal of increasing shareholder value, our strategy is to maintainand develop strong independent agent relationships by providing our agents witha full package of insurance products and information technology services. Webelieve this strategy will allow us to:

·       Furtherpenetrate the Massachusetts private passenger and commercial automobileinsurance markets;

·       Continueto selectively cross-sell homeowners, dwelling fire, personal umbrella in thepersonal lines market and business owner policies, commercial property packageand commercial umbrella in the commercial lines market in order to capture alarger share of the total Massachusetts property and casualty insurancebusiness written by each of our independent agents; and

·       Continue to expand ourtechnology to enable independent agents to more easily serve their customersand conduct business with us, thereby strengthening their relationships withus.

**TheMassachusetts Property and Casualty Insurance Market**

*Introduction.*   We are licensed by theCommonwealth of Massachusetts Commissioner of Insurance (“the Commissioner”) totransact property and casualty insurance in Massachusetts. All of our businessis extensively regulated by the Commissioner.

*The Massachusetts Marketfor Private Passenger Automobile Insurance.*   Private passenger automobileinsurance is heavily regulated in Massachusetts. In many respects, the privatepassenger automobile insurance market in Massachusetts is unique, in comparisonto other states. This is due to a number of factors, including unusualregulatory conditions, the market dominance of domestic companies, the relativeabsence of large national companies, and the heavy reliance on independentinsurance agents as the market’s principal distribution channel. For manyinsurance companies, these factors present substantial challenges, but webelieve they provide us a competitive advantage, because, as our financialhistory shows, we have a thorough understanding of this market.

Theprincipal factors that generally distinguish the Massachusetts privatepassenger automobile insurance market from that market in other states are asfollows:

·       *Compulsory Insurance.*Massachusettsmotorists must obtain automobile insurance prior to registering a vehicle withthe Registry of Motor Vehicles. Insurers are required to notify the Registry ofMotor Vehicles when coverage is cancelled and the Registry of Motor Vehicles isauthorized to seize the license plates of uninsured motor vehicles.

·       *“Take All Comers.”* With very fewexceptions, CAR, which is the residual market program for automobile insurancein Massachusetts, may not refuse to cover an applicant. Servicing carriers ofCAR, such as us, may not refuse to issue a policy to an applicant based on theapplicant’s driving record or other underwriting criteria commonly used byinsurers in other states to decide whether to insure a motorist.

·       *Standard Policy Form.*The policy form thatis used by all automobile insurers is developed by the Commissioner and must beused by all companies. The policy consists of several mandatory coverages: nofault coverage (i.e., “personal injury protection”); minimum limits of bodilyinjury and property damage liability coverage; and coverage for accidentscaused by uninsured or hit-and-run motorists. In addition to these standardmandatory coverages, several additional optional coverages (such as higherbodily injury and property damage liability coverages, and collision andcomprehensive coverages) must be offered. No carrier may offer any other typeof coverage or deductible or use any form of policy endorsement without theprior approval of the Commissioner, which can be granted only after a formalhearing.

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·       *Premium Rates are “fixed and established” by theCommissioner*. In Massachusetts, automobile insurance companies areobligated to use premium rates that are determined on an annual basis by theCommissioner. As a matter of law, the Commissioner’s rate must be adequate,which the Massachusetts courts have ruled requires that the rate be sufficientto allow insurers the opportunity to earn a reasonable rate of return. The ratesetting process involves a lengthy and complex administrative proceeding inwhich the Commissioner considers historic information related to claim costs aswell as outside factors affecting insurance costs. Different data is presentedfor the Commissioner’s consideration by the Automobile Insurers Bureau (onbehalf of the insurance industry), the State Rating Bureau, and theMassachusetts Attorney General. At the close of this proceeding, theCommissioner sets a premium rate for each of several classes of drivers, manydifferent types of vehicles, and thirty-three different geographic territorieswithin Massachusetts. The Commissioner usually sets the rate on or before December 15th of the preceding year. The Commissionermandated average rate decreases in private passenger automobile premiums of8.7% and 1.7% for 2006 and 2005, respectively, and an increase of 2.5% for 2004.Beginning in 2007 the effective date of the Commissioner’s rate decision willbe April 1st of eachyear as compared to January 1st of2006 and prior rate decisions. Hence, the 2006 rates will be in effect from January 1,2006, until March 31, 2007. The Commissioner announced on December 15,2006, an 11.7% statewide average rate decrease effective April 1, 2007. Inaddition, the Commissioner annually establishes the minimum commission ratethat insurers must pay their auto insurance agents. The Commissioner approved acommission rate, as a percentage of premiums of 11.8%, 10.9%, and 10.5%, in2006, 2005, and 2004, respectively. The Commissioner approved a commission rateof 13.0% effective April 1, 2007.

·       *Safe Driver Insurance Plan.*In otherstates, insurance companies are free to design their own systems for rewardingdrivers with superior driving records by providing lower prices to such driversand charging higher prices for drivers who have caused claims or who have poordriving records. In Massachusetts, all companies must use the system the Commissionerhas developed. Known as the Safe Driver Insurance Plan, the system was revisedeffective January 1, 2006 and is based on points assessed for at-faultaccidents and conviction of certain traffic violations. The Plan consists of aseries of points ranging from 0 points to 45 points, with each point above 0points imposing surcharges on motorists. The revised Plan offers credits tomotorists with two excellent driver awards, an Excellent Driver Discount Plus(Credit code 99) for a driver with no accidents or violations in the preceding6 years, and an Excellent Driver Discount (Credit code 98) for a driver with noaccidents or violations in the preceding 5 years. Each driver is assignedpoints by the state. The Safe Driver Insurance Plan system is revenue neutral,which means that the aggregate cost of the discounts must be funded by theaggregate income of the surcharges.

·       *Price competition is limited.*An insurermay charge less than the Commissioner’s fixed and established premium rates byoffering discounts to all members of a particular class of motorists, but onlyif the discount is approved by the Commissioner after a public hearing. Duringthe years 1996 to 2001, most insurance companies offered rate discounts fordrivers with the best driving records. We offered competitively priceddiscounts during the 1996 to 2001 time period, but like most of ourcompetitors, we have discontinued using these discounts since 2001. Only twocompanies offered such discounts in 2005, further reduced to one company in2006.

·       *Affinity Group Marketing.*In addition tothe use of class discounts, insurers can charge lower rates than theCommissioner’s fixed rate by providing discounts to all members of an affinitygroup. An affinity group consists of all of the employees of a particularemployer or the members of a trade union, association or other organization.These discounts must be filed with the Commissioner and are subject to theCommissioner’s approval. We currently offer discounts to 192 groups 

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representing approximately9.0% of the private passenger automobile policies we issue, with discountsranging from 3% to 5%.

·       *Exclusive Representative Producers.*Asnoted above, the Commissioner sets a different rate for each of thirty-threeterritories in Massachusetts. The methodology the Commissioner uses to adjustthe rates among each territory results in the reduction of rates in high costurban communities from the actuarially appropriate rate while increasing ratesin suburban and rural parts of Massachusetts. As a result, in the aggregate,rates in urban communities are considered inadequate by most insurers. In orderto ensure that motorists living in such communities have access to automobileinsurance, licensed insurance producers located in such areas who have not beenappointed as a voluntary agent of a company may apply to CAR, to be appointedas an involuntary agent, or ERP, of an insurer selected by CAR. ERPs areassigned to all insurers writing private passenger automobile insurance inMassachusetts and ERP assignments are generally based upon an insurer’s marketshare. On September 30, 2005, the Commissioner instructed CAR to completea redistribution of all ERPs to establish for all servicing carriers overallparity in the quantity and quality of their ERP exposures. ERP assignments andother recent related developments are discussed further in Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations,Executive Summary and Overview.

·       *Commonwealth Automobile Reinsurers.*Inorder to protect insurers from the assignment of ERPs and certain otherinsurance regulatory conditions, the Massachusetts Legislature created CAR,which runs a reinsurance pool. CAR is governed by a committee that is appointedby the Commissioner, but its rules and decisions are subject to the reviewand approval of the Commissioner. Under CAR’s current rules, companies may cedeto the reinsurance pool private passenger policies that they determine are notlikely to be profitable. As a result, CAR operates at an underwriting deficit.This deficit is allocated among every private passenger automobile insurancecompany based on a complex formula that takes into consideration a company’svoluntary market share, the amount of business it cedes to CAR and credits thecompany earns under a system CAR has designed to encourage carriers tovoluntarily write business in selected under-priced classes andterritories. We have developed underwriting and actuarial analysis systems toevaluate the profitability of ceding a risk to CAR or writing it voluntarily.CAR also runs a reinsurance pool for commercial automobile policies andbeginning January 1, 2006, we are one of six servicing carriers that canservice commercial automobile policies for CAR. Commercial automobile businessthat is not written in the voluntary market is apportioned to one of the sixservicing carriers who handle the business on behalf of CAR. The underwritingresult of CAR’s commercial automobile pool is allocated among everyMassachusetts commercial automobile insurance company, based each company’scommercial automobile voluntary market share.

·       *Proposed Reform of CAR.*On December 31,2004, the then Commissioner approved new rules for CAR, which becameeffective on January 1, 2005 (the “Approved Rules”). Pursuant to theApproved Rules, CAR’s current system of assigning ERPs to each insurer andproviding reinsurance to insurers is to be replaced by the MassachusettsAutombile Insurance Plan (the “MAIP”). The MAIP is a type of assigned risk plansimilar to that used to manage the automobile insurance residual market in mostother states. On June 20, 2005, the Massachusetts Superior Court ruledthat the Commissioner lacked the statutory authority to implement the Approved Rules andordered them vacated. As a result, the Approved Rules did not go intoeffect. The Commissioner appealed the decision of the Massachusetts SuperiorCourt. On August 23, 2006, the Massachusetts Supreme Judicial Courtoverturned the decision of the Massachusetts Superior Court and unanimouslyruled that the Commissioner did not need legislative approval to put in placethe provisions in the Approved Rules which establish an assigned riskplan. On December 13, 2006, the Commissioner approved changes to the MAIPthat called for three year phase in of an assigned risk 

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plan beginning April 1,2007, to minimize disruption to consumers and agents. On January 19, 2007,following the dismissal of the Commissioner by newly elected Governor DevalPatrick, Acting Commissioner Joseph G. Murphy suspended the MAIP Rules (the“Suspended Rules”) for a period not to exceed 90 days. A hearing was held on February 15,2007, for testimony regarding the Suspended Rules and recommendations oramendments to those Rules. At this time we are unable to predict whether theSuspended Rules will be delayed for more than 90 days, modified, adoptedor rescinded. The Suspended Rules and other recent related developmentsare discussed further in Item 7—Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, Executive Summary and Overview.

·       *Dominance of Domestic Companies.*Manylarge national private passenger automobile insurance writers, such as StateFarm, Allstate, Progressive, Berkshire Hathaway (GEICO), and Farmers, writevery little or no private passenger automobile insurance business inMassachusetts. We actively participate in major industry policy-makingorganizations in Massachusetts, such as the Automobile Insurers Bureau and CAR,where our employees serve on a number of committees.

·       *Prominence of Independent Insurance Agents.*Finally, andperhaps most importantly to our Company’s success, approximately 78.2% of thedirect written premiums in the Massachusetts automobile insurance market wasplaced by independent agents in 2005, according to A.M. Best. Nationally,independent agents wrote only about 40.8% of the automobile insurance market in2005, according to A.M. Best. Accordingly, to be successful, a companymust have a strategy designed to encourage the best agents to place their bestbusiness with that company. We have designed a system of agent commissions,profit sharing, bonuses and other strategies, such as our informationtechnology capabilities, that we believe favorably distinguishes our companyfrom our competitors. We aggressively market our company to independent agentsin attempting to get the best agents and the best business.

**Products**

Historically, we havefocused on underwriting private passenger automobile insurance, which iswritten through our subsidiary, Safety Insurance, at rates that are determinedon an annual basis by the Commissioner. In 1989, we formed Safety Indemnity tooffer commercial automobile insurance at preferred rates. Since 1997, we haveexpanded the breadth of our product line in order for agents to address agreater portion of their clients’ insurance needs by selling multiple products.Homeowners, business owners policies, personal umbrella, dwelling fire andcommercial umbrella insurance are written by Safety Insurance at standardrates, and written by Safety Indemnity at preferred rates. In December 2006,we formed Safety P&C which will be used to add a third pricing tier tocertain of our insurance products for our agents to sell to their clients. Thetable below shows our premiums in each of these product lines for the periodsindicated and the portions of our total premiums each product line represented.

| ** **                            | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------|------------|---------------------------------------------------------------|-------------|
| **Direct Written Premiums** | ** ** | ** **                                                    | ** **  | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Private passenger automobile          | ** ** | **$**                                                         | **478,175** | ** ** | **76.0** | **%** | $ | 521,062 |   | 80.3 | % | $ | 509,038 |   | 81.0 | % |
| Commercial automobile                 | ** ** | **88,174**                                                    | ** **  | **14.0** |   | 69,963 |   | 10.8 |   | 65,057 |   | 10.4 |   |
| Homeowners                            | ** ** | **49,644**                                                    | ** **  | **7.9** |   | 47,055 |   | 7.2 |   | 45,175 |   | 7.2 |   |
| Business owners policies              | ** ** | **9,204**                                                     | ** **  | **1.5** |   | 7,073 |   | 1.1 |   | 5,332 |   | 0.8 |   |
| Personal umbrella                     | ** ** | **1,811**                                                     | ** **  | **0.3** |   | 1,645 |   | 0.3 |   | 1,647 |   | 0.3 |   |
| Dwelling fire                         | ** ** | **1,971**                                                     | ** **  | **0.3** |   | 1,878 |   | 0.3 |   | 1,728 |   | 0.3 |   |
| Commercial umbrella                   | ** ** | **532**                                                       |        | — |   | 437 |   | — |   | 318 |   | — |   |
| Total                                 | ** ** | **$**                                                         | **629,511** | ** ** | **100.0** | **%** | $ | 649,113 |   | 100.0 | % | $ | 628,295 |   | 100.0 | % |
|                                       |            |                                                               |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Our product lines are as follows:

*PrivatePassenger Automobile (76.0% of 2006 direct written premiums).*   Private passenger automobileinsurance is our primary product, and we support all Massachusetts policy formsand limits of coverage. Private passenger automobile policies provide coveragefor bodily injury and property damage to others, no-fault personal injurycoverage for the insured/insured’s car occupants, and physical damage coveragefor an insured’s own vehicle for collision or other perils. We have priced ourprivate passenger coverage competitively by offering group discounts since 1995and Safe Driver Insurance Plan rate deviations from 1996 to 2001. Since 2001,we have not filed for any Safe Driver Insurance Plan deviation. We currentlyoffer approximately 192 affinity group discount programs ranging from 3% to 5%discounts.

*CommercialAutomobile (14.0% of 2006 direct written premiums).*   Our commercial automobileprogram supports all Massachusetts policy forms and limits of coverageincluding endorsements that broaden coverage over and above that offered on thestandard Massachusetts policy forms. Commercial automobile policies providecoverage for bodily injury and property damage to others, no-fault personalinjury coverage, and physical damage coverage for an insured’s own vehicle forcollision or other perils resulting from the ownership or use of commercialvehicles in a business. We offer insurance for commercial vehicles used forbusiness purposes such as private passenger-type vehicles, trucks, tractors andtrailers, and insure individual vehicles as well as commercial fleets.Commercial automobile policies are written at a standard rate with qualifyingrisks eligible for preferred lower rates. We received approval for a rateincrease of 2.1% effective December 16, 2004, and did not file for a ratechange during 2005 or 2006.

*Homeowners(7.9.% of 2006 direct written premiums).*   We offer a broad selection ofcoverage forms for qualified policyholders. Homeowners policies providecoverage for losses to a dwelling and its contents from numerous perils, andcoverage for liability to others arising from ownership or occupancy. We writepolicies on homes, condominiums, and apartments. We offer loss-free credits ofup to 16% for eight years of loss free experience, along with a discount of 15%when a home is written together with an automobile. All forms of homeownerscoverage are written at a standard rate with qualifying risks eligible forpreferred lower rates. We received approval for a rate increase of 3.4%effective March 1, 2007.

*BusinessOwners Policies (1.5% of 2006 direct written premiums).*   We serve eligible small andmedium sized commercial accounts with a program that covers apartments andresidential condominiums; mercantile establishments, including limited cookingrestaurants; offices, including office condominiums; processing and servicesbusinesses; special trade contractors; and wholesaling businesses. Businessowner policies provide liability and property coverage for many perils,including business interruption from a covered loss. Equipment breakdowncoverage is automatically included, and a wide range of additional coverage isavailable to qualified customers. We write policies for business owners atstandard rates with qualifying risks eligible for preferred lower rates.

*CommercialPackage Policies (Included in our Business Owners Policies direct writtenpremiums).*   Forlarger commercial accounts, or those clients that require more specialized ortailored coverages, we offer a commercial package policy program that covers amore extensive range of business enterprises. Commercial package policiesprovide any combination of property, general liability, crime and inland marineinsurance. Property automatically includes equipment breakdown coverage, and awide range of additional coverage is available to qualified customers. We writecommercial package policies at standard rates with qualifying risks eligiblefor preferred lower rates.

*PersonalUmbrella (Less than 0.3% of 2006 direct written premiums).*   We offer personal excessliability coverage over and above the limits of individual automobile,watercraft, and homeowner’s insurance policies to clients. We offer a discountof 10% when an umbrella policy is written together with an automobile insurancepolicy. We write policies at standard rates with limits of $1,000 to $5,000.

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*DwellingFire (0.3% of 2006 direct written premiums).*   We underwrite dwelling fireinsurance, which is a limited form of a homeowner’s policy for non-owner occupiedresidences. We offer superior construction and protective device credits, witha discount of 5% when a dwelling fire policy is issued along with an automobilepolicy. We write all forms of dwelling fire coverage at standard rates withqualifying risks eligible for preferred lower rates.

*CommercialUmbrella (Less than 0.1% of 2006 direct written premiums).*   We offer an excess liabilityproduct to clients for whom we underwrite both commercial automobile andbusiness owner policies. The program is directed at commercial automobile riskswith private passenger-type automobiles or light and medium trucks. We writecommercial umbrella policies at standard rates with limits ranging from $1,000to $5,000.

*InlandMarine (Included in our Homeowners direct written premiums).*   We offer inland marinecoverage as an endorsement for all homeowners and business owner policies, andas part of our commercial package policy. Inland marine provides additionalcoverage for jewelry, fine arts and other items that a homeowners or businessowner policy would limit or not cover. Scheduled items valued at more than $5must meet our underwriting guidelines and be appraised.

*Watercraft(Included in our Homeowners direct written premiums).*   We offer watercraft coveragefor small and medium sized pleasure craft with maximum lengths of 32 feet,valued at less than $75 and maximum speed of 39 knots. We write this coverageas an endorsement to our homeowner’s policies.

In the wake of the September 11,2001 tragedies, the insurance industry is also impacted by terrorism, and wehave filed and received approval for a number of terrorism endorsements fromthe Commissioner, which limit our liability and property exposure according tothe Terrorism Risk Insurance Act of 2002, and the Terrorism Risk InsuranceExtension Act of 2005. See “Reinsurance”, discussed below.

**Distribution**

We distribute our products exclusively throughindependent agents, unlike some of our competitors, which use multiple distributionchannels. We believe this gives us a competitive advantage with the agents. Wehave two types of independent agents: those with which we have voluntarilyentered into an agreement, which we refer to as voluntary agents, and thosethat CAR has assigned to us as ERPs. With the exception of our ERPs, we do notaccept business from insurance brokers. Our voluntary agents have authoritypursuant to our voluntary agency agreement to bind our Insurance Subsidiariesfor any coverage that is within the scope of their authority. We reserve theability under Massachusetts law to cancel any coverage, other than privatepassenger automobile insurance, within the first 30 days after it isbound. In total, our 652 independent agents have 760 offices (some agencieshave more than one office) and approximately 4,500 customer servicerepresentatives.

*VoluntaryAgents.**  *In2006, we obtained approximately 77.0% of our direct written premiums forautomobile insurance and 100% of our direct written premiums for all of ourother lines of business through our voluntary agents. As of February 28,2007, we had agreements with 495 voluntary agents. Our voluntary agents arelocated in all regions of Massachusetts.

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We look for agents with profitable portfolios ofbusiness. To become a voluntary agent for our Company, we generally requirethat an agency: (i) have been in business for at least five years; (ii) haveexhibited a three year private passenger average ratio of losses, excludingloss adjustment expenses, to net earned premiums (“pure loss ratio”) of 64.0%or less on the portion of the agent’s portfolio that we would underwrite; (iii) makea commitment for us to underwrite at least 500 policies from the agency duringthe first twelve months after entering an agreement with us; and (iv) offermultiple product lines. Every year, we review the performance of our agentsduring the prior year. If an agent fails to meet our profitability standards,we try to work with the agent to improve the profitability of the business itplaces with us. We generally terminate contracts each year with a few agencies,which, despite our efforts, have been consistently unable to meet ourstandards. Although independent agents usually represent several unrelatedinsurers, our goal is to be one of the top two insurance companies representedin each of our agencies, as measured by premiums. No individual agencygenerated more than 3.0% of our direct written premiums in 2006.

*ExclusiveRepresentative Producers.**  *In 2006, our ERPs generated approximately 23.0% ofour direct written premiums for automobile insurance. As of December 31,2006, we had 63 private passenger automobile ERPs. CAR defines ERPs as licenseddwelling fire or casualty insurance agents or brokers who have a place ofbusiness in Massachusetts, but have no existing voluntary independent agencyrelationship with an automobile insurer conducting business in Massachusetts.An ERP’s policy portfolio typically includes a significant percentage of what areconsidered to be under-priced automobile policies.

Massachusetts law guarantees that CAR provide motorvehicle insurance coverage to all qualified applicants. To facilitate thissystem, under CAR’s current rules, any qualified licensed insurance producerthat is unable to obtain a voluntary automobile relationship with an insurerbecomes an ERP and is assigned to an insurer, which is then required to writethat agent’s policies. The number of mandated ERP policies assigned to aMassachusetts insurance carrier is intended to be proportionate to itsvoluntary market share. However, because no insurer can control the relativevolumes of voluntary and ERP business with certainty, carriers are usuallyeither relatively oversubscribed or undersubscribed with ERP policies.Periodically, CAR assigns or re-assigns an ERP to the most undersubscribedinsurer.

On September 30, 2005, the Commissionerinstructed CAR to complete a redistribution of all ERPs to establish for allservicing carriers overall parity in the quantity and quality of their ERPexposures. The redistribution plan for ERPs, as adopted by the CAR GoverningCommittee on November 16 and December 14, 2005, was approved by theCommissioner on January 27, 2006. On January 31, 2006, CAR notifiedeach reassigned ERP and all servicing carriers of the redistribution. Accordingto the January 31, 2006 CAR Private Passenger ERP Redistribution Summary,18 Safety ERPs with 25,590 exposures were assigned to other servicing carriersbeginning with new business effective March 1, 2006 and renewal business May 1,2006. In addition, CAR assigned 29 ERPs with 24,670 exposures from otherservicing carriers to Safety. However 25 of these ERPs with 23,116 exposureswere given voluntary contracts by their former servicing carrier or othercarriers and were, as a result, no longer eligible for assignment to Safety asERPs. The redistribution and other recent related CAR developments arediscussed further in Item 7—Management’s Discussion and Analysis of FinancialCondition and Results of Operations, Executive Summary and Overview.

Beginning January 1, 2006, CAR implemented aLimited Servicing Carrier Program (the “LSC program”) for ceded commercialautomobile policies. CAR approved Safety and five other servicing carriersthrough a Request for Proposal to process approximately $200,000 of cededcommercial automobile business based on CAR data as of December 31, 2005,which will be spread equitably among the six servicing carriers. CAR assigned353 voluntary agents (many of which were already voluntary agents of Safety)and 103 ERPs to Safety for the LSC program.

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Thetable below shows our direct written exposures in each of our product lines forthe periods indicated and the change in exposures for each product line.

| ** **                                | ** ** | **For the Years Ended December 31,** | ** **  |
|-------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Line of Business**            | ** ** | ** **                                                    | ** **  | **Exposures** | ** ** | **Change** | ** ** | **Exposures** | ** ** | **Change** | ** ** | **Exposures** | ** ** | **Change** | ** ** |
| Private passenger  automobile             | ** ** |                                                          | ** **  |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Voluntary agents                          | ** ** |                                                          | **366,220** |   | ** ** | ** ** | **3.7** | **%** |   |   | 353,109 | ** ** |   |   | 3.4 | % |   |   | 341,517 | ** ** |   |   | 2.3 | % |   |
| Exclusive Representative Producers        | ** ** |                                                          | **99,196**  |   | ** ** | ** ** | **-15.3** | ** ** |   |   | 117,112 | ** ** |   |   | -0.4 |   |   |   | 117,616 | ** ** |   |   | 7.4 |   |   |
| Private passenger automobile total        | ** ** |                                                          | **465,416** |   | ** ** | ** ** | **-1.0** | ** ** |   |   | 470,221 | ** ** |   |   | 2.4 |   |   |   | 459,133 | ** ** |   |   | 3.5 |   |   |
| Commercial automobile                     | ** ** |                                                          | ** **  |   | ** ** | ** ** | ** ** | ** ** |   |   |   | ** ** |   |   |   |   |   |   |   | ** ** |   |   |   |   |   |
| Voluntary Agents                          | ** ** |                                                          | **48,117**  |   | ** ** | ** ** | **3.7** | ** ** |   |   | 46,396 | ** ** |   |   | 7.5 |   |   |   | 43,174 | ** ** |   |   | 5.7 |   |   |
| Exclusive Representative Producers        | ** ** |                                                          | **6,619**   |   | ** ** | ** ** | **180.5** | ** ** |   |   | 2,360 | ** ** |   |   | 9.6 |   |   |   | 2,153 | ** ** |   |   | 4.3 |   |   |
| Commercial automobile total               | ** ** |                                                          | **54,736**  |   | ** ** | ** ** | **12.3** | ** ** |   |   | 48,756 | ** ** |   |   | 7.6 |   |   |   | 45,327 | ** ** |   |   | 5.6 |   |   |
| Homeowners                                | ** ** |                                                          | **64,020**  |   | ** ** | ** ** | **-0.3** | ** ** |   |   | 64,193 | ** ** |   |   | -2.9 |   |   |   | 66,120 | ** ** |   |   | -2.0 |   |   |
| Business owners  policies                 | ** ** |                                                          | **4,838**   |   | ** ** | ** ** | **22.5** | ** ** |   |   | 3,950 | ** ** |   |   | 24.4 |   |   |   | 3,174 | ** ** |   |   | 19.3 |   |   |
| Personal umbrella                         | ** ** |                                                          | **7,705**   |   | ** ** | ** ** | **2.9** | ** ** |   |   | 7,491 | ** ** |   |   | 0.2 |   |   |   | 7,478 | ** ** |   |   | 0.7 |   |   |
| Dwelling fire                             | ** ** |                                                          | **2,173**   |   | ** ** | ** ** | **-3.2** | ** ** |   |   | 2,245 | ** ** |   |   | -5.7 |   |   |   | 2,381 | ** ** |   |   | -2.4 |   |   |
| Commercial  umbrella                      | ** ** |                                                          | **311**     |   | ** ** | ** ** | **25.9** | ** ** |   |   | 247 | ** ** |   |   | 30.7 |   |   |   | 189 | ** ** |   |   | 13.9 |   |   |
| Total                                     | ** ** |                                                          | **599,199** |   | ** ** | ** ** | **0.4** | ** ** |   |   | 597,103 | ** ** |   |   | 2.3 |   |   |   | 583,802 | ** ** |   |   | 3.0 |   |   |
| Voluntary agents total                    | ** ** |                                                          | **493,384** |   | ** ** | ** ** | **3.3** | ** ** |   |   | 477,631 | ** ** |   |   | 2.9 |   |   |   | 464,033 | ** ** |   |   | 2.0 |   |   |
| Exclusive  Representative Producers total | ** ** |                                                          | **105,815** |   | ** ** | ** ** | **-11.4** | **%** |   |   | 119,472 | ** ** |   |   | -0.2 | % |   |   | 119,769 | ** ** |   |   | 7.3 | % |   |
|                                           |            |                                                               |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our total writtenexposures increased by 0.4% for the year ended December 31, 2006. Theincrease was the result of our voluntary agent written exposures increasing by3.3% and our ERP written exposures decreasing by 11.4%. Our private passengerexposures decreased by 1.0% primarily as a result of the CAR ERPredistribution. Our commercial automobile exposures increased by 12.3%primarily as a result of the CAR LSC program. Our homeowners and dwelling fireexposures decreased 0.3% and 3.2%, respectively, due to our continuedre-underwriting of coastal properties. Our business owners policies, personalumbrella and commercial umbrella exposures increased 22.5%, 2.9% and 25.9%respectively primarily as a result of our voluntary agents efforts to sellmultiple products to their clients

**Marketing**

We view theindependent agent as our customer and business partner. As a result, ourmarketing efforts focus on developing interdependent relationships with leadingMassachusetts agents that write profitable business and positioning ourselvesas the preferred insurance carrier of those agents, thereby receiving a largerportion of each agent’s aggregate business. We do not market ourselves topotential policyholders. Our principal marketing strategies are:

·       Tooffer a range of products, which we believe enables our agents to meet theinsurance needs of their clients, and overcomes agents’ resistance to placingtheir clients’ automobile insurance and other coverages with differentinsurers;

·       Toprice our products competitively, including offering discounts when and whereappropriate for safer drivers and for affinity groups, and also offeringaccount discounts for policyholders that have both an automobile and homeownerspolicy with us;

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·       Tooffer agents competitive commissions, with incentives for placing their moreprofitable business with us; and

·       Toprovide a level of support and service that enhances the agent’s ability to dobusiness with its clients and with us.

*CommissionSchedule and Profit Sharing Plan.**  *We have several programs designedto attract profitable new private passenger automobile business from agents bypaying them more than the minimum commission the law requires (which is 11.8%of premiums for 2006, and 13.0% in 2007). We recognize our top performingagents by making them members of our President’s Club or Executive Club. In2006, President’s Club members received a commission equal to 17.0% of premiumsfor each new policy with a safe driver credit code of 99 and 98 (drivers withno accidents or violations in the prior six and five years respectively), whileExecutive Club members received a commission equal to 14.0% of premiums forsuch policies. In 2006, 62.7% of our drivers were in Safe Driver Insurance Plancredit code 99 and 98, as compared to 62.7% for the Massachusetts privatepassenger automobile industry as a whole, based on the number of drivers permonth in each step according to CAR.

Further, we have a competitive agency incentivecommission program under which we pay agents up to 8.0% of premiums based onthe loss ratio on their business.

We have received no inquiries from the Commissioner,the Massachusetts Attorney General, or any other government agency relative tohow we conduct our contingent commissions and profit sharing programs.

*Service and Support.**  *We believe that the level andquality of service and support we provide helps differentiate us from otherinsurers. We have made a significant investment in information technologydesigned to facilitate our agents’ business. Our AVC website helps agentsmanage their work efficiently. We provide a substantial amount of informationonline that agents need to serve their customers, such as information about thestatus of new policies, bill payments and claims. Providing this type of contentreduces the number of customer calls we receive and empowers the agent’scustomer service representatives by enabling them to respond to customers’inquiries while the customer is on the telephone. Finally, we believe that theknowledge and experience of our employees enhance the quality of support weprovide.

**Underwriting**

Our underwritingdepartment is responsible for a number of key decisions affecting theprofitability of our business, including:

·       Pricingof discounts offered on our private passenger automobile product;

·       Pricingof our commercial automobile, homeowners, dwelling fire, personal umbrella,business owners policies, commercial umbrella and commercial package products;

·       Determiningwhich policies to cede to CAR’s reinsurance pool and which to retain; and

·       Evaluatingwhether to accept transfers of a portion of an existing or potential new agent’sportfolio from another insurer.

We are organized into three underwriting units, aseparate unit for Massachusetts private passenger automobile, a separate unitfor all other personal lines underwriting including homeowners, dwelling fire,personal umbrella and inland marine coverages, and a separate unit forcommercial lines, including commercial auto, business owners policies,commercial umbrella and commercial package policies.

*Pricing.**  *Our pricing strategy for privatepassenger automobile insurance primarily depends on the maximum permittedpremium rates and minimum permitted commission levels mandated by the 

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Commissioner. For severalyears prior to 2002, we offered discounts off the state-mandated rates todrivers in the lower Safe Driver Insurance Plan steps, as did a number of otherinsurers. However, starting in 1998, we began to reduce the discounts weoffered, in light of the reductions or minimal increases in average rates theCommissioner has mandated in each year since 1998. We currently do not offerany Safe Driver Insurance Plan credit code-based discounts.

Although we do not currently offer any Safe DriverInsurance Plan discounts, we do offer group discounts to members of 192affinity groups, including the Boston College Alumni Association, theMassachusetts Bar Association and the Massachusetts Medical Society. Ingeneral, we target affinity groups with a mature and stable membership basealong with favorable driving records, offering between a 3% and 5% discount(with 4% being the average discount offered). Approximately 9.0% of the privatepassenger policies we issue receive an affinity group discount.

Subject to Commissioner review, CAR sets the premiumrates for commercial automobile policies reinsured through CAR. Subject toCommissioner review, we set rates for commercial automobile policies that arenot reinsured through CAR, and for all other insurance lines we offer,including homeowners, dwelling fire, personal umbrella, commercial umbrella,commercial package policies and business owner policies. We base our rates onindustry loss cost data, our own loss experience, residual market deficits,catastrophe modeling and prices charged by our competitors in the Massachusettsmarket. We have two pricing tiers for most products, utilizing Safety Insurancefor standard rates and Safety Indemnity for preferred rates. In December 2006,we formed Safety P&C which will be used to add a third pricing tier to ourinsurance products for our agents to sell to their clients. We receivedapproval for a rate increase of 2.1% for our commercial automobile lineeffective December 16, 2004, and did not file for a rate change during2005 or 2006. We received approval for a rate increase of 3.4% for ourhomeowners line effective March 1, 2007.

*Cede/RetainDecisions.**  *UnderCAR’s current rules for private passenger policies, we must decide, within23 days after the effective date of a new policy or before renewing anexisting policy, whether to cede it to CAR’s reinsurance pool. EachMassachusetts private passenger automobile insurer must bear a portion of thelosses of the private passenger reinsurance pool. Under CAR’s current rules, weare able to reduce our total allocated share of the losses of the reinsurancepool by ceding less business to the pool than our proportionate share. As aresult, in determining whether to cede an under priced policy to CAR’s privatepassenger automobile reinsurance pool, we attempt to evaluate whether we arelikely to incur greater total losses by ceding it to the pool or by retainingit. According to the January 19, 2007 CAR Cession Volume Analysis—PrivatePassenger Report, as of November 30, 2006, we have ceded 4.9% of ourprivate passenger automobile business to the pool in 2006, compared to anaverage of 5.1% for the industry. Our goal is to cede only those policies thatincur less total losses resulting from a cession to CAR, than the total lossesincurred by retaining the policy.

CAR also runs a reinsurance pool for commercialautomobile policies and beginning January 1, 2006, we are one of sixservicing carriers that can service commercial automobile policies for CAR.Commercial automobile business that is not written in the voluntary market isapportioned to one of the six servicing carriers who handle the business onbehalf of CAR. Each Massachusetts commercial automobile insurer must bear aportion of the losses of the commercial reinsurance pool that is serviced bythe six servicing carriers.

*BulkPolicy Transfers and New Voluntary Agents.**  *From time to time, we receiveproposals from existing voluntary agents to transfer a portfolio of the agent’sbusiness from another insurer to us. Our underwriters model the profitabilityof these portfolios before we accept these transfers. Among other things, weusually require that the private passenger portion of the portfolio have a pureloss ratio of 64.0% or less on the portion of the agent’s portfolio that wewould underwrite. In addition, we require any new voluntary agent to commit totransfer a portfolio to us consisting of at least 500 policies.

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*PolicyProcessing and Rate Pursuit.**  *Our underwriting department assists in processingpolicy applications, endorsements, renewals and cancellations. In the pastthree years, we have introduced new proprietary software that enables agents toconnect to our network and enter policy and endorsement applications forprivate passenger automobile insurance from their office computers. In ourprivate passenger automobile insurance line, our agents now submitapproximately 98% of all applications for new policies or endorsements forexisting policies through our proprietary information portal, the AVC.

Our rate pursuit teamaggressively monitors all insurance transactions to make sure we receive thecorrect premium for the risk insured. We accomplish this by verifyingMassachusetts pricing criteria, such as proper classification of drivers, themake, model and age of insured vehicles and the availability of discounts. Weverify that operators are properly listed and classified, assignment ofoperators to vehicles, vehicle garaging, vehicle pre-inspection requirementsand in some cases the validity of discounts. In our homeowners and dwellingfire lines, our team has completed a project to update the replacement costsfor each dwelling. We use third-party software to assist in theseappraisal efforts.

**Technology**

The focuses of ourinformation technology effort are:

·       toconstantly reengineer internal processes to allow more efficient operations,resulting in lower operating costs;

·       tomake it easier for independent agents to transact business with us; and

·       toenable agents to efficiently provide their clients with a high level ofservice.

We believe that our technology initiatives haveincreased revenue and decreased costs. For example, these initiatives haveallowed us to reduce the number of call-center transactions which we perform,and to transfer many manual processing functions from our internal operationsto our independent agents. We also believe that these initiatives havecontributed to our overall increases in productivity. In 1990, we had 399employees and $154,997 in direct written premiums. As of December 31,2006, we had 579 employees and $629,511 in direct written premiums, whichrepresents an increase from $388 direct written premiums per employee in 1990to $1,087 direct written premiums per employee in 2006.

*InternalApplications (Intranet).**  *Our employees access our proprietary applicationsthrough our corporate intranet. Our intranet applications streamline internalprocesses and improve overall operational efficiencies in areas including:

*Claims.**  *Our claims workload managementapplication allows our claims and subrogation adjusters to better manage injuryclaims. Subrogation refers to the process by which we are reimbursed by otherinsurers for claims costs we incur due to the fault of their insureds. The useof this application has reduced the time it takes for us to respond to andsettle casualty claims, which we believe helps reduce the total amount of ourclaims expense.

The automated adjuster assignment system categorizesour new claims by severity and assigns them to the appropriate adjusterresponsible for investigation. Once assigned, the integrated workloadmanagement tools facilitate the work of promptly assigning appraisers,investigating liability, issuing checks and receiving subrogation receipts.

The RadicalGlass.com application allows our claimsdepartment to contain glass costs by increasing the windshield repair toreplacement ratio. For every windshield that is repaired rather than replacedthere is an average savings of $290 per windshield claim.

A VIP Claims Center was introduced during 2006 toprovide increased service levels to our independent insurance agents and theirclients. The VIP Claims Center uses a network of rental car 

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centers and auto bodyrepair shops to provide a higher level of service to the clients of theindependent insurance agents while reducing costs, such as rental, throughreduced cycle times.

*Billing.**  *Proprietary billing systems,integrated with the systems of our print and lock-box vendors, expedite theprocessing and collection of premium receipts and finance charges from agentsand policyholders. We believe the sophistication of our direct bill systemhelps us to limit our bad debt expense. In both 2006 and 2005 our bad debtexpense as a percentage of direct written premiums was less than 0.2%.

*ExternalApplications.**  *Agencyemployees can securely access business critical applications through ourcorporate extranet, which we call AVC. AVC includes Web-enabled applications,advanced security and an Internet-enabled communications network, whichwe believe constitutes many of our agents’ only high-speed Internet connection.We believe that AVC is unique to the Massachusetts private passenger automobileinsurance industry because using AVC allows an agent to access a variety ofvendors and other carriers over the Internet through a single portal. Wecurrently have a patent application pending on AVC. The patent applicationpertains to the method and system by which AVC delivers customer services toindependent insurance agents. The capability for agency personnel to scheduleonline appointments with third-party vendors (such as glass repairretailers and rental car agencies) for their clients is also available. Wedesigned AVC to be scalable so that these types of vendors and potentially,other insurers, can link to the network and create a “once and done”environment for the independent agent.

Listed below are examples of the business criticalapplications agents may access through AVC.

*NewBusiness and Endorsement Processing.**  *Agents can perform new business andendorsement processing with our point of sale application. Agents can uploadpolicy data to our system directly from their agency system or rate quotesoftware in AVC’s secure Web environment without having to re-enter policyinformation. Agents are then able to download many of these transactions totheir agency management system the next business day.

*InquiryAccess.**  *InquiryAccess is a customer service application designed to provide agency customerservice representatives with real-time access to our database of insuredinformation. This application allows agents to view the status of claims,billing and policy detail.

*PolicyholderInquiry.**  *PolicyholderInquiry provides 24 hours a day, 7 days a week self-service accountinformation to our policyholders through our website or through theirindependent agents’ websites. This application provides policyholders withround-the-clock access to billing and claims information.

*OtherTools and Services.**  *AVCgives agents access to electronic versions of underwriting manuals, whichinclude updated guidelines for acceptable risks, commission levels and productpricing. Further, we have our agents using third-party software (the XNETCost Estimator from Marshall Swift/Boeck) that we make available through AVC tohelp assess home replacement costs. This initiative helps ensure that wereceive the correct premium with respect to homeowners policies and provide thecorrect level of coverage against home loss. Finally, we provide agents a dailyreport of all their insurance transactions processed through AVC. This reportallows our agents to monitor their performance and review profitability goals.

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**Claims**

Because of the uniquedifferences between the management of casualty claims and property claims, weuse separate departments for each of these types of claims.

*Casualty Claims*

We have a proven record of settling casualty claimsbelow the industry average in Massachusetts. According to the AutomobileInsurers Bureau, our average casualty claim settlement during the period from January 1994through June 30, 2006, was $5,514, approximately 3.9% lower than theMassachusetts industry average of $5,737.

We have adopted stringent claims settlementprocedures, which include guidelines that establish maximum settlement offersfor soft tissue injuries, which constituted approximately 72% of our bodilyinjury claims. If we are unable to settle these claims within our guidelines,we generally take the claim to litigation. We believe that these proceduresresult in providing our adjusters with a uniform approach to negotiation.

We believe an important component of handling claimsefficiently is prompt investigation and settlement. We find that faster claimssettlements often result in less expensive claims settlements. Our E-Claimreporting system is an online product that reduces the time it takes for agentsto notify our adjusters about claims, thereby enabling us to contact third-partyclaimants and other witnesses quickly. After business hours we outsource claimsadjustment support to an independent firm whose employees contact third-partyclaimants and other witnesses. We believe that early notification results inour adjusters conducting prompt investigations of claims and compiling moreaccurate information about those claims. Our claims workload managementsoftware also assists our adjusters in handling claims quickly.

We believe the structure of our casualty claims unitallows us to respond quickly to claimants anywhere in the Commonwealth ofMassachusetts. Comprising 122 people, the department is organized into distinctclaim units that contain loss costs for soft tissue injuries. Field adjustersare located geographically for prompt response to claims, with our litigationunit focused on managing loss costs and litigation expenses for serious injuryclaims.

Additionally, we utilize aspecial unit to investigate fraud in connection with casualty claims. This specialunit has one manager and nine employees. In cases where adjusters suspect fraudin connection with a claim, we deploy this special unit to conductinvestigations. We deny payment to claimants in cases in which we havesucceeded in accumulating sufficient evidence of fraud.

*Property Claims*

Our property claims unit handles property claimsarising in our private passenger and commercial automobile, homeowners andother insurance lines. Process automation has streamlined our property claimsfunction. Many of our property claims are now handled by the agents through AVCusing our Power Desk software application. As agents receive calls fromclaimants, Power Desk permits the agent to immediately send information relatedto the claim directly to us and to an independent appraiser selected by theagent to value the claim. Once we receive this information, an automated systemredirects the claim to the appropriate internal adjuster responsible forinvestigating the claim to determine liability. Upon determination ofliability, the system automatically begins the process of seeking a subrogationrecovery from another insurer, if liable. We believe this process results in ashorter time period from when the claimant first contacts the agent to when theclaimant receives a claim payment, while enabling our agents to buildcredibility with their clients by responding to claims in a timely andefficient manner. We benefit from decreased labor expenses from the need forfewer employees to handle the reduced property claims call volume.

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Another important factorin keeping our overall property claims costs low is collecting subrogationrecoveries. We track the amounts we pay out in claims costs and identify casesin which we believe we can reclaim some or all of those costs through the useof our automated workload management tools.

**Reserves**

Significant periods of time can elapse between theoccurrence of an insured loss, the reporting of the loss to the insurer and theinsurer’s payment of that loss. To recognize liabilities for unpaid losses,insurers establish reserves as balance sheet liabilities representing estimatesof amounts needed to pay reported and unreported losses and the expensesassociated with investigating and paying the losses, or loss adjustment expenses.Every quarter, we review and establish our reserves. Regulations promulgated bythe Commissioner require us to annually obtain a certification from either aqualified actuary or an approved loss reserve specialist that our loss and lossadjustment expenses reserves are reasonable.

When a claim is reported, claims personnel establish a“case reserve” for the estimated amount of the ultimate payment. The amount ofthe reserve is primarily based upon an evaluation of the type of claiminvolved, the circumstances surrounding each claim and the policy provisionsrelating to the loss. The estimate reflects informed judgment of such personnelbased on general insurance reserving practices and on the experience andknowledge of the claims person. During the loss adjustment period, theseestimates are revised as deemed necessary by our claims department based onsubsequent developments and periodic reviews of the cases.

In accordance with industry practice, we also maintainreserves for estimated losses incurred but not yet reported. Incurred but notyet reported reserves are determined in accordance with commonly acceptedactuarial reserving techniques on the basis of our historical information andexperience. We make adjustments to incurred but not yet reported reservesquarterly to take into account changes in the volume of business written,claims frequency and severity, our mix of business, claims processing and otheritems that can be expected to affect our liability for losses and lossadjustment expenses over time.

When reviewing reserves, we analyze historical dataand estimate the impact of various loss development factors, such as ourhistorical loss experience and that of the industry, legislative enactments,judicial decisions, legal developments in imposition of damages, and changesand trends in general economic conditions, including the effects of inflation.There is no precise method, however, for evaluating the impact of any specificfactor on the adequacy of reserves, because the eventual development ofreserves is affected by many factors. After taking into account all relevantfactors, management believes that our provision for unpaid losses and lossadjustment expenses at December 31, 2006, is adequate to cover theultimate net cost of losses and claims incurred as of that date.

Management determines its loss and LAE reservesestimates based upon the analysis of the Company’s actuaries. Management hasestablished a process for the Company’s actuaries to follow in establishingreasonable reserves. The process consists of meeting with our claimsdepartment, establishing ultimate incurred losses by using development modelsaccepted by the actuarial community, and reviewing the analysis with management.The Company’s estimate for loss and LAE reserves, net of the effect of cededreinsurance, ranges from a low of $327,472 to a high of $377,497 as of December 31,2006. The Company’s loss and LAE reserves, based on management’s best estimate,were set at $370,980 as of December 31, 2006. The ultimate liability maybe greater or less than reserves carried at the balance sheet date.Establishment of appropriate reserves is an inherently uncertain process, andthere can be no certainty that currently established reserves will proveadequate in light of subsequent actual experience. To the extent that reservesare inadequate and are strengthened, the amount of such increase is treated asa charge to earnings in the period that the deficiency is recognized. To theextent that reserves are redundant and are released, the amount of the releaseis a credit to earnings in the period the redundancy is recognized. We do notdiscount any of our reserves.

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Thefollowing table presents development information on changes in the reserves forlosses and loss adjustment expenses (“LAE”) of our Insurance Subsidiaries forthe three years ended December 31, 2006.

| ** **                                                   | ** ** | **For the Years Ended December 31,** | ** **  |
|--------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                   | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Reserves for  losses and LAE, beginning of year              | ** ** | **$**                                                         | **450,716** |   | $ | 450,897 |   | $ | 383,551 |   |
| Less reinsurance  recoverable on unpaid losses and LAE  | ** ** | **(80,550**                                                   | **)**       | (84,167 | ) | (73,539 | ) |
| Net reserves for  losses and LAE, beginning of year          | ** ** | **370,166**                                                   |        | 366,730 |   | 310,012 |   |
| Incurred losses and LAE  related to:                         | ** ** | ** **                                                    |        |   |   |   |   |
| Current year                                                 | ** ** | **396,653**                                                   |        | 425,213 |   | 431,839 |   |
| Prior years                                                  | ** ** | **(42,747**                                                   | **)**       | (39,620 | ) | (6,778 | ) |
| Total incurred  losses and LAE                               | ** ** | **353,906**                                                   |        | 385,593 |   | 425,061 |   |
| Paid losses and LAE  related to:                             | ** ** | ** **                                                    |        |   |   |   |   |
| Current year                                                 | ** ** | **219,879**                                                   |        | 237,557 |   | 217,989 |   |
| Prior years                                                  | ** ** | **133,213**                                                   |        | 144,600 |   | 150,354 |   |
| Total paid losses  and LAE                                   | ** ** | **353,092**                                                   |        | 382,157 |   | 368,343 |   |
| Net reserves for  losses and LAE, end of year                | ** ** | **370,980**                                                   |        | 370,166 |   | 366,730 |   |
| Plus reinsurance  recoverables on unpaid losses and LAE | ** ** | **78,464**                                                    |        | 80,550 |   | 84,167 |   |
| Reserves for losses and  LAE, end of year                    | ** ** | **$**                                                         | **449,444** |   | $ | 450,716 |   | $ | 450,897 |   |

 

At the end of each period, the reserves werere-estimated for all prior accident years. Our prior year reserves decreased by$42,747, $39,620 and $6,778 during 2006, 2005 and 2004, respectively. Thedecrease in prior year reserves during 2006 resulted from re-estimations ofprior year ultimate loss and LAE liabilities and is primarily composed ofreductions of $23,945 in the Company’s retained automobile reserves and $14,006in the CAR assumed reserves. It is not appropriate to extrapolate futurefavorable or unfavorable development of reserves from this past experience.

The following table represents the development ofreserves, net of reinsurance, for calendar years 1996 through 2006. The topline of the table shows the reserves at the balance sheet date for each of theindicated years. This represents the estimated amounts of losses and lossadjustment expenses for claims arising in all years that were unpaid at thebalance sheet date, including losses that had been incurred but not yetreported to us. The upper portion of the table shows the cumulative amountspaid as of the end of each successive year with respect to those claims. Thelower portion of the table shows the re-estimated amount of the previouslyrecorded reserves based on experience as of the end of each succeeding year,including cumulative payments made since the end of the respective year. Theestimate changes as more information becomes known about the payments,frequency and severity of claims for individual years. Favorable lossdevelopment, shown as a cumulative redundancy in the table, exists when theoriginal reserve estimate is greater than the re-estimated reserves at December 31,2006.

Information with respect to the cumulative developmentof gross reserves (that is, without deduction for reinsurance ceded) alsoappears at the bottom portion of the table.

Inevaluating the information in the table, it should be noted that each amountentered incorporates the effects of all changes in amounts entered for priorperiods. Thus, if the 2004 estimate for a previously incurred loss was $150,000and the loss was reserved at $100,000 in 2000, the $50,000 deficiency (laterestimate minus original estimate) would be included in the cumulativeredundancy (deficiency) in each of the years 2000-2004 shown in thetable. It should further be noted that the table does not present accident orpolicy year development data. In addition, conditions and trends that haveaffected the development of 

17

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liability in the past may not necessarily recur in thefuture. Accordingly, it is not appropriate to extrapolate future redundanciesor deficiencies from the table.

| ** **                                           | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** | **1996** | ** ** |
| **Reserves for losses and LAE originally estimated** |       | $                                                                                     | 370,980    |   | $ | 370,166 |   | $ | 366,730 |   | $ | 310,012 |   | $ | 266,636 |   | $ | 227,377 |   | $ | 211,834 |   | $ | 206,613 |   | $ | 195,990 |   | $ | 195,145 |   | $ | 189,420 |   |
| **Cumulative amounts paid as  of:**             |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                                       |       |                                                                                  |       | 133,213 |   | 144,600 |   | 150,354 |   | 137,092 |   | 118,141 |   | 114,016 |   | 107,937 |   | 92,791 |   | 75,233 |   | 68,246 |   |
| Two years later                                      |       |                                                                                  |       |   |   | 202,435 |   | 201,287 |   | 199,119 |   | 168,344 |   | 163,768 |   | 133,414 |   | 113,323 |   | 105,046 |   | 96,219 |   |
| Three years later                                    |       |                                                                                  |       |   |   |   |   | 232,539 |   | 225,350 |   | 196,340 |   | 185,396 |   | 154,395 |   | 135,024 |   | 125,574 |   | 111,706 |   |
| Four years later                                     |       |                                                                                  |       |   |   |   |   |   |   | 238,087 |   | 212,079 |   | 194,891 |   | 163,903 |   | 144,985 |   | 136,730 |   | 121,100 |   |
| Five years later                                     |       |                                                                                  |       |   |   |   |   |   |   |   |   | 217,009 |   | 204,290 |   | 167,829 |   | 149,548 |   | 141,843 |   | 126,924 |   |
| Six years later                                      |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   | 206,324 |   | 171,148 |   | 150,940 |   | 143,457 |   | 128,804 |   |
| Seven years later                                    |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   | 171,871 |   | 152,243 |   | 143,998 |   | 129,356 |   |
| Eight years later                                    |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 152,533 |   | 144,727 |   | 129,535 |   |
| Nine years later                                     |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 144,900 |   | 130,047 |   |
| Ten years later                                      |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 130,163 |   |
|                                                      |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** | **1996** | ** ** |
| **Reserves  re-estimated as   of:**          |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                               |       |                                                                                  |       | $ | 327,419 |   | $ | 327,110 |   | $ | 303,234 |   | $ | 266,817 |   | $ | 225,115 |   | $ | 204,531 |   | $ | 179,650 |   | $ | 169,940 |   | $ | 171,803 |   | $ | 161,083 |   |
| Two years later                              |       |                                                                                  |       |   |   | 304,891 |   | 291,100 |   | 269,941 |   | 227,764 |   | 206,340 |   | 176,008 |   | 156,590 |   | 153,846 |   | 144,727 |   |
| Three years later                            |       |                                                                                  |       |   |   |   |   | 280,507 |   | 264,961 |   | 231,190 |   | 208,587 |   | 175,868 |   | 154,867 |   | 147,455 |   | 134,721 |   |
| Four years later                             |       |                                                                                  |       |   |   |   |   |   |   | 260,398 |   | 229,699 |   | 209,517 |   | 176,025 |   | 154,530 |   | 146,059 |   | 131,694 |   |
| Five years later                             |       |                                                                                  |       |   |   |   |   |   |   |   |   | 227,428 |   | 208,343 |   | 175,367 |   | 154,572 |   | 145,670 |   | 131,051 |   |
| Six years later                              |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   | 208,232 |   | 174,469 |   | 153,926 |   | 145,607 |   | 130,903 |   |
| Seven years later                            |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   | 174,121 |   | 153,920 |   | 145,465 |   | 130,730 |   |
| Eight years later                            |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 153,778 |   | 145,452 |   | 130,599 |   |
| Nine years later                             |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 145,335 |   | 130,590 |   |
| Ten years later                              |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 130,476 |   |
| **Cumulative  (redundancy) deficiency 2006** | ** ** | ** **                                                                            |       | (42,747 | ) | (61,839 | ) | (29,505 | ) | (6,238 | ) | 51 |   | (3,602 | ) | (32,492 | ) | (42,212 | ) | (49,810 | ) | (58,944 | ) |
|                                              |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                             | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** | **1996** | ** ** |
| Gross  liability-end of   year         |       | $                                                                                     | 449,444    |   | $ | 450,716 |   | $ | 450,897 |   | $ | 383,551 |   | $ | 333,297 |   | $ | 302,556 |   | $ | 302,131 |   | $ | 315,226 |   | $ | 311,846 |   | $ | 319,453 |   | $ | 326,802 |   |
| Reinsurance  recoverables              |       | 78,464                                                                                |       | 80,550 |   | 84,167 |   | 73,539 |   | 66,661 |   | 75,179 |   | 90,297 |   | 108,613 |   | 115,856 |   | 124,308 |   | 137,382 |   |
| Net liability-end  of year             |       | 370,980                                                                               |       | 370,166 |   | 366,730 |   | 310,012 |   | 266,636 |   | 227,377 |   | 211,834 |   | 206,613 |   | 195,990 |   | 195,145 |   | 189,420 |   |
| Gross estimated  liability—latest |       |                                                                                  |       | 400,145 |   | 374,010 |   | 346,264 |   | 323,264 |   | 281,539 |   | 275,274 |   | 241,959 |   | 225,313 |   | 220,803 |   | 210,654 |   |
| Reinsurance  recoverables—latest  |       |                                                                                  |       | 72,726 |   | 69,119 |   | 65,757 |   | 62,866 |   | 54,111 |   | 67,042 |   | 67,838 |   | 71,535 |   | 75,468 |   | 80,178 |   |
| Net estimated  liability—latest   |       |                                                                                  |       | 327,419 |   | 304,891 |   | 280,507 |   | 260,398 |   | 227,428 |   | 208,232 |   | 174,121 |   | 153,778 |   | 145,335 |   | 130,476 |   |
|                                        |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As the table shows, ournet reserves grew at a faster rate than our gross reserves over the ten-yearperiod. As we have grown, we have been able to retain a greater percentage ofour direct business. Additionally, in the past we conducted substantialbusiness as a servicing carrier for other insurers, in which we would servicethe residual market automobile insurance business assigned to other carriersfor a fee. All business generated through this program was ceded to the othercarriers. As we reduced the amount of our servicing carrier business, ourproportion of reinsurance ceded diminished.

The table also shows thatwe have substantially benefited in the current and prior years from releasingredundant reserves. In the years ended December 31, 2006, 2005 and 2004 wedecreased loss reserves related to prior years by $42,747, $39,620 and $6,778,respectively. Reserves and development are discussed further in Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations,Executive Summary and Overview.

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As a result of our focuson core business lines since our founding in 1979, we believe we have noexposure to asbestos or environmental pollution liabilities.

**Reinsurance**

We reinsure with otherinsurance companies a portion of our potential liability under the policies wehave underwritten, thereby protecting us against an unexpectedly large loss ora catastrophic occurrence that could produce large losses. Reinsurance involvesan insurance company transferring (ceding) a portion of its exposure oninsurance underwritten by it to another insurer (reinsurer). The reinsurerassumes a portion of the exposure in return for a share of the premium.Reinsurance does not legally discharge an insurance company from its primaryliability for the full amount of the policies, but it does make the reinsurerliable to the company for the reinsured portion of any loss realized.

We are selective inchoosing our reinsurers, seeking only those companies that we consider to befinancially stable and adequately capitalized. In an effort to minimizeexposure to the insolvency of a reinsurer, we continuously evaluate and reviewthe financial condition of our reinsurers. Swiss Re, our primary reinsurer,maintains an A.M. Best rating of “A+” (Superior). All of our otherreinsures have an A.M. Best rating of “A” (excellent) or better except forFolksamerica, Endurance Re, Montpelier Re and Amlin Bermuda which are rated “A-”(excellent).

We maintain reinsurancecoverage to help lessen the effect of losses from catastrophic events,maintaining coverage that during 2006 protected us in the event of a “415-yearstorm” (that is, a storm of a severity expected to occur once in a415 year period). We use various software products to measure our exposureto catastrophe losses and the probable maximum loss to us for catastrophelosses such as hurricanes. The models include estimates for our share of thecatastrophe losses generated in the residual market for property insurance bythe Massachusetts Property Insurance Underwriting Association. In 2006, wepurchased three layers of excess catastrophe reinsurance providing coverage forproperty losses in excess of $15,000 up to a maximum of $250,000. Ourreinsurers co-participation is 90.0% of $15,000 for the 1st layer, 90.0% of $30,000 forthe 2nd layer, and 90.0% of $190,000 for the 3rd layer.

In the aftermath ofHurricane Katrina in 2005, the reinsurance market has seen from the varioussoftware modelers, increases in the estimate of damage from hurricanes in thesouthern and northeast portions of the United States due to revised estimationsof increased hurricane activity and increases in the estimation of demand surgein the periods following a significant event. While we have continued to manageour exposure to catastrophes such as hurricanes, and have not increased theamount of property we insure subject to a loss from a hurricane, the changes tothe various software models during 2006 have increased our modeled probablemaximum loss due to catastrophic events. We have adjusted our reinsuranceprograms as a result of the changes to the models. In 2007, we have purchasedfour layers of excess catastrophe reinsurance providing coverage for propertylosses in excess of $15,000 up to a maximum of $280,000. Our reinsurersco-participation is 90.0% of $15,000 for the 1st layer, 85.0% of $30,000 for the  2nd layer, 85.0% of $190,000 for the 3rd layer, and 50% of $30,000 forthe 4th layer. As a result of these changes to themodels, and our revised reinsurance program, we maintain coverage that protectsus in the event of a “300-year storm” (that is, a storm of a severityexpected to occur once in a 300 year period).

We also have casualtyexcess of loss reinsurance for large casualty losses occurring in ourautomobile, homeowners, dwelling fire, business owners policies, commercialpackage policies, personal umbrella and commercial umbrella lines of businessin excess of $1,000 up to a maximum of $5,000, with an annual aggregatedeductible of $500. We have property excess of loss reinsurance coverage forlarge property losses, with coverage in excess of $1,500 up to a maximum of$15,000, for our homeowners, business owner, and commercial package policies.In addition, we have a quota share reinsurance agreement under which we cede90.0% of the premiums and losses under our personal and commercial umbrellapolicies with an annual aggregate deductible of $75. We also have a reinsuranceagreement with Hartford Steam Boiler 

19

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Inspectionand Insurance Company, which is a quota share agreement under which we cede100% of the premiums and losses for the equipment breakdown coverage under ourbusiness owner policies and commercial package policies.

In the wake of the September 11,2001, tragedies, reinsurers have begun to exclude coverage for claims inconnection with any act of terrorism. Our reinsurance programs for 2006 and2007 excludes coverage for acts of terrorism, except for fire or collapselosses as a result of terrorism, under homeowners, dwelling fire, privatepassenger automobile and commercial automobile policies. For business owner policiesand commercial package policies, terrorism is excluded if the total insuredvalue is greater than $20,000.

The Terrorism RiskInsurance Act of 2002 (“TRIA”) was signed into law on November 26, 2002,and expired December 31, 2005. The Terrorism Risk Insurance Extension Actof 2005 (“TRIEA”) was signed into law on December 22, 2005, whichreauthorizes TRIA for two years, while expanding the private sector role andreducing the federal share of compensation for insured losses under theprogram. The intent of this legislation is to provide federal assistance to theinsurance industry for the needs of commercial insurance policyholders with thepotential exposure for losses due to acts of terrorism. The TRIEA providesreinsurance for certified acts of terrorism. Effective January 1, 2006, weissued policy endorsements for all commercial policyholders to comply withTRIEA after obtaining Commissioner approval.

As of December 31,2006, we had no material amounts recoverable from any reinsurer, excluding theresidual markets described below. On March 10, 2005, our Board ofDirectors adopted a resolution that prohibits Safety from purchasing finitereinsurance (reinsurance that transfers only a relatively finite or limitedamount of risk to the reinsurer) without approval by the Board. To date, theCompany has never purchased a finite reinsurance contract.

In addition to the abovementioned reinsurance programs, we are a participant in CAR, the Massachusettsmandated residual market under which premiums, expenses, losses and lossadjustment expenses on ceded business are shared by all insurers writingautomobile insurance in Massachusetts. We also participate in the MassachusettsProperty Insurance Underwriting Association in which premiums, expenses, lossesand loss adjustment expenses on homeowners business that cannot be placed inthe voluntary market are shared by insurers writing homeowners insurance inMassachusetts.

**Competition**

The property and casualtyinsurance business is highly competitive and many of our competitors havesubstantially greater financial and other resources than we do. We compete withboth large national writers and smaller regional companies. Our competitorsinclude companies, which, like us, serve the independent agency market, as wellas companies which sell insurance directly to customers. Direct writers mayhave certain competitive advantages over agency writers, including increasedname recognition, loyalty of the customer base to the insurer rather than to anindependent agency and, potentially, lower cost structures. A materialreduction in the amount of business independent agents sell would adverselyaffect us. In the past, competition in the Massachusetts private passengerautomobile market has included offering significant discounts from the maximumpermitted rates, and there can be no assurance that these conditions will notrecur. Further, we and others compete on the basis of the commissions and othercash and non-cash incentives provided to agents. Although a number of nationalinsurers that are much larger than we are do not currently compete in amaterial way in the Massachusetts private passenger automobile market, if oneor more of these companies decided to aggressively enter the market it couldhave a material adverse effect on us. These companies include some that wouldbe able to sustain significant losses in order to acquire market share, as wellas others which use distribution methods that compete with the independentagent channel. There can be no assurance that we will be able to competeeffectively against these companies in the future.

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In Massachusetts, as of December 31,2006, 19 insurers actively wrote private passenger automobile insurance,according to CAR. Of these 19 insurers, 4 are national companies which useindependent agents to sell their products, 8 are regional or Massachusetts-onlycompanies which use independent agents to sell their products (including us)and 7 are national, regional or Massachusetts-only companies which sell theirproducts directly to policyholders. Our principal competitors within theMassachusetts private passenger automobile insurance industry are both regionalcompanies, Commerce Group, Inc. and Arbella Insurance Group, which held31.1% and 9.7% market shares based on automobile exposures, respectively, in2006 according to CAR.

**Employees**

At December 31, 2006,we employed 579 employees. Our employees are not covered by any collectivebargaining agreement. Management considers our relationship with our employeesto be good.

**Investments**

Investment income is an important source of revenuefor us and the return on our investment portfolio has a material effect on ournet earnings. Our investment objective is to focus on maximizing total returnswhile investing conservatively. We maintain a high quality investment portfolioconsistent with our established investment policy. As of December 31,2006, there were no securities below investment grade (as defined by Moody’s,S&P, and the Securities Valuation Office of the NAIC (see further detailsbelow)) in our fixed income securities portfolio. According to our investmentguidelines, no more than 2.0% of our portfolio may be invested in thesecurities of any one issuer (excluding U.S. government-backedsecurities), and no more than 0.5% of our portfolio may be invested insecurities of any one issuer rated “Baa”, or the lowest investment gradeassigned by Moody’s. We continually monitor the mix of taxable and tax-exemptsecurities, in an attempt to maximize our total after-tax return. Since 1986,our investment manager has been Deutsche Asset Management, formerly known asScudder Investments.

Thefollowing table reflects the composition of our investment portfolio at December 31,2006 and 2005:

| ** **                                                               | ** ** | **At December 31,**  | ** **  |
|--------------------------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                                               | ** ** | **2006**                       | ** **  | **2005** | ** ** |
| ** **                                                               | ** ** | **Estimated  Fair Value** | ** **  | **% of Portfolio** | ** ** | **Estimated  Fair Value** | ** ** | **% of Portfolio** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) | ** ** | **$**                          | **183,436** | ** ** |   | **19.5** | **%** |   | $ | 125,220 |   |   | 17.5 | % |   |
| Obligations of  states and political subdivisions                        | ** ** | **434,359**                    | ** **  |   | **46.2** | ** ** |   | 322,609 |   |   | 45.1 |   |   |
| Asset-backed  securities(1)                                              | ** ** | **178,611**                    | ** **  |   | **19.0** | ** ** |   | 123,475 |   |   | 17.3 |   |   |
| Corporate and  other securities                                          | ** ** | **139,874**                    | ** **  |   | **14.8** | ** ** |   | 141,234 |   |   | 19.8 |   |   |
| Subtotal, fixed maturity securities                                      | ** ** | **$**                          | **936,280** | ** ** |   | **99.5** | ** ** |   | $ | 712,538 |   |   | 99.7 |   |   |
| Equity securities                                                        | ** ** | **4,325**                      | ** **  |   | **0.5** | ** ** |   | 2,005 |   |   | 0.3 |   |   |
| Totals                                                                   | ** ** | **$**                          | **940,605** | ** ** |   | **100.0** | **%** |   | $ | 714,543 |   |   | 100.0 | % |   |

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(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC),Federal National Mortgage Association (FNMA) and Small Business Administration(SBA). The total of these fixed maturity securities was $175,394 and $117,766at amortized cost and $173,539 and $115,284 at fair value as of December 31,2006 and 2005, respectively. As such, the asset-backed securitiespresented exclude such 

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issuers already presentedunder U.S. Treasury securities and obligations of U.S. Government Agencies.

While we have held common equity securities in ourinvestment portfolio in the past, as of December 31, 2006, we held no suchsecurities in our investment portfolio, except for interests in mutual funds tofund the Safety Insurance Company Executive Incentive Compensation Plan, anon-qualified deferred compensation plan maintained for the purpose ofproviding deferred compensation to a select group of management. We made thedecision to divest common equity securities in order to maximize the currentinvestment income earned by our portfolio and to reduce our overall investmentrisk. We continuously evaluate market conditions and we expect in the future topurchase common equity securities.

The principal risks inherent in holding mortgage-backedsecurities and other pass-through securities are prepayment and extensionrisks, which affect the timing of when cash flows will be received. Wheninterest rates decline, mortgages underlying mortgage-backed securitiestend to be prepaid more rapidly than anticipated, causing early repayments.When interest rates rise, the underlying mortgages tend to be prepaid at aslower rate than anticipated, causing the principal repayments to be extended.Although early prepayments may result in acceleration of income fromrecognition of any unamortized discount, the proceeds typically are reinvestedat a lower current yield, resulting in a net reduction of future investmentincome.

Thefollowing table reflects our investment results for each year in the three-yearperiod ended December 31, 2006:

| ** **                                      | ** ** | **For the Years Ended December 31,** | ** **  |
|-------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                      | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Average cash and  invested securities (at cost) | ** ** | **$**                                                         | **917,980** | ** ** | $ | 837,200 |   | $ | 734,576 |   |
| Net investment  income(1)                       | ** ** | **$**                                                         | **40,293**  | ** ** | $ | 31,573 |   | $ | 27,259 |   |
| Net effective yield(2)                          | ** ** | **4.4**                                                       | **%**       | 3.8 | % | 3.7 | % |

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(1)          After investmentexpenses, excluding realized investment gains (losses).

(2)          Net investment incomefor the period divided by average invested securities and cash for the sameperiod.

Net effective yield increased in 2006 from 2005primarily due to an increase of $80,780 in average cash and investmentsecurities (at cost) and a shift to fixed maturity securities from cash andcash equivalents related to management’s investment strategy to lengthen theportfolio duration. Net effective yield increased in 2005 from 2004 due tohigher yields on our short-term investments combined with a $72,871 increase inaverage cash and cash equivalents.

As of December 31, 2006, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities (i.e., all our securities received a rating assigned by Moody’s ofBaa or higher, except the few securities not rated by Moody’s which receivedStandard and Poor’s ratings of A- or higher, as well as a rating assigned bythe Securities Valuation Office of the National Association of InsuranceCommissioners of 1 or 2.)

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Thecomposition of our fixed income security portfolio by Moody’s rating was asfollows:

| ** **                                                            | ** ** | **December 31, 2006** | ** **  |
|-----------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                            | ** ** | **Estimated  Fair Value**  | ** **  | **Percent** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$**                           | **183,436** |   |   | **19.6** | **%** |   |
| Aaa/Aa                                                                | ** ** | **584,191**                     |        |   | **62.4** | ** ** |   |
| A                                                                     | ** ** | **106,092**                     |        |   | **11.3** | ** ** |   |
| Baa                                                                   | ** ** | **39,845**                      |        |   | **4.3** | ** ** |   |
| Not rated  (Standard & Poor’s rating of A- or higher)   | ** ** | **22,716**                      |        |   | **2.4** | ** ** |   |
| Total                                                                 | ** ** | **$**                           | **936,280** |   |   | **100.0** | **%** |   |

 

Ratings are assigned by Moody’s, or the equivalent, asdiscussed above. Such ratings are generally assigned upon the issuance of thesecurities and are subject to revision on the basis of ongoing evaluations.Ratings in the table are as of the date indicated.

Moody’s rating system utilizes nine symbols toindicate the relative investment quality of a rated bond. Aaa rated bonds arejudged to be of the best quality and are considered to carry the smallestdegree of investment risk. Aa rated bonds are also judged to be of high qualityby all standards. Together with Aaa bonds, these bonds comprise what aregenerally known as high grade bonds. Bonds rated A possess many favorableinvestment attributes and are considered to be upper medium grade obligations.Baa rated bonds are considered as medium grade obligations; they are neitherhighly protected nor poorly secured. Bonds rated Ba or lower (those rated B,Caa, Ca and C) are considered to be too speculative to be of investmentquality.

The Securities Valuation Office of the NationalAssociation of Insurance Commissioners evaluates all public and private bondspurchased as investments by insurance companies. The Securities ValuationOffice assigns one of six investment categories to each security it reviews.Category 1 is the highest quality rating and Category 6 is thelowest. Categories 1 and 2 are the equivalent of investment grade debt asdefined by rating agencies such as Standard & Poor’s Ratings Servicesand Moody’s, while Categories 3-6 are the equivalent of below investmentgrade securities. Securities Valuation Office ratings are reviewed at leastannually. At December 31, 2006, approximately 88.5% of our fixed maturityinvestments were rated Category 1, and 11.5% of our fixed maturityinvestments were rated Category 2, the two highest ratings assigned by theSecurities Valuation Office. At December 31, 2006, we had no fixedmaturity investments rated Category 3 or lower by the Securities ValuationOffice.

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The following tableindicates the composition of our fixed income security portfolio (at carryingvalue) by time to maturity as of December 31, 2006:

| ** **                                | ** ** | **December 31, 2006** | ** **  |
|-------------------------------------------|------------|---------------------------------|-------------|
| ** **                                | ** ** | **Estimated  Fair Value**       | ** **  | **Percent** | ** ** |
| Due in one year or less                   | ** ** | **$**                           | **24,589**  | ** ** |   | **2.6** | **%** |   |
| Due after one year  through five years    | ** ** | **167,133**                     | ** **  |   | **17.9** | ** ** |   |
| Due after five years  through ten years   | ** ** | **160,940**                     | ** **  |   | **17.2** | ** ** |   |
| Due after ten years  through twenty years | ** ** | **218,783**                     | ** **  |   | **23.4** | ** ** |   |
| Due after twenty years                    | ** ** | **12,685**                      | ** **  |   | **1.4** | ** ** |   |
| Asset-backed securities                   | ** ** | **352,150**                     | ** **  |   | **37.5** | ** ** |   |
| Totals                                    | ** ** | **$**                           | **936,280** | ** ** |   | **100.0** | **%** |   |

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(1)          Actualmaturities of asset-backed securities differ from contractual maturitiesbecause borrowers may have the right to call or prepay obligations with orwithout call or prepayment penalties. Prepayment rates are influenced by anumber of factors that cannot be predicted with certainty, including: therelative sensitivity of the underlying mortgages or other collateral to changesin interest rates; a variety of economic, geographic and other factors; and therepayment priority of the securities in the overall securitization structures.

**Ratings**

A.M. Best, which rates insurance companies based onfactors of concern to policyholders, currently assigns Safety Insurance an “A(Excellent)” rating. Our “A” rating was reaffirmed by A.M. Best on April 18,2006. Such rating is the third highest rating of 13 ratings that A.M. Bestassigns to solvent insurance companies, which currently range from “A++(Superior)” to “D (Very Vulnerable).” Publications of A.M. Best indicatethat the “A” rating is assigned to those companies that in A.M. Best’sopinion have a strong ability to meet their obligations to policyholders over along period of time. In evaluating a company’s financial and operatingperformance, A.M. Best reviews the company’s profitability, leverage andliquidity, as well as its book of business, the adequacy and soundness of itsreinsurance, the quality and estimated market value of its assets, the adequacyof its loss reserves, the adequacy of its surplus, its capital structure, theexperience and competence of its management and its market presence. A.M.Best’s ratings reflect its opinion of an insurance company’s financialstrength, operating performance and ability to meet its obligations topolicyholders and are not evaluations directed to purchasers of an insurancecompany’s securities.

In assigning SafetyInsurance’s rating, A.M. Best recognized its excellent capitalization,sustained operating profitability, and favorable market position as anautomobile insurer in Massachusetts. A.M. Best also noted among ourpositive attributes: favorable operating earnings in recent years; ourdisciplined underwriting approach; and expertise in the highly regulatedMassachusetts automobile insurance industry. A.M. Best cited other factorsthat partially offset these positive attributes, including our geographic concentration,elevated underwriting leverage and limited product scope. We are subject to thecompetitive and highly regulated Massachusetts private passenger automobilemarket, which is characterized by mandated rates set by the Commissioner.

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**Supervision andRegulation**

*Introduction.**  *Our principal operations areconducted through the Insurance Subsidiaries which are subject to comprehensiveregulation by the Division of Insurance, of which the Commissioner is thesenior official. The Commissioner is appointed by the Governor. We are subjectto the authority of the Commissioner in many areas of our business underMassachusetts law, including:

·       ourlicenses to transact insurance;

·       thepremium rates and policy forms we may use;

·       ourfinancial condition including the adequacy of our reserves and provisions forunearned premium;

·       thesolvency standards that we must maintain;

·       thetype and size of investments we may make;

·       theprescribed or permitted statutory accounting practices we must use; and

·       thenature of the transactions we may engage in with our affiliates.

In addition, the Commissioner periodically conducts afinancial examination of all licensees domiciled in Massachusetts. We were mostrecently examined for the five-year period ending December 31, 2003. TheDivision had no material findings as a result of this examination.

*InsuranceHolding Company Regulation.**  *Our principal operating subsidiaries are insurancecompanies, and therefore we are subject to certain laws in Massachusettsregulating insurance holding company systems. These laws require that wefile a registration statement with the Commissioner that discloses theidentity, financial condition, capital structure and ownership of each entitywithin our corporate structure and any transactions among the members of ourholding company system. In some instances, we must provide prior notice to theCommissioner for material transactions between our insurance companysubsidiaries and other affiliates in our holding company system. These holdingcompany statutes also require, among other things, prior approval of thepayment of extraordinary dividends or distributions and any acquisition of adomestic insurer.

*InsuranceRegulation Concerning Dividends.**  *We rely on dividends from theInsurance Subsidiaries for our cash requirements. The insurance holding companylaw of Massachusetts requires notice to the Commissioner of any dividend to thestockholders of an insurance company. The Insurance Subsidiaries may not makean “extraordinary dividend” until thirty days after the Commissioner hasreceived notice of the intended dividend and has not objected in such time. Ashistorically administered by the Commissioner, this provision requires theprior approval by the Commissioner of an extraordinary dividend. Anextraordinary dividend is defined as any dividend or distribution that,together with other distributions made within the preceding twelve monthsexceeds the greater of 10% of the insurer’s surplus as of the preceding December 31,or the insurer’s net income for the twelve-month period ending thepreceding December 31, in each case determined in accordance with statutoryaccounting practices. Under Massachusetts law, an insurer may pay cashdividends only from its unassigned funds, also known as its earned surplus, andthe insurer’s remaining surplus must be both reasonable in relation to itsoutstanding liabilities and adequate to its financial needs. At year-end 2006,the statutory surplus of Safety Insurance was $457,505 and its net income for2006 was $110,075. A maximum of $110,075 will be available by the end of 2007for such dividends without prior approval of the Division.

*Acquisitionof Control of a Massachusetts Domiciled Insurance Company.**  *Massachusetts law requires advanceapproval by the Commissioner of any change in control of an insurance companythat is domiciled in Massachusetts. That law presumes that control exists whereany person, directly or indirectly, owns, controls, holds the power to vote orholds proxies representing 10% or more of our outstanding voting 

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stock. Even persons who donot acquire beneficial ownership of more than 10% of the outstanding shares ofour common stock may be deemed to have acquired control if the Commissionerdetermines that control exists in fact. Any purchaser of shares of common stockrepresenting 10% or more of the voting power of our capital stock will bepresumed to have acquired control of the Insurance Subsidiaries unless,following application by that purchaser the Commissioner determines that theacquisition does not constitute a change of control or is otherwise not subjectto regulatory review. These requirements may deter, delay or preventtransactions affecting the control of or the ownership of our common stock,including transactions that could be advantageous to our stockholders.

*ProtectionAgainst Insurer Insolvency.**  *Massachusetts law requires that insurers licensed todo business in Massachusetts participate in the Massachusetts InsurersInsolvency Fund. The Massachusetts Insurers Insolvency Fund must pay any claimup to $300 of a policyholder of an insolvent insurer if the claim existed priorto the declaration of insolvency or arose within sixty days after thedeclaration of insolvency. Members of the Massachusetts Insurers InsolvencyFund are assessed the amount the Massachusetts Insurers Insolvency Fund deemsnecessary to pay its obligations and expenses in connection with handlingcovered claims. Subject to certain exceptions, assessments are made in theproportion that each member’s net written premiums for the prior calendar yearfor all property and casualty lines bore to the corresponding net writtenpremiums for Massachusetts Insurers Insolvency Fund members for the sameperiod. As a matter of Massachusetts law, insurance rates and premiums includeamounts to recoup any amounts paid by insurers for the costs of theMassachusetts Insurers Insolvency Fund. With respect to private passengerautomobile insurance rates and premiums, the Commissioner has historically madean adjustment in his or her annual rate decision reflecting any MassachusettsInsurers Insolvency Fund-related costs reported by the industry in its ratefiling. By statute, no insurer in Massachusetts may be assessed in any year anamount greater than two percent of that insurer’s direct written premium forthe calendar year prior to the assessment. We account for allocations from theMassachusetts Insurers Insolvency Fund as underwriting expenses. In 2006 and2004, we incurred charges of $464 and $2,538, respectively, for our allocationfrom the Massachusetts Insurers Insolvency Fund for the insolvencies of otherinsurers. In 2005, we received a refund of prior years’ assessments of $50. CARalso assesses its members as a result of insurer insolvencies. Because CAR isnot able to recover an insolvent company’s share of the net CAR losses from theMassachusetts Insurers Insolvency Fund, CAR must increase each of its member’sshare of the deficit in order to compensate for the insolvent carrier’sinability to pay its deficit assessment. It is anticipated that there will beadditional assessments from time to time relating to various insolvencies.

*TheInsurance Regulatory Information System.**  *The Insurance RegulatoryInformation System was developed to help state regulators identify companiesthat may require special financial attention. The Insurance RegulatoryInformation System consists of a statistical phase and an analytical phasewhereby financial examiners review annual statements and financial ratios. Thestatistical phase consists of 12 key financial ratios based on year-end datathat are generated from the National Association of Insurance Commissioners’database annually; each ratio has an established “usual range” of results.These ratios assist state insurance departments in executing their statutorymandate to oversee the financial condition of insurance companies.

A ratio result falling outside the usual range ofInsurance Regulatory Information System ratios is not considered a failingresult; rather, unusual values are viewed as part of the regulatory earlymonitoring system. Furthermore, in some years, it may not be unusual forfinancially sound companies to have several ratios with results outside theusual ranges. Generally, an insurance company will become subject to regulatoryscrutiny if it falls outside the usual ranges of four or more of the ratios. In2006 and 2005, all our ratios for both the Insurance Subsidiaries were withinthe normal range except for Net Change in Adjusted Policyholders’ Surplus whichexceeded the higher limit of the range. In 2004, all our ratios for both the 

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Insurance Subsidiarieswere within the normal range except for Investment Yield, which fell below therange primarily due to our investment strategy to increase tax-exempt holdingsin our portfolio.

*Risk Based CapitalRequirements.**  *TheNational Association of Insurance Commissioners (“NAIC”) has adopted a formulaand model law to implement risk based capital requirements for most propertyand casualty insurance companies, which are designed to determine minimumcapital requirements and to raise the level of protection that statutorysurplus provides for policyholder obligations. The risk based capital formulafor property and casualty insurance companies measures three major areas ofrisk facing property and casualty insurers:

·       underwriting,which encompasses the risk of adverse loss developments and inadequate pricing;

·       declinesin asset values arising from market and/or credit risk; and

·       off-balancesheet risk arising from adverse experience from non-controlled assets,guarantees for affiliates or other contingent liabilities and reserve andpremium growth.

Under Massachusetts law, insurers having less totaladjusted capital than that required by the risk based capital calculation willbe subject to varying degrees of regulatory action, depending on the level ofcapital inadequacy.

The risk based capital law provides for four levels ofregulatory action. The extent of regulatory intervention and action increasesas the level of total adjusted capital to risk based capital falls. The firstlevel, the company action level, as defined by the NAIC, requires an insurer tosubmit a plan of corrective actions to the Commissioner if total adjustedcapital falls below 200% of the risk based capital amount. The regulatoryaction level, as defined by the NAIC requires an insurer to submit a plancontaining corrective actions and requires the Commissioner to perform anexamination or other analysis and issue a corrective order if total adjustedcapital falls below 150% of the risk based capital amount. The authorizedcontrol level, as defined by the NAIC, authorizes the Commissioner to takewhatever regulatory actions he or she considers necessary to protect the bestinterest of the policyholders and creditors of the insurer which may includethe actions necessary to cause the insurer to be placed under regulatorycontrol, i.e., rehabilitation or liquidation, if total adjusted capital fallsbelow 100% of the risk based capital amount. The fourth action level is themandatory control level, as defined by the NAIC, which requires theCommissioner to place the insurer under regulatory control if total adjustedcapital falls below 70% of the risk based capital amount.

The formulas have not been designed to differentiateamong adequately capitalized companies that operate with higher levels ofcapital. Therefore, it is inappropriate and ineffective to use the formulas torate or to rank these companies. At December 31, 2006, our InsuranceSubsidiaries had total adjusted capital in excess of amounts requiring companyor regulatory action at any prescribed risk based capital action level.

*Regulationof Private Passenger Automobile Insurance in Massachusetts.*   Our principal line of businessis Massachusetts private passenger automobile insurance. As described in moredetail above under “The Massachusetts Property and Casualty Insurance Market”,regulation of private passenger automobile insurance in Massachusetts differssignificantly from how this line of insurance is regulated in other states.These differences include the requirements that the premium rate we and allinsurers must charge is fixed and established by the Commissioner, that ourability and that of our competitors to deviate from the rate set by theCommissioner is restricted, and that some of our insurance producers areassigned to us as a matter of law. See “The Massachusetts Property and CasualtyInsurance Market”, as discussed above.

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**Executive Officersand Directors**

Thetable below sets forth certain information concerning our directors andexecutive officers as of the date of this annual report.

| ** **                   | ** ** | ** ** | ** ** | ** **                                                                        | ** ** | **Years**    | ** ** |
|------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------|------------|--------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** **                                                                        | ** ** | **Employed** | ** ** |
| **Name**                     | ** ** | ** ** | ** ** | **Age**                                                                           | ** ** | **Position** | ** ** | **by Safety** | ** ** |
| David F. Brussard            |       | 55         |       | President, Chief  Executive Officer and Chairman of the Board                     |       | 31           |       |
| William J.  Begley, Jr. |       | 52         |       | Vice President, Chief  Financial Officer and Secretary                            |       | 21           |       |
| James D. Berry               |       | 47         |       | Vice President—Insurance  Operations                                         |       | 24           |       |
| George M. Murphy             |       | 40         |       | Vice President—Marketing                                                     |       | 18           |       |
| Robert J. Kerton             |       | 60         |       | Vice President—Claims                                                        |       | 20           |       |
| David E. Krupa               |       | 46         |       | Vice President—Claims  Operations                                            |       | 24           |       |
| Daniel D. Loranger           |       | 67         |       | Vice President—Management  Information Systems and Chief Information Officer |       | 26           |       |
| Edward N.  Patrick, Jr. |       | 58         |       | Vice President—Underwriting                                                  |       | 33           |       |
| A. Richard  Caputo, Jr. |       | 41         |       | Director                                                                          |       | —       |       |
| Frederic H. Lindeberg        |       | 66         |       | Director                                                                          |       | —       |       |
| Peter J. Manning             |       | 68         |       | Director                                                                          |       | —       |       |
| David K. McKown              |       | 69         |       | Director                                                                          |       | —       |       |
|                              |            |            |            |                                                                                   |            |              |            |  |  |

 

*David F. Brussard* was appointed Chairman of the Board in March 2004and President and Chief Executive Officer (“CEO”) in June 2001. Mr. Brussardhas served as a Director of the Company since October 2001. Since January 1999,Mr. Brussard has been the CEO and President of the Insurance Subsidiaries.Previously, Mr. Brussard served as Executive Vice President of theInsurance Subsidiaries from 1985 to 1999 and as Chief Financial Officer andTreasurer of the Insurance Subsidiaries from 1979 to 1999. Mr. Brussardhas been employed by one or more of our subsidiaries for over 31 years. Mr. Brussardis also Chairman of the Governing Committee and a member of the BudgetCommittee, Executive Committee and Nominating Committee of the AutomobileInsurers Bureau of Massachusetts and is Chairman of the Governing Committee anda member of the Budget and Personnel Committee of CAR. Mr. Brussard isalso on the Board of Trustees of the Insurance Library Association of Boston.

*William J. Begley, Jr.* was appointed Chief Financial Officer, VicePresident and Secretary of the Company on March 4, 2002. Since January 1999,Mr. Begley has been the Chief Financial Officer and Treasurer of theInsurance Subsidiaries. Previously, Mr. Begley served as AssistantController of the Insurance Subsidiaries from 1985 to 1987, as Controller from 1987to 1990 and as Assistant Vice President/Controller from 1990 to 1999. Mr. Begleyhas been employed by the Insurance Subsidiaries for over 21 years. Mr. Begleyalso serves on the Audit Committee of CAR and is a member of the Board ofDirectors of the Massachusetts Insurers Insolvency Fund.

*James D. Berry* was appointed Vice President of Insurance Operationsof the Company on October 1, 2005. Mr. Berry has been employed by theInsurance Subsidiaries for over 24 years and has directed the Company’s MassachusettsPrivate Passenger line of business since 2001. Mr. Berry serves on theMarket Review Committee of CAR and the Personal Lines Rules and FormsCommittee of the Automobile Insurers Bureau of Massachusetts. He alsorepresents Safety on the Computer Sciences Corporation Series II AdvisoryCouncil.

*George M. Murphy* was appointed Vice President of Marketing on October 1,2005. Mr. Murphy has been employed by the Insurance Subsidiaries for over18 years and most recently served as Director of Marketing.

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*Robert J. Kerton* was appointed Vice President of Casualty Claims ofthe Company on March 4, 2002. Mr. Kerton has served as Vice Presidentof Claims of the Insurance Subsidiaries since 1986 and has been employed by theInsurance Subsidiaries for over 20 years. Mr. Kerton previouslyserved 18 years with Allstate Insurance Company in various Massachusettsclaim management assignments. Mr. Kerton serves as Chairman of the ClaimsCommittee of the Automobile Insurers Bureau of Massachusetts, Vice Chairman ofthe Claims Committee of CAR, a member of the Governing Board of theMassachusetts Insurance Fraud Bureau.

*David E. Krupa* was appointed Vice President of Property Claims ofthe Company on March 4, 2002. Mr. Krupa has served as Vice Presidentof Claims of the Insurance Subsidiaries since July 1990 and has beenemployed by the Insurance Subsidiaries for over 24 years. Mr. Krupawas first employed by the Company in 1982 and held a series of managementpositions in the Claims Department before being appointed Vice President in1990. In addition, Mr. Krupa has been a member of several claimscommittees both at the Automobile Insurers Bureau of Massachusetts and CAR.

*Daniel D. Loranger* was appointed Vice President of ManagementInformation Systems of the Company on November 7, 1980. Mr. Lorangerhas served as Vice President of Management Information Systems and ChiefInformation Officer of the Insurance Subsidiaries since 1980 and has beenemployed by the Insurance Subsidiaries for over 26 years. Mr. Lorangerbegan his data processing career with Raytheon Manufacturing in 1960.

*Edward N. Patrick, Jr.*was appointed Vice President of Underwriting of theCompany on March 4, 2002. Mr. Patrick has served as Vice President ofUnderwriting of the Insurance Subsidiaries since 1979 and as Secretary since1999. He has been employed by one or more of our subsidiaries for over33 years. Mr. Patrick has served on several committees of CAR,including the MAIP Steering, Actuarial, Market Review, Servicing Carrier,Statistical, Automation and Reinsurance Operations Committees. Mr. Patrickhas also served on the Operations Committee of CAR since 1984 and has served asits chairman since 1998.

*A. Richard Caputo, Jr.*has served as a director of the Company since June 2001.Mr. Caputo has been with The Jordan Company L.P. and its predecessors, aprivate investment firm, since 1990. Mr. Caputo is also a director of TALInternational, Inc., Universal Technical Institute, Inc. and variousprivately held companies.

*Frederic H. Lindeberg* has served as a director of the Company since August 2004.Mr. Lindeberg has had a consulting practice providing taxation, managementand investment counsel since 1991, focusing on finance, real estate,manufacturing and retail industries. Mr. Lindeberg retired in 1991 asPartner-In-Charge of various KPMG tax offices, after 24 years of servicewhere he provided both accounting and tax counsel to various clients. Mr. Lindebergwas formerly an adjunct professor at Penn State Graduate School of Business. Mr. Lindebergis currently a director of TAL International, Inc.

*Peter J. Manning* has served as a director of the Company since September 2003.Mr. Manning retired in 2003 as Vice Chairman of FleetBoston Financial,after 31 years with FleetBoston Financial Corporation (formerly BankBoston)where he also held the positions of Comptroller and Executive Vice Presidentand Chief Financial Officer. Mr. Manning started his career with Coopers &Lybrand in 1962 prior to his 1972 employment with BankBoston. He currently is adirector of Thermo Fisher Scientific, and various non-profit companies and isChairman of the Board of the Tournament Players Club of Boston.

*David K. McKown* hasserved as director of the Company since November 2002. Mr. McKown hasbeen a Senior Advisor to Eaton Vance Management since 2000, focusing onbusiness origination in real estate and asset-based loans. Mr. McKownretired in March 2000 having served as a Group Executive with BankBostonsince 1993, where he focused on acquisitions and high-yield bank debt financings.Mr. McKown has been in the banking industry for 47 years, worked forBankBoston for over 32 years and 

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*hadpreviously been the head of BankBoston’s real estate department, corporatefinance department, and a managing director of BankBoston’s private equityunit. Mr. McKown is currently a director of Global Partners L.P., ofNewcastle Investment Corp., and various privately held companies.*

***ITEM 1A.****            RISKFACTORS*

*An investment in our common stock involves a number ofrisks. Any of the risks described below could result in a significant ormaterial adverse effect on our results of operations or financial condition,and a corresponding decline in the market price of our common stock.*

***Because we are primarily a private passengerautomobile insurance carrier, our business may be adversely affected byconditions in this industry.***

Approximately 76.0% of ourdirect written premiums for the year ended December 31, 2006, weregenerated from private passenger automobile insurance policies. As a result ofour focus on that line of business, negative developments in the economic,competitive or regulatory conditions affecting the private passenger automobileinsurance industry could have a material adverse effect on our results ofoperations and financial condition. In addition, these developments would havea disproportionate effect on us, compared to insurers which conduct operationsin multiple business lines.

***Because we write insurance only in Massachusetts,our business may be adversely affected by conditions in Massachusetts.***

All of our direct writtenpremiums are generated in Massachusetts. Our revenues and profitability aretherefore subject to prevailing regulatory, economic, demographic, competitiveand other conditions in Massachusetts. Changes in any of these conditions couldmake it more costly or difficult for us to conduct our business. Adverseregulatory developments in Massachusetts, which could include, among others,reductions in the maximum rates permitted to be charged, inadequate rateincreases or more fundamental changes in the design or implementation of theMassachusetts automobile insurance regulatory framework, could have a materialadverse effect on our results of operations and financial condition. Inaddition, these developments would have a disproportionate effect on us,compared to insurers which conduct operations in multiple states.

***We have exposure to claims related to severeweather conditions, which may result in an increase in claims frequency andseverity.***

We are subject to claims arising out of severe weatherconditions, such as rainstorms, snowstorms and ice storms, that may have asignificant effect on our results of operations and financial condition. Theincidence and severity of weather conditions are inherently unpredictable. Thereis generally an increase in claims frequency and severity under the privatepassenger automobile insurance we write when severe weather occurs because ahigher incidence of vehicular accidents and other insured losses tend to occuras a result of severe weather conditions. In addition, we have exposure to anincrease in claims frequency and severity under the homeowners and otherproperty insurance we write because property damage may result from severeweather conditions.

Because some of ourinsureds live near the Massachusetts coastline, we also have a potentialexposure to losses from hurricanes and major coastal storms such as Nor’easters.Although we purchase catastrophe reinsurance to limit our exposure to thesetypes of natural catastrophes, in the event of a major catastrophe resulting inproperty losses to us in excess of $280,000, our losses would exceed the limitsof this reinsurance.

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***If we arenot able to attract and retain independent agents, it could adversely affectour business.***

We market our insurancesolely through independent agents. We must compete with other insurancecarriers for the business of independent agents. Some of our competitors offera larger variety of products, lower prices for insurance coverage or highercommissions. While we believe that the commissions and services we provide toour agents are competitive with other insurers, changes in commissions,services or products offered by our competitors could make it harder for us toattract and retain independent agents to sell our insurance products.

***Established competitors with greater resources maymake it difficult for us to market our products effectively and offer ourproducts at a profit.***

The property and casualty insurance business is highlycompetitive and many of our competitors have substantially greater financialand other resources than us. We compete with both large national writers andsmaller regional companies. Further, our competitors include other companieswhich, like us, serve the independent agency market, as well as companies whichsell insurance directly to customers. Direct writers may have certaincompetitive advantages over agency writers, including increased namerecognition, loyalty of the customer base to the insurer rather than to anindependent agency and, potentially, lower cost structures. A materialreduction in the amount of business independent agents sell would directly andnegatively affect our profitability and our ability to compete with insurersthat do not rely solely on the independent agency market to sell theirproducts. In the past, competition in the Massachusetts personal auto insurancemarket has included offering significant discounts from the maximum permittedrates, and there can be no assurance that these conditions will not recur.Further, our Company and others compete on the basis of the commissions andother cash and non-cash incentives provided to agents. Although a number ofnational insurers that are much larger than we are do not currently compete ina material way in the Massachusetts personal auto market, if one or more ofthese companies decided to aggressively enter the market it could reduce ourshare of the Massachusetts market and thereby have a material adverse effect onus. These companies include some that would be able to sustain significantlosses in order to acquire market share, as well as others which usedistribution methods that compete with the independent agent channel.

***As a holding company, Safety Insurance Group, Inc.is dependent on the results of operations of the Safety Insurance Company****.*

Safety Insurance Group, Inc.is a company and a legal entity separate and distinct from Safety InsuranceCompany, our principal operating subsidiary. As a holding company withoutsignificant operations of its own, the principal sources of Safety InsuranceGroup, Inc.’s funds are dividends and other distributions from SafetyInsurance Company. Our rights to participate in any distribution of assets ofSafety Insurance Company are subject to prior claims of policyholders,creditors and preferred stockholders, if any, of Safety Insurance Company(except to the extent that our rights, if any, as a creditor are recognized).Consequently, our ability to pay debts, expenses and cash dividends to ourstockholders may be limited. The ability of Safety Insurance Company to paydividends is subject to limits under Massachusetts insurance law. Further, theability of Safety Insurance Group, Inc. to pay dividends, and oursubsidiaries’ ability to incur indebtedness or to use the proceeds of equityofferings, will be subject to limits under our revolving credit facility.

***We are subject to comprehensive regulation byMassachusetts and our ability to earn profits may be restricted by theseregulations.***

*GeneralRegulation.*   We are subject to regulation bygovernment agencies in Massachusetts, and we must obtain prior approval forcertain corporate actions. We must comply with regulations involving:

·       transactionsbetween an insurance company and any of its affiliates;

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·       thepayment of dividends;

·       theacquisition of an insurance company or of any company controlling an insurancecompany;

·       approvalor filing of premium rates and policy forms;

·       solvencystandards;

·       minimumamounts of capital and surplus which must be maintained;

·       limitationson types and amounts of investments;

·       restrictionson the size of risks which may be insured by a single company;

·       limitationof the right to cancel or non-renew policies in some lines;

·       regulationof the right to withdraw from markets or terminate involvement with agencies;

·       requirementsto participate in residual markets;

·       licensingof insurers and agents;

·       depositsof securities for the benefit of policyholders; and

·       reportingwith respect to financial condition.

In addition, insurance department examiners fromMassachusetts perform periodic financial and market conduct examinations ofinsurance companies. Such regulation is generally intended for the protectionof policyholders rather than security holders.

Massachusetts requires that all licensed property andcasualty insurers bear a portion of the losses suffered by some insureds as aresult of impaired or insolvent insurance companies by participating in the Massachusetts Insurers Insolvency Fund (“InsolvencyFund”). Members of the Insolvency Fund are assessed a proportionate share ofthe obligations and expenses of the Insolvency Fund in connection with aninsolvent insurer. In 2006 and 2004, the Company received notice of assessmentsfrom the Insolvency Fund amounting to $464 and $2,538, respectively. In 2005,the Company received a refund of prior years’ assessments from the InsolvencyFund of $50. These assessments were made by the Insolvency Fund to coverthe cost of paying eligible claims of policyholders of these insolventinsurers, and by CAR, to recover the shares of net CAR losses that would havebeen assessed to the insolvent companies but for their insolvencies. Inaddition, Massachusetts has established an underwriting association in order toensure that property insurance is available for owners of high risk propertywho are not able to obtain insurance from private insurers. The losses of thisunderwriting association are shared by all insurers that write property andcasualty insurance in Massachusetts. We are assessed from time to time to paythese losses. The effect of these assessments could reduce our profitability inany given period and limit our ability to grow our business.

Because we are unable to predict with certaintychanges in the political, economic or regulatory environments in Massachusettsin the future, there can be no assurance that existing insurance-related lawsand regulations will not become more restrictive in the future or that newrestrictive laws will not be enacted and, therefore, it is not possible topredict the potential effects of these laws and regulations on us.

*MassachusettsPersonal Auto Regulation.  *Weare subject to the extensive regulation of the private passenger automobileinsurance industry in Massachusetts. Owners of registered automobiles arerequired to maintain minimum automobile insurance coverages. Generally, we arerequired by law to issue a policy to any applicant who seeks it. We areassigned certain agents that have been unable to obtain a voluntary contractwith another insurer. We call these agents ERPs. In addition, we are requiredto participate in a state mandated reinsurance program run by CAR, to which wecede certain undesirable risks and from 

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*which weare allocated a portion of the program’s overall losses. This program operatesat an underwriting deficit and results in expense for us. Our ability to earnprofits may be restricted by these requirements.*

Our marketing andunderwriting strategies are limited by maximum premium rates and minimum agencycommission levels for personal automobile insurance, which are mandated by theCommissioner. The Commissioner mandated an average rate decrease in privatepassenger automobile premiums of 8.7% and 1.7% for 2006 and 2005, respectively.The Commissioner mandated average rate increases of 2.5% and 2.7% for 2004 and2003, respectively, and no rate change for 2002. Beginning in 2007 the effectivedate of the Commissioner’s rate decision will be April 1st of each year as compared to January 1st of 2006 and prior ratedecisions. The 2006 rates will be in effect from January 1, 2006 until March 31,2007. The Commissioner announced on December 15, 2006, an 11.7% statewideaverage private passenger automobile insurance rate decrease for 2007 whichwill take effect on April 1, 2007. In addition, the Commissioner annuallyestablishes the minimum commission rate that insurers must pay their auto insuranceagents. The Commissioner approved a commission rate, as a percentage ofpremiums of 11.8%, 10.9%, 10.5%, and 11.0%, in 2006, 2005, 2004, and 2003,respectively. The Commissioner approved a commission rate of 13.0% for 2007which will take effect on April 1, 2007. Premium rates are set following aproceeding in which the Commissioner considers historic information relating toclaims costs as well as outside factors affecting insurance costs. If theinformation considered does not accurately predict the future benefit andexpense costs of insurers, or if the Commissioner otherwise sets inadequatepremium rates, our future profitability could decrease. Future increases incommission rates would also decrease our profitability.

***We may enter new markets and there can be noassurance that our diversification strategy will be effective.***

Although we intend toconcentrate on our core businesses in Massachusetts, we also may seek to takeadvantage of prudent opportunities to expand our core businesses into other stateswhere we believe the independent agent distribution channel is strong. As aresult of a number of factors, including the difficulties of findingappropriate expansion opportunities and the challenges of operating in anunfamiliar market, we may not be successful in this diversification.Additionally, in order to carry out any such strategy we would need to obtainthe appropriate licenses from the insurance regulatory authority of any suchstate. Today, we do not possess any licenses outside of Massachusetts and wecould encounter unexpected regulatory obstacles that prevent us from obtainingthese licenses in a timely fashion, or at all.

***Our failure to maintain a commercially acceptablefinancial strength rating would significantly and negatively affect our abilityto implement our business strategy successfully.***

A.M. Best has currentlyassigned Safety Insurance an ‘‘A (Excellent)’’ rating. An ‘‘A’’ rating is A.M.Best’sthird highest rating, out of 13 possible rating classifications for solventcompanies. An ‘‘A’’ rating is assigned to insurers that in A.M. Best’sopinion have a strong ability to meet their ongoing obligations topolicyholders. Moreover, an ‘‘A’’ rating is assigned to companies that have, onbalance, excellent balance sheet strength, operating performance and businessprofile when compared to the standards established by A.M. Best. A.M.Best bases its ratings on factors that concern policyholders and not uponfactors concerning investor protection. Such ratings are subject to change and arenot recommendations to buy, sell or hold securities. An important factor in aninsurer’s ability to compete effectively is its A.M. Best rating. Our A.M.Best rating is lower than those of some of our competitors. Any future decreasein our rating could affect our competitive position.

***Our losses and loss adjustment expenses may exceedour reserves, which could significantly affect our business.***

The reserves for losses and loss adjustment expensesthat we have established are estimates of amounts needed to pay reported andunreported claims and related expenses based on facts and circumstances knownto us as of the time we established the reserves. Reserves are based onhistorical 

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claims information,industry statistics and other factors. The establishment of appropriatereserves is an inherently uncertain process. If our reserves are inadequate andare strengthened, we would have to treat the amount of such increase as acharge to our earnings in the period that the deficiency is recognized. As aresult of these factors, there can be no assurance that our ultimate liabilitywill not materially exceed our reserves and have a negative effect on ourresults of operations and financial condition.

Due to the inherentuncertainty of estimating reserves, it has been necessary, and may over timecontinue to be necessary, to revise estimated future liabilities as reflectedin our reserves for claims and policy expenses. The historic development ofreserves for losses and loss adjustment expenses may not necessarily reflectfuture trends in the development of these amounts. Accordingly, it is notappropriate to extrapolate redundancies or deficiencies based on historicalinformation.

***If we lose key personnel, our ability to implementour business strategy could be delayed or hindered.***

Our future success dependssignificantly upon the efforts of certain key management personnel, includingDavid F. Brussard, our Chief Executive Officer and President. We have enteredinto employment agreements with Messrs. Brussard, Begley, Kerton, Krupa,Loranger, Patrick, Murphy, and Berry, the eight members of our Management Team.The loss of key personnel could prevent us from fully implementing our businessstrategy and could significantly and negatively affect our financial conditionand results of operations. As we continue to grow, we will need to recruit andretain additional qualified management personnel, and our ability to do so willdepend upon a number of factors, such as our results of operations andprospects and the level of competition then prevailing in the market forqualified personnel.

***Market fluctuations and changes in interest ratescan have significant and negative effects on our investment portfolio.***

Our results of operationsdepend in part on the performance of our invested assets. As of December 31,2006, based upon fair value measurement, 99.5% of our investment portfolio wasinvested in fixed maturity securities and 0.5% in common equity securities.Certain risks are inherent in connection with debt securities including lossupon default and price volatility in reaction to changes in interest rates andgeneral market factors.

***We may not be able to successfully alleviate riskthrough reinsurance arrangements which could cause us to reduce our premiumswritten in certain lines or could result in losses.***

In order to reduce riskand to increase our underwriting capacity, we purchase reinsurance. Theavailability and the cost of reinsurance protection is subject to marketconditions, which are outside of our control. As a result, we may not be ableto successfully alleviate risk through these arrangements. For example, ifreinsurance capacity for homeowners risks were reduced as a result of terroristattacks, climate change or other causes, we might seek to reduce the amount ofhomeowners business we write. In addition, we are subject to credit risk withrespect to our reinsurance because the ceding of risk to reinsurers does notrelieve us of our liability to our policyholders. A significant reinsurer’sinsolvency or inability to make payments under the terms of a reinsurancetreaty could have a material adverse effect on our results of operations andfinancial condition.

***There are anti-takeover provisions contained in ourorganizational documents and in laws of the State of Delaware and theCommonwealth of Massachusetts that could impede an attempt to replace or removeour management or prevent the sale of our company, which could diminish thevalue of our common stock.***

Our certificate of incorporation, bylaws and the lawsof Delaware contain provisions that may delay, deter or prevent a takeoverattempt that stockholders might consider in their best interests. For example, 

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our organizationaldocuments provide for a classified board of directors with staggered terms,prevent stockholders from taking action by written consent, preventstockholders from calling a special meeting of stockholders, provide forsupermajority voting requirements to amend our certificate of incorporation andcertain provisions of our bylaws and provide for the filling of vacancies onour board of directors by the vote of a majority of the directors then inoffice. These provisions will render the removal of the incumbent board ofdirectors or management more difficult. In addition, these provisions mayprevent stockholders from receiving the benefit of any premium over the marketprice of our common stock offered by a bidder in a potential takeover. Even inthe absence of a takeover attempt, the existence of these provisions mayadversely affect the prevailing market price of our common stock if they areviewed as discouraging takeover attempts in the future.

The Massachusetts insurance law prohibits any personfrom acquiring control of us, and thus indirect control of Safety InsuranceGroup, Inc., without the prior approval of the Commissioner. That lawpresumes that control exists where any person, directly or indirectly, owns,controls, holds the power to vote or holds proxies representing 10% or more ofour outstanding voting stock. Even persons who do not acquire beneficialownership of more than 10% of the outstanding shares of our common stock may bedeemed to have acquired such control if the Commissioner determines that suchcontrol exists in fact. Therefore, any person seeking to acquire a controllinginterest in us would face regulatory obstacles which could delay, deter orprevent an acquisition that stockholders might consider in their bestinterests.

Section 203 of theGeneral Corporation Law of Delaware, the jurisdiction in which the Company isorganized, may affect the ability of an “interested stockholder” to engage incertain business combinations including mergers, consolidations or acquisitionsof additional shares, for a period of three years following the time that thestockholder becomes an interested stockholder. An interested stockholder isdefined to include persons owning directly or indirectly 15% or more of theoutstanding voting stock of the corporation.

***Future sales of shares of our common stock by ourexisting stockholders in the public market, or the possibility or perception ofsuch future sales, could adversely affect the market price of our stock.***

Investors currently knownto be the beneficial owners of greater than 5.0% of our outstanding commonstock, hold approximately 20.4% of the common stock of Safety Insurance Group, Inc.on a fully diluted basis. No prediction can be made as to the effect, if any,that future sales of shares by our existing stockholders, or the availabilityof shares for future sale, will have on the prevailing market price of ourcommon stock from time to time. Sales of substantial amounts of our commonstock in the public market by our existing stockholders, or the possibility orperception that such sales could occur, could cause the prevailing marketprices for our common stock to decrease. If such sales reduce the market priceof our common stock, our ability to raise additional capital in the equitymarkets may be adversely affected.

***ITEM 1B.****            UNRESOLVEDSTAFF COMMENTS*

As of the date of thisreport, the Company had no unresolved comments from the Commission staffregarding its periodic or current reports under the Exchange Act.

***ITEM 2.****                 PROPERTIES*

We conduct most of ouroperations in approximately 89 thousand square feet of leased space at 20Custom House Street in downtown Boston, Massachusetts. Our lease expires in December 2008.

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***ITEM 3.****                 LEGALPROCEEDINGS*

Our Insurance Subsidiariesare parties to a number of lawsuits arising in the ordinary course of theirinsurance business. We believe that the ultimate resolution of these lawsuitswill not, individually or in the aggregate, have a material adverse effect onour financial condition. Other than these lawsuits, we are not involved in anylegal proceedings.

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

There were no matters submitted to a vote of theCompany’s shareholders during the fourth quarter of 2006.

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**PART II.**

***ITEM 5.****                 MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES*

As of February 26, 2007, there were 27 holders ofrecord of the Company’s common stock, par value $0.01 per share, and we estimateanother 12,200 held in “Street Name”.

TheCompany’s common stock (symbol: SAFT) is listed on the NASDAQ Global SelectMarket. The following table sets forth the high and low sales prices per sharefor each full quarterly period within the Company’s two most recent fiscalyears.

| **2006**       | ** ** | ** ** | ** ** | **High**   | ** ** | **Low**   | ** ** |
|----------------|------------|------------|------------|------------|------------|-----------|------------|
| First Quarter  | ** ** | **$**      | **46.31**  | ** ** | **$**      | **37.50** | ** ** |
| Second Quarter | ** ** | **$**      | **50.08**  | ** ** | **$**      | **40.80** | ** ** |
| Third Quarter  | ** ** | **$**      | **56.03**  | ** ** | **$**      | **46.40** | ** ** |
| Fourth Quarter | ** ** | **$**      | **53.96**  | ** ** | **$**      | **48.61** | ** ** |

 

| **2005**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 40.54      |     | $          | 30.13   |       |
| Second Quarter |       | $          | 34.61      |     | $          | 26.20   |       |
| Third Quarter  |       | $          | 37.23      |     | $          | 32.52   |       |
| Fourth Quarter |       | $          | 44.34      |     | $          | 34.27   |       |

 

The closing price of the Company’s common stock on February 23,2007 was $46.37 per share.

During 2006, the Company declared and paid four quarterlycash dividends to stockholders, which totaled $13,733. The Company’s Board ofDirectors declared a quarterly cash dividend on February 15, 2007, of$0.25 per share to stockholders of record on March 1, 2007, payable on March 15,2007. The Company plans to continue to declare and pay quarterly cash dividendsin 2007, depending on the Company’s financial position and the regularity ofits cash flows.

The Company relies ondividends from its Insurance Subsidiaries for a portion of its cashrequirements. The payment by the Company of any cash dividends to the holdersof common stock therefore depends on the receipt of dividend payments from itsInsurance Subsidiaries. The payment of dividends by the Insurance Subsidiariesis subject to limitations imposed by Massachusetts law, as discussed in Item 1,Business, Supervision and Regulation, “Insurance Regulation ConcerningDividends”, and also in Item 7—Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, Liquidity and Capital Resources.

**COMMON STOCKPERFORMANCE GRAPH**

Set forth below is a linegraph comparing the dollar change in the cumulative total shareholder return onthe Company’s Common Stock, for the period beginning on November 27, 2002(the close of the Company’s IPO and first trade date for the Company’s commonstock) and ending on December 31, 2006, with the cumulative total returnof the NASDAQ Stock Market Index and a peer group comprised of six selectedproperty & casualty insurance companies over the same period. The peergroup consists of Baldwin & Lyons, Inc., the Commerce Group, Inc.,Mercury General Corp., State Auto Financial Corp., Selective Insurance Group, Inc.,and 21st Century Insurance Group. The graph shows thechange in value of an initial $100 investment on November 27, 2002,assuming re-investment of all dividends.

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**ComparativeCumulative Total Returns since 11/27/2002 IPO AmongSafety Insurance Group, Inc.,Property & Casualty Insurance Peer Group and the NASDAQ Stock MarketIndex**

****

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***ITEM 6.****                 SELECTEDFINANCIAL DATA*

The following table sets forth our selected historicalconsolidated financial data as of and for each of the five years ended December 31,2006.

The selected historical consolidated financial datafor the years ended December 31, 2006, 2005 and 2004 and as of December 31,2006, 2005, and 2004 have been derived from the financial statements of SafetyInsurance Group, Inc. included in this annual report which have beenaudited by PricewaterhouseCoopers LLP, an independent registered publicaccounting firm. The selected historical consolidated financial data for theyears ended December 31, 2003 and 2002 and as of December 31, 2003and 2002 have been derived from Safety Insurance Group, Inc.’sconsolidated financial statements not included in this annual report, whichhave been audited by PricewaterhouseCoopers LLP.

We have prepared the selected historical consolidatedfinancial data, other than statutory data, in conformity with U. S. generallyaccepted accounting principles (“GAAP”). We have derived the statutory datafrom the annual statements of our Insurance Subsidiaries filed with insuranceregulatory authorities, which were prepared in accordance with statutoryaccounting practices, which vary in certain respects from GAAP.

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Theselected financial data presented below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe consolidated financial statements and the accompanying notes included inthis Form 10-K in order to more fully understand the historicalconsolidated financial data.

| ** **                                                     | ** ** | **For the Year Ended December 31,** | ** **  |
|----------------------------------------------------------------|------------|--------------------------------------------------------------|-------------|
| ** **                                                     | ** ** | **2006**                                                     | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Direct written  premiums                                       | ** ** | **$**                                                        | **629,511** |   | $ | 649,113 |   | $ | 628,295 |   | $ | 571,545 |   | $ | 516,556 |   |
| Net written  premiums                                          | ** ** | **620,908**                                                  |        | 632,836 |   | 618,923 |   | 566,970 |   | 517,614 |   |
| Net earned  premiums                                           | ** ** | **624,933**                                                  |        | 622,831 |   | 592,292 |   | 540,248 |   | 489,256 |   |
| Investment income                                              | ** ** | **40,293**                                                   |        | 31,573 |   | 27,259 |   | 26,086 |   | 26,142 |   |
| Net realized  gains (losses) on investments                    | ** ** | **358**                                                      |        | 305 |   | 1,274 |   | 10,051 |   | (277 | ) |
| Finance and other  service income                              | ** ** | **15,128**                                                   |        | 16,748 |   | 15,615 |   | 15,409 |   | 14,168 |   |
| Total revenue                                                  | ** ** | **680,712**                                                  |        | 671,457 |   | 636,440 |   | 591,794 |   | 529,289 |   |
| Loss and loss  adjustment expenses                             | ** ** | **353,906**                                                  |        | 385,593 |   | 425,061 |   | 420,969 |   | 375,178 |   |
| Underwriting,  operating and related expenses                  | ** ** | **162,220**                                                  |        | 146,669 |   | 145,075 |   | 130,636 |   | 128,866 |   |
| Other expenses                                                 | ** ** | **—**                                                   |        | — |   | — |   | — |   | 6,250 |   |
| Interest expenses                                              | ** ** | **86**                                                       |        | 948 |   | 672 |   | 646 |   | 7,254 |   |
| Total expenses                                                 | ** ** | **516,212**                                                  |        | 533,210 |   | 570,808 |   | 552,251 |   | 517,548 |   |
| Income before  income  taxes                                   | ** ** | **164,500**                                                  |        | 138,247 |   | 65,632 |   | 39,543 |   | 11,741 |   |
| Income tax  expense                                            | ** ** | **52,559**                                                   |        | 43,065 |   | 20,642 |   | 11,061 |   | 1,280 |   |
| Net income before  preferred share dividends                   | ** ** | **111,941**                                                  |        | 95,182 |   | 44,990 |   | 28,482 |   | 10,461 |   |
| Dividends on mandatorily redeemable preferred shares           | ** ** | **—**                                                   |        | — |   | — |   | — |   | (1,219 | ) |
| Net income  available to common shareholders                   | ** ** | **$**                                                        | **111,941** |   | $ | 95,182 |   | $ | 44,990 |   | $ | 28,482 |   | $ | 9,242 |   |
| Net income per common  share available to common shareholders: | ** ** | ** **                                                   |        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Basic                                                          | ** ** | **$**                                                        | **7.07**    |   | $ | 6.11 |   | $ | 2.94 |   | $ | 1.87 |   | $ | 1.44 |   |
| Diluted                                                        | ** ** | **$**                                                        | **6.99**    |   | $ | 5.97 |   | $ | 2.90 |   | $ | 1.86 |   | $ | 1.38 |   |
| Cash dividends  paid per common share                          | ** ** | **$**                                                        | **0.86**    |   | $ | 0.60 |   | $ | 0.44 |   | $ | 0.34 |   | $ | — |   |
| Weighted average number  of common shares outstanding:         |       |                                                         |        |   |   |   |   |   |   |   |   |
| Basic                                                          | ** ** | **15,838,335**                                               |        | 15,578,039 |   | 15,315,877 |   | 15,259,991 |   | 6,433,786 |   |
| Diluted                                                        | ** ** | **16,005,913**                                               |        | 15,953,737 |   | 15,526,892 |   | 15,340,047 |   | 6,699,338 |   |

 

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| ** **                                   | ** ** | **Year Ended December 31,** | ** **  |
|----------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                   | ** ** | **2006**                                   | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Balance  Sheet Data:**                     |       |                                       |        | ** ** |   | ** ** |   | ** ** |   | ** ** | ** ** |
| Total cash and investment securities         | ** ** | **$**                                      | **966,888** | ** ** | $ | 877,570 |   | $ | 820,269 |   | $ | 699,920 |   | $ | 638,663 |   |
| Total assets                                 | ** ** | **1,355,748**                              | ** **  | 1,257,675 |   | 1,206,445 |   | 1,076,296 |   | 978,596 |   |
| Losses and loss adjustment expenses reserves | ** ** | **449,444**                                | ** **  | 450,716 |   | 450,897 |   | 383,551 |   | 333,297 |   |
| Total debt                                   | ** ** | **—**                                 | ** **  | — |   | 19,956 |   | 19,956 |   | 19,956 |   |
| Total liabilities                            | ** ** | **859,400**                                | ** **  | 869,726 |   | 901,111 |   | 808,276 |   | 733,344 |   |
| Mandatorily redeemable preferred stock       | ** ** | **—**                                 | ** **  | — |   | — |   | — |   | 22,680 |   |
| Total shareholders’ equity              | ** ** | **496,348**                                | ** **  | 387,949 |   | 305,334 |   | 268,020 |   | 245,252 |   |
| **Statutory  Data:**                         | ** ** | ** **                                 | ** **  |   |   |   |   |   |   |   |   |
| Policyholders’ surplus (at period end)  | ** ** | **$**                                      | **457,505** | ** ** | $ | 350,833 |   | $ | 278,161 |   | $ | 258,551 |   | $ | 234,204 |   |
| Loss ratio(1)                                | ** ** | **56.6**                                   | **%**       | 61.9 | % | 71.7 | % | 78.0 | % | 77.5 | % |
| Expense ratio(1)                             | ** ** | **26.2**                                   | ** **  | 23.4 |   | 23.7 |   | 23.5 |   | 24.9 |   |
| Combined ratio(1)                            | ** ** | **82.8**                                   | **%**       | 85.3 | % | 95.4 | % | 101.5 | % | 102.4 | % |
| **GAAP  Ratios:**                            | ** ** | ** **                                 | ** **  |   | ** ** |   | ** ** |   |   |   |   |
| Loss ratio(1)                                | ** ** | **56.6**                                   | **%**       | 61.9 | % | 71.8 | % | 77.9 | % | 76.7 | % |
| Expense ratio(1)                             | ** ** | **26.0**                                   | ** **  | 23.5 |   | 24.5 |   | 24.2 |   | 26.3 |   |
| Combined ratio(1)                            | ** ** | **82.6**                                   | **%**       | 85.4 | % | 96.3 | % | 102.1 | % | 103.0 | % |

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(1)          The loss ratio is theratio of losses and loss adjustment expenses to net earned premiums. Theexpense ratio, when calculated on a statutory accounting basis, is the ratio ofunderwriting expenses to net written premiums, and when calculated on a GAAPbasis is the ratio of underwriting expense to net earned premiums. The combinedratio is the sum of the loss ratio and the expense ratio. Please refer to *Insurance Ratios* under Item 7—Management’s Discussion andAnalysis of Financial Condition and Results of Operations, Liquidity andCapital Resources for a discussion on the comparison of the above statutoryinsurance ratios to our GAAP ratios.

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***ITEM 7.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS*

*The followingdiscussion should be read in conjunction with our accompanying consolidatedfinancial statements and notes thereto, which appear elsewhere in this document.In this discussion, all dollar amounts are presented in thousands, except shareand per share data.*

*The following discussion contains forward-lookingstatements. We intend statements which are not historical in nature to be, andare hereby identified as “forward-looking statements” to be covered bythe safe harbor provisions of the Private Securities Litigation Reform Act of1995. In addition, the Company’s senior management may make forward-lookingstatements orally to analysts, investors, the media and others. This safeharbor requires that we specify important factors that could cause actualresults to differ materially from those contained in forward-lookingstatements made by or on behalf of us. We cannot promise that our expectationsin such forward-looking statements will turn out to be correct. Ouractual results could be materially different from and worse than ourexpectations. See “Forward-Looking Statements” below for specificimportant factors that could cause actual results to differ materially fromthose contained in forward-looking statements.*

**Executive Summaryand Overview**

In this discussion, “Safety” refers to SafetyInsurance Group, Inc. and “our Company,” “we,” “us” and “our” refer toSafety Insurance Group, Inc. and its consolidated subsidiaries. Oursubsidiaries consist of Safety Insurance Company (“Safety Insurance”), SafetyIndemnity Insurance Company (“Safety Indemnity”), Safety Property and CasualtyInsurance Company (“Safety P&C”), Whiteshirts Asset Management Corporation(“WAMC”), and Whiteshirts Management Corporation, which is WAMC’s holdingcompany.

We are a leading providerof private passenger automobile insurance in Massachusetts. In addition toprivate passenger automobile insurance (which represented 76.0% of our directwritten premiums in 2006), we offer a portfolio of other insurance products,including commercial automobile (14.0% of 2006 direct written premiums),homeowners (7.9% of 2006 direct written premiums), dwelling fire, umbrella andbusiness owner policies (totaling 2.1% of 2006 direct written premiums).Operating exclusively in Massachusetts through our insurance companysubsidiaries, Safety Insurance, Safety Indemnity, and Safety P&C, which wasformed in December 2006 but has not yet commenced writing business,(together referred to as the “Insurance Subsidiaries”), we have establishedstrong relationships with 652 independent insurance agents in 760 locationsthroughout Massachusetts. We have used these relationships and our extensiveknowledge of the Massachusetts market to become the second largest privatepassenger automobile and third largest commercial automobile insurance carrierin Massachusetts, capturing an approximate 11.2% and 11.8% share respectivelyof the Massachusetts automobile market in 2006, according to the CAR CessionVolume Analysis Report of January 19, 2007, based on automobile exposures.These statistics total, for each vehicle insured, the number of months duringthe year insurance for that vehicle is in effect, to arrive at an aggregatenumber of car-months for each insurer; this aggregate number, divided by 12,equals the insurer’s number of car-years, a measure we refer to in thisdiscussion as automobile exposures.

*MassachusettsAutomobile Insurance Market*

We are subject to the extensive regulation of theprivate passenger automobile insurance industry in Massachusetts, whichrepresented 76.0% of our direct written premiums in 2006. Owners of registeredautomobiles in Massachusetts are required to maintain minimum automobileinsurance coverages. We are required to participate in a state-mandatedreinsurance program run by CAR to which we cede certain unprofitable risks andfrom which we are allocated a portion of the overall losses. As a servicingcarrier of CAR, we are required to issue a policy to all qualified applicants. Thisprogram operates at an underwriting deficit. This deficit is allocated amongevery Massachusetts automobile insurance company, 

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including us, based on acomplex formula that takes into consideration a company’s voluntary marketshare, the rate at which it cedes business to CAR, and the company’sutilization of a credit system CAR has designed to encourage carriers to reducetheir use of CAR. In addition, based on our market share, we are assignedcertain licensed producers by CAR that have been unable to obtain a voluntarycontract with another insurer. We call these agents Exclusive RepresentativeProducers, or ERPs.

On December 31, 2004, the Commissioner approvednew rules for CAR, which became effective on January 1, 2005 (the “ApprovedRules”). The Approved Rules provided for the adoption of an assigned riskplan by CAR. Shortly thereafter, litigation was commenced in Suffolk SuperiorCourt by Commerce Insurance Company against the Commissioner seeking an orderpermanently enjoining implementation and/or enforcement of the Approved Rules.Certain ERPs, Arbella Mutual Insurance Company and the Center for InsuranceResearch intervened as plaintiffs and CAR intervened as a defendant in this lawsuit.On June 20, 2005, the Massachusetts Superior Court ruled that theCommissioner lacked the statutory authority to implement the Approved Rules andordered them vacated. As a result, the Approved Rules did not go intoeffect. The Commissioner appealed the decision of the Massachusetts SuperiorCourt. On August 23, 2006, the Massachusetts Supreme Judicial Courtoverturned the decision of the Massachusetts Superior Court and unanimouslyruled that the Commissioner did not need legislative approval to put in placethe provisions in the Approved Rules which establish an assigned riskplan. On October 18, 2006, the Commissioner reviewed the Approved Rules andproposed changes (the “Revised Rules”) that would, in part, establish anassigned risk plan called the Massachusetts Automobile Insurance Plan (the “MAIP”).As proposed, the Revised Rules would: 1) eliminate provisions in thecurrent CAR Rules that are no longer necessary in light of the litigationdescribed above; 2) integrate the Revised Rules into the current CARRules; 3) set a timetable for the implementation of the MAIP; and 4) revise theMAIP to conform with the Supreme Judicial Court’s remand regarding theso-called “clean in three” provisions contained in the Approved Rules. Ahearing was held November 10, 2006, on the Revised Rules and on December 13,2006, the Commissioner approved changes to the MAIP rules (the “MAIP Rules”)that called for three year phase in of an assigned risk plan beginning April 1,2007.

On January 5, 2007, Deval L. Patrick was sworn inas Governor of the Commonwealth of Massachusetts replacing outgoingGovernor Mitt Romney. The Commissioner of Insurance Julianne M. Bowler wasreplaced by the new Governor and on January 19, 2007, Acting Commissioner,Joseph G. Murphy, suspended the MAIP Rules (the “Suspended Rules”) for aperiod not to exceed 90 days. A hearing was held on February 15, 2007, fortestimony regarding recommendations or amendments to the Suspended Rules. Atthis time, we are unable to predict whether the Suspended Rules will beadopted and what the financial impact of the Suspended Rules on us wouldbe if they are adopted.

Governor Patrick has selected former MassachusettsSuperior Court Justice, Nonnie Burns, to be Massachusetts Commissioner ofInsurance effective February 26, 2007, and Governor Patrick has appointeda commission to study and report on the Massachusetts private passengerautomobile system. We are unable to predict what, if any, changes thecommission may recommend.

While the litigation described above was pending andbefore the MAIP Rules were approved, in order to address certain perceivedinequities in the distribution of ERP exposures, CAR approved on June 15,2005, rules to modify the ERP subscription relief process, making thereassignment of ERP exposures from an oversubscribed servicing carrier moretimely and responsive, while enhancing equity in the ERP distribution for allservicing carriers (the “ERP Subscription Rules”). Also, the practice of twoand three-party agreements between ERPs and servicing carriers wasprohibited. On September 30, 2005, the Commissioner approved the ERPSubscription Rules, and instructed CAR to complete a redistribution of all ERPsto establish for all servicing carriers overall parity in the quantity andquality of their ERP exposures. The redistribution plan for ERPs, as adopted bythe CAR Governing Committee on November 16 and December 14, 2005, wasapproved by the Commissioner on January 27, 2006. On January 31,2006, CAR notified each reassigned ERP and all servicing carriers of theredistribution. 

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According to the January 31,2006 CAR Private Passenger ERP Redistribution Summary, 18 Safety ERPs with25,590 exposures were assigned to other servicing carriers beginning with newbusiness effective March 1, 2006 and renewal business May 1, 2006. Inaddition, CAR assigned 29 ERPs with 24,670 exposures from other servicingcarriers to Safety. However 25 of these ERPs with 23,116 exposures were givenvoluntary contracts by their former servicing carrier or other carriers andwere, as a result, no longer eligible for assignment to Safety as ERPs. Weexpect that the redistribution of ERPs will eliminate our disproportionateshare of high loss ratio ERP business, and would therefore result in areduction of the expense we have incurred because of our historicdisproportionate share of high loss ratio ERPs.

CAR also runs a reinsurance poolfor commercial automobile policies and beginning January 1, 2006,CAR has implemented a Limited Servicing Carrier Program (“LSC”) for cededcommercial automobile policies. CAR approved Safety and five other servicingcarriers through a Request for Proposal to process approximately $200,000 ofceded commercial automobile business based on CAR data as of December 31,2005, which will be spread equitably among the six servicing carriers. Each Massachusetts commercial automobile insurermust bear a portion of the losses of the commercial reinsurance pool that isserviced by the six servicing carriers in the LSC program. Subject toCommissioner review, CAR sets the premium rates for commercial automobilepolicies reinsured through CAR and this reinsurance pool can generate anunderwriting result that is a profit or deficit based upon CAR’s rate level.This underwriting result is allocated among every Massachusetts commercialautomobile insurance company, including us, based on a company’s commercialautomobile voluntary market share.

Each year, the Commissioner sets maximum premium ratesthat may be charged and minimum commissions that must be paid to agents forprivate passenger automobile insurance. Beginning in 2007, the effective dateof the Commissioner’s rate decision will be April 1st of each year as compared to January 1st of 2006 and prior ratedecisions. The 2006 rates will be in effect from January 1, 2006 until March 31,2007. The Commissioner announced on December 15, 2006, an 11.7% statewideaverage private passenger automobile insurance rate decrease for 2007, comparedto a 8.7% decrease for 2006. Coinciding with the 2006 rate decision, theCommissioner also approved a 13.0% commission rate agents receive for sellingprivate passenger automobile insurance, as a percentage of premiums, comparedto a commission rate of 11.8% in 2006.

While state-mandatedaverage maximum private passenger automobile insurance rates decreased 8.7% for2006, our average premium per automobile exposure in the year ended December 31,2006, decreased from the year ended December 31, 2005, by approximately6.8%. This lesser decrease was primarily the result of purchases of newautomobiles by our insureds. We believe that the continued benefits of our ratepursuit initiative, which validates insured rating classifications and discounteligibility, also contributed to the lesser decrease than state mandated averagepremiums received per automobile exposure. The table below shows averageMassachusetts-mandated private passenger automobile premium rate changesand changes in our average premium per automobile exposure from 1997-2006.

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**MassachusettsPrivate Passenger Rate Decisions**

| ** ** | ** ** | **State Mandated** | ** ** | **Safety Change in**    | ** ** |
|------------|------------|-------------------------|------------|-----------------------------------|------------|
| ** ** | ** ** | **Average Rate**   | ** ** | **Average Premium per** | ** ** |
| **Year**   | ** ** | ** **              | ** ** | **Change(1)**                     | ** ** | **Automobile Exposure(2)** | ** ** |
| **2006**   | ** ** |                    | **(8.7**   | **)%**                            |       |   | **(6.8** | **)%** |   |
| 2005       |       |                    | (1.7       | )%                                |       |   | 0.1 | % |   |
| 2004       |       |                    | 2.5        | %                                 |       |   | 6.1 | % |   |
| 2003       |       |                    | 2.7        | %                                 |       |   | 6.9 | % |   |
| 2002       |       |                    | 0.0        | %                                 |       |   | 5.2 | % |   |
| 2001       |       |                    | (8.3       | )%                                |       |   | 0.0 | % |   |
| 2000       |       |                    | 0.7        | %                                 |       |   | 7.4 | % |   |
| 1999       |       |                    | 0.7        | %                                 |       |   | 10.9 | % |   |
| 1998       |       |                    | (4.0       | )%                                |       |   | 2.8 | % |   |
| 1997       |       |                    | (6.2       | )%                                |       |   | (5.1 | )% |   |
|            |            |                         |            |                                   |            |  |  |  |  |  |  |

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(1)          Source: Commissionerrate decisions for 1997 - 2006.

(2)          Source:Safety Insurance.

*StatutoryAccounting Principles*

Our results arereported in accordance with GAAP, which differ from amounts reported inaccordance with statutory accounting principles (“SAP”) as prescribed byinsurance regulatory authorities. Specifically, under GAAP:

·       Policyacquisition costs such as commissions, premium taxes and other variable costsincurred in connection with writing new and renewal business are capitalizedand amortized on a pro rata basis over the period in which the related premiumsare earned, rather than expensed as incurred, as required by SAP.

·       Certainassets are included in the consolidated balance sheets whereas, under SAP, suchassets are designated as “non admitted assets,” and charged directly againststatutory surplus. These assets consist primarily of premium receivables thatare outstanding over ninety days, federal deferred tax assets in excess ofstatutory limitations, furniture, equipment, leasehold improvements and prepaidexpenses.

·       Amountsrelated to ceded reinsurance are shown gross of ceded unearned premiums andreinsurance recoverables, rather than netted against unearned premium reservesand loss and loss adjustment expense reserves, respectively, as required bySAP.

·       Fixedmaturities securities, which are classified as available-for-sale, are reportedat current market values, rather than at amortized cost, or the lower ofamortized cost or market, depending on the specific type of security, asrequired by SAP.

·       Equitysecurities are reported at quoted market values, which may differ from the NationalAssociation of Insurance Commissioners market values as required by SAP.

·       The differing treatment ofincome and expense items results in a corresponding difference in federalincome tax expense. Changes in deferred income taxes are reflected as an itemof income tax benefit or expense, rather than recorded directly to surplus asregards policyholders, as required by SAP. Admittance testing may result in acharge to unassigned surplus for non-admitted portions of deferred tax assets.Under GAAP reporting, a valuation allowance may be recorded against thedeferred tax asset and reflected as an expense.

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*Insurance Ratios*

The property and casualty insurance industry uses thecombined ratio as a measure of underwriting profitability. The combined ratio isthe sum of the loss ratio (losses and loss adjustment expenses incurred as apercent of net earned premiums) plus the expense ratio (underwriting expensesas a percent of net written premiums, if calculated on a SAP basis, or netearned premiums, if calculated on a GAAP basis). The combined ratio reflectsonly underwriting results, and does not include income from investments orfinance and other service income. Underwriting profitability is subject tosignificant fluctuations due to competition, catastrophic events, weather,economic and social conditions and other factors.

Ourstatutory insurance ratios are outlined in the following table:

|                       | ** ** | **For the Years  Ended December 31,** | ** ** |
|-----------------------|------------|-----------------------------------------------------------|------------|
| ** **            | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Statutory Ratios:** |       |                                                      |       |   |   |   |   |
| Loss Ratio            |       | **56.6**                                                  | **%**      | 61.9 | % | 71.7 | % |
| Expense Ratio         |       | **26.2**                                                  | ** ** | 23.4 |   | 23.7 |   |
| Combined Ratio        |       | **82.8**                                                  | **%**      | 85.3 | % | 95.4 | % |

 

Under GAAP, the loss ratio is computed in the samemanner as under SAP, but the expense ratio is determined by matchingunderwriting expenses to the period over which net premiums were earned, ratherthan to the period that net premiums were written.

OurGAAP insurance ratios are outlined in the following table:

| ** **       | ** ** | **For the Years  Ended December 31,** | ** ** |
|------------------|------------|-----------------------------------------------------------|------------|
| ** **       | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **GAAP Ratios:** |       |                                                      |       |   |   |   |   |
| Loss Ratio       | ** ** | **56.6**                                                  | **%**      | 61.9 | % | 71.8 | % |
| Expense Ratio    | ** ** | **26.0**                                                  |       | 23.5 |   | 24.5 |   |
| Combined Ratio   | ** ** | **82.6**                                                  | **%**      | 85.4 | % | 96.3 | % |

 

*Stock-BasedCompensation*

On June 25, 2002, theBoard adopted the 2002 Management Omnibus Incentive Plan (the “Incentive Plan”).The Incentive Plan provides for a variety of awards, including nonqualifiedstock options (“NQSOs”), stock appreciation rights and restricted stock (“RS”)awards.

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OnMarch 10, 2006, the Board of Directors (“Board”) of the Company approvedamendments to the Incentive Plan, subject to shareholder approval, to(i) increase the number of shares of common stock available for issuanceby 1,250,000 shares, (ii) remove obsolete provisions, and (iii) makeother non-material changes. A total of 1,250,000 shares of common stock had previouslybeen authorized for issuance under the Incentive Plan. The Incentive Plan, asamended, was approved by the shareholders at the 2006 Annual Meeting ofShareholders which was held on May 19, 2006. Under the Incentive Plan, asamended, the maximum number of shares of common stock with respect to whichawards may be granted is 2,500,000. As of December 31, 2006, there were1,289,991 shares available for future grant. The Board and the CompensationCommittee intend to issue more awards under the Incentive Plan in the future.Grants outstanding under the Incentive Plan as of December 31, 2006, werecomprised of 126,790 restricted shares and373,996 nonqualified stock options. Grants made under the Incentive Plan are asfollows.

| ** **       | ** ** | ** **              | ** ** | ** **         | ** **  | **Exercise**           | ** ** | ** **             | ** ** | ** **               | ** ** |
|------------------|------------|-------------------------|------------|--------------------|-------------|------------------------|------------|------------------------|------------|--------------------------|------------|
| **Type of** | ** ** | ** **              | ** ** | **Number of** | ** **  | **Price(1) or**   | ** ** | ** **             | ** ** | ** **               | ** ** |
| **Equity**       | ** ** | ** **              | ** ** | **Awards**         | ** **  | **Fair Value(2)** | ** ** | ** **             | ** ** | ** **               | ** ** |
| **Awarded**      | ** ** | **Effective Date** | ** ** | **Granted**        | ** **  | **per Share**     | ** ** | **Vesting Terms** | ** ** | **Expiration Date** | ** ** |
| NQSOs            |       | November 27,  2002 |       |               | 379,000     |                   |       |                   | $          | 12.00                    | (1)        |   | 5  years, 20% annually |   | November 27,  2012 |   |
| NQSOs            |       | February 20, 2003  |       |               | 99,000      |                   |       |                   | $          | 13.30                    | (1)        |   | 5  years, 20% annually |   | February 20,  2013 |   |
| NQSOs            |       | March 31, 2003     |       |               | 292,000     |                   |       |                   | $          | 13.03                    | (1)        |   | 3  years, 30%-30%-40% |   | March 31,  2013 |   |
| NQSOs            |       | August 21, 2003    |       |               | 10,000      |                   |       |                   | $          | 15.89                    | (1)        |   | 5  years, 20% annually |   | August 21,  2013 |   |
| NQSOs            |       | March 25, 2004     |       |               | 111,000     |                   |       |                   | $          | 18.50                    | (1)        |   | 5  years, 20% annually |   | March 25,  2014 |   |
| RS               |       | March 25, 2004     |       |               | 70,271      |                   |       |                   | $          | 18.50                    | (2)        |   | 3  years, 30%-30%-40% |   | N/A |   |
| NQSOs            |       | August 30, 2004    |       |               | 10,000      |                   |       |                   | $          | 21.40                    | (1)        |   | 5  years, 20% annually |   | August 30,  2014 |   |
| NQSOs            |       | March 16, 2005     |       |               | 78,000      |                   |       |                   | $          | 35.23                    | (1)        |   | 5  years 20% annually |   | March 16,  2015 |   |
| RS               |       | March 16, 2005     |       |               | 56,770      |                   |       |                   | $          | 35.23                    | (2)        |   | 3  years, 30%-30%-40% |   | N/A |   |
| RS               |       | March 16, 2005     |       |               | 4,000       |                   |       |                   | $          | 35.23                    | (2)        |   | No  vesting period(3) |   | N/A |   |
| **NQSOs**        | ** ** | **March 10, 2006** | ** ** | ** **         | **126,225** |                   | ** ** | ** **             | **$**      | **42.85**                | **(1)**    | ** ** | **5 years, 20% annually** | ** ** | **March 10, 2016** | ** ** |
| **RS**           | ** ** | **March 10, 2006** | ** ** | ** **         | **58,342**  |                   | ** ** | ** **             | **$**      | **42.85**                | **(2)**    | ** ** | **3 years, 30%-30%-40%** | ** ** | **N/A** | ** ** |
| **RS**           | ** ** | **March 10, 2006** | ** ** | ** **         | **4,000**   |                   | ** ** | ** **             | **$**      | **42.85**                | **(2)**    | ** ** | **No  vesting period(3)** | ** ** | **N/A** | ** ** |

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(1)          The exercise price ofthe options grant effective on November 27, 2002, is equal to the IPOprice of our stock on that same day. The exercise price of the remaining optiongrants is equal to the closing price of our common stock on the grant effectivedate.

(2)          The fair value of therestricted stock grant is equal to the closing price of our common stock on thegrant effective date.

(3)          Theshares cannot be sold, assigned, pledged, or otherwise transferred, encumberedor disposed of until the recipient is no longer a member of our Board ofDirectors.

*Reinsurance*

We reinsure with other insurance companies a portionof our potential liability under the policies we have underwritten, therebyprotecting us against an unexpectedly large loss or a catastrophic occurrencethat could produce large losses, primarily in our homeowners line of business. We use various software products to measure ourexposure to catastrophe losses and the probable maximum loss to us forcatastrophe losses such as hurricanes. The models include estimates for ourshare of the catastrophe losses generated in the residual market for propertyinsurance by the Massachusetts Property Insurance Underwriting Association.In the aftermath of Hurricane Katrina in2005, the reinsurance market has seen from the various software modelers,increases in the estimate of damage from hurricanes in the southern andnortheast portions of the United States due to revised estimations of increasedhurricane activity and increases in the estimation of demand surge in theperiods following a significant event. We have adjusted our reinsuranceprograms as a result of the changes to the models. As of January 2007, ourcatastrophe reinsurance provides gross per occurrence reinsurance coverage upto $280,000. As a result of the changes tothe models, and our revised reinsurance program, our catastrophereinsurance protects us in the event of a “300-year storm” 

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(that is, a storm of aseverity expected to occur once in a 300-year period). Swiss Re, ourprimary reinsurer, maintains an A.M. Best rating of “A+” (Superior). Allof our other reinsurers have an A.M. Best rating of “A” (Excellent) orbetter except for Folksamerica, Montpelier Re, Endurance Re and Amlin Bermudawhich are rated “A-” (Excellent). We are a participant in CAR, a state-establishedbody that runs the residual market reinsurance programs for both privatepassenger and commercial automobile insurance in Massachusetts under whichpremiums, expenses, losses and loss adjustment expenses on ceded business areshared by all insurers writing automobile insurance in Massachusetts. We alsoparticipate in the Massachusetts Property Insurance Underwriting Association (“FAIRPlan”) in which premiums, expenses, losses and loss adjustment expenses onhomeowners business that cannot be placed in the voluntary market are shared byall insurers writing homeowners insurance in Massachusetts. The FAIR Plan hasgrown dramatically over the past few years as insurance carriers have reducedtheir exposure to coastal property. The FAIR Plan’s exposure to catastrophelosses has increased and as a result the FAIR Plan has decided to buyreinsurance to reduce their exposure to catastrophe losses. On July 1,2006, the FAIR Plan purchased $455,000 of catastrophe reinsurance for propertylosses in excess of $180,000. At December 31, 2006, we had no materialamounts recoverable from any reinsurer, excluding the residual marketsdescribed above.

On March 10, 2005,our Board of Directors adopted a resolution that prohibits Safety frompurchasing finite reinsurance (reinsurancethat transfers only a relatively finite or limited amount of risk to thereinsurer) without approval by the Board. To date, the Company has neverpurchased a finite reinsurance contract.

*Effects ofInflation*

We do not believe thatinflation has had a material effect on our consolidated results of operations,except insofar as inflation may affect interest rates.

**Critical AccountingPolicies and Estimates**

*Loss and LossAdjustment Expense Reserves.*

Significant periods of time can elapse between theoccurrence of an insured loss, the reporting to us of that loss and our finalpayment of that loss. To recognize liabilities for unpaid losses, we establishreserves as balance sheet liabilities. Our reserves represent estimates ofamounts needed to pay reported and unreported losses and the expenses ofinvestigating and paying those losses, or loss adjustment expenses. Everyquarter, we review our previously established reserves and adjust them, ifnecessary.

When a claim is reported, claims personnel establish a“case reserve” for the estimated amount of the ultimate payment. The amount ofthe reserve is primarily based upon an evaluation of the type of claiminvolved, the circumstances surrounding each claim and the policy provisionsrelating to the loss. The estimate reflects the informed judgment of suchpersonnel based on general insurance reserving practices and on the experienceand knowledge of the claims person. During the loss adjustment period, theseestimates are revised as deemed necessary by our claims department based onsubsequent developments and periodic reviews of the cases.

In accordance with industry practice, we also maintainreserves for estimated losses incurred but not yet reported (“IBNR”). IBNRreserves are determined in accordance with commonly accepted actuarial reservingtechniques on the basis of our historical information and experience. We reviewand make adjustments to incurred but not yet reported reserves quarterly.

When reviewing reserves, we analyze historical dataand estimate the impact of various loss development factors, such as ourhistorical loss experience and that of the industry, trends in claims frequencyand severity, our mix of business, our claims processing procedures,legislative enactments, 

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judicial decisions, legaldevelopments in imposition of damages, and changes and trends in generaleconomic conditions, including the effects of inflation. A change in any ofthese factors from the assumption implicit in our estimate can cause our actualloss experience to be better or worse than our reserves, and the difference canbe material. There is no precise method, however, for evaluating the impact ofany specific factor on the adequacy of reserves, because the eventualdevelopment of reserves is affected by many factors.

Managementdetermines the Company’s loss and LAE reserves estimate based upon the analysis ofthe Company’s actuaries. A reasonable estimate is derived by selecting a pointestimate within a range of indications as calculated by the Company’sactuaries using generally accepted actuarial techniques. The key assumptionin most actuarial analysis is that past patterns of frequency and severity willrepeat in the future, unless a significant change in the factors describedabove takes place. Our key factors and resulting assumptions are theultimate frequency and severity of claims, based upon the most recent ten yearsof claims reported to the Company, and the data CAR reports to us to calculateour share of the residual market, as of the date of the applicable balancesheet. For each accident year and each coverage within a line of business ouractuaries calculate the ultimate losses incurred. Our total reserves are thedifference between the ultimate losses incurred and the cumulative loss andloss adjustment payments made to date. Our IBNR reserves are calculated as thedifference between our total reserves and the outstanding case reserves at theend of the accounting period. To determine ultimate losses our actuariescalculate a range of indications and select a point estimation usingsuch actuarial techniques as:

·       *Paid Loss Indications:* This method projects ultimate lossestimates based upon extrapolations of historic paid loss trends. This methodtends to be used on short tail lines such as automobile physical damage.

·       *Incurred Loss Indications:* This method projects ultimateloss estimates based upon extrapolations of historic incurred loss trends. Thismethod tends to be used on long tail lines of business such as automobileliability and homeowner’s liability.

·       *Bornhuetter-Ferguson Indications:* This method projectsultimate loss estimates based upon extrapolations of an expected amount ofIBNR, which is added to current incurred losses or paid losses. This methodtends to be used on small, immature, or volatile lines of business, such as ourBOP and umbrella lines of business.

·       *Bodily Injury Code Indications:* This method projectsultimate loss estimates for our private passenger and commercial automobilebodily injury coverage based upon extrapolations of the historic number ofaccidents and the historic number of bodily injury claims per accident.Projected ultimate bodily injury claims are then segregated into expectedclaims by type of injury (e.g. soft tissue injury vs. hard tissue injury) basedon past experience. An ultimate severity, or average paid loss amounts, isestimated based upon extrapolating historic trends. Projected ultimate lossestimates using this method are the aggregate of estimated losses by injurytype.

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Such techniques assume that past experience, adjustedfor the effects of current developments and anticipated trends, are anappropriate basis for predicting our ultimate losses, total reserves andresulting IBNR reserves. It is possible that the final outcome may fall aboveor below these amounts as a result of a number of factors, including immaturedata, sparse data, or significant growth in a line of business. Using thesemethodologies our actuaries established a range of reasonably possibleestimations for net reserves of approximately $327,472 to $377,497 as of December 31,2006, as compared to a range of $332,266 to $382,506 for 2005. In general, thelow and high values of the ranges represent reasonable minimum and maximumvalues of the indications based on the techniques described above. Thecompanies selected point estimate of net loss and LAE reserves based upon theanalysis of the company’s actuaries was $370,980 as of December 31, 2006,as compared to $370,166 for 2005.

The following tables presentthe point estimation of the recorded reserves and the range of estimations byline of business for net loss and LAE reserves as of December 31, 2006 andDecember 31, 2005.

**Rangeof Net Reserves for Losses and LAE as of December 31, 2006**

| **Line of Business** | ** ** | ** ** | ** **  | **Low**    | ** ** | **Recorded** | ** ** | **High** | ** **  |
|--------------------------------|------------|------------|-------------|------------|------------|--------------|------------|----------|-------------|
| Private passenger  automobile  | ** ** | **$**      | **240,371** | ** ** | **$**      | **274,889**  | ** ** | **$**    | **276,195** | ** ** |
| Commercial  automobile         | ** ** | **48,306** | ** **  | **53,340** | ** ** | **56,262**   | ** ** |
| Homeowners                     | ** ** | **29,086** | ** **  | **31,048** | ** ** | **31,782**   | ** ** |
| All other                      | ** ** | **9,709**  | ** **  | **11,703** | ** ** | **13,258**   | ** ** |
| Total                          | ** ** | **$**      | **327,472** | ** ** | **$**      | **370,980**  | ** ** | **$**    | **377,497** | ** ** |

 

**Rangeof Net Reserves for Losses and LAE as of December 31, 2005**

| **Line of Business** | ** ** | ** ** | ** ** | **Low** | ** ** | **Recorded** | ** ** | **High** | ** ** |
|--------------------------------|------------|------------|------------|---------|------------|--------------|------------|----------|------------|
| Private passenger  automobile  |       | $          | 253,277    |    | $          | 278,415      |       | $        | 288,410    |   |
| Commercial  automobile         |       | 47,135     |       | 51,946  |       | 52,772       |       |
| Homeowners                     |       | 25,185     |       | 30,745  |       | 31,750       |       |
| All other                      |       | 6,669      |       | 9,060   |       | 9,574        |       |
| Total                          |       | $          | 332,266    |    | $          | 370,166      |       | $        | 382,506    |   |

 

Thefollowing tables present our total net reserves and the corresponding casereserves and IBNR reserves for each line of business as of December 31,2006 and December 31, 2005.

| ** **                             | ** ** | **December 31, 2006** | ** **  |
|----------------------------------------|------------|---------------------------------|-------------|
| **Line of Business**         | ** ** | ** **                      | ** **  | **Case** | ** ** | **IBNR** | ** ** | **Total** | ** ** |
| Private passenger  automobile          | ** ** | **$**                           | **207,645** | ** ** | **$** | **10,371** | ** ** | **$** | **218,016** | ** ** |
| CAR assumed  private passenger auto    | ** ** | **34,424**                      | ** **  | **22,449** | ** ** | **56,873** | ** ** |
| Commercial  automobile                 | ** ** | **29,229**                      | ** **  | **6,566** | ** ** | **35,795** | ** ** |
| CAR assumed commercial  automobile     | ** ** | **12,606**                      | ** **  | **4,939** | ** ** | **17,545** | ** ** |
| Homeowners                             | ** ** | **15,844**                      | ** **  | **5,426** | ** ** | **21,270** | ** ** |
| FAIR Plan assumed  homeowners          | ** ** | **5,651**                       | ** **  | **4,127** | ** ** | **9,778** | ** ** |
| All other                              | ** ** | **5,303**                       | ** **  | **6,400** | ** ** | **11,703** | ** ** |
| Total net reserves for  losses and LAE | ** ** | **$**                           | **310,702** | ** ** | **$** | **60,278** | ** ** | **$** | **370,980** | ** ** |
|                                        |            |                                 |             |  |  |  |  |  |  |  |  |  |

 

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| ** **                             | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------|------------|----------------------------|------------|
| **Line of  Business**                  | ** ** | ** **                 | ** ** | **Case** | ** ** | **IBNR** | ** ** | **Total** | ** ** |
| Private passenger  automobile          |       | $196,009                   |       | $15,318 |   | $211,327 |   |
| CAR assumed  private passenger auto    |       | 43,509                     |       | 23,579 |   | 67,088 |   |
| Commercial  automobile                 |       | 29,361                     |       | 7,621 |   | 36,982 |   |
| CAR assumed  commercial automobile     |       | 6,700                      |       | 8,264 |   | 14,964 |   |
| Homeowners                             |       | 16,194                     |       | 7,303 |   | 23,497 |   |
| FAIR Plan assumed  homeowners          |       | 3,492                      |       | 3,756 |   | 7,248 |   |
| All other                              |       | 3,649                      |       | 5,411 |   | 9,060 |   |
| Total net reserves for  losses and LAE |       | $298,914                   |       | $71,252 |   | $370,166 |   |
|                                        |            |                            |            |  |  |  |  |  |  |

 

For our private passenger automobile, commercialautomobile and homeowners lines of business as of December 31, 2006 and2005, due to the relatively long time we have been writing these lines ofinsurance, and our stable long-term trends in frequency and severity, the rangeof reserves is relatively narrow. We recorded reserves slightly higher than themid-point of the range.

For our all other lines of business as of December 31,2006 and 2005, due to the relatively short time we have been writing theselines of business, the sparse amount of data and the resulting immature historyavailable for our analysis, the range of reserves are relatively wide. Werecorded reserves closer to the high of the range of projections.

Our IBNR reserves for CAR assumed private passengerand commercial automobile business are 39.5% and 28.2% respectively of ourtotal reserves for CAR assumed private passenger and commercial automobilebusiness as of December 31, 2006 due to the reporting delays in theinformation we receive from CAR, as described further in the section on *CAR Loss and Loss Adjustment Expense Reserves.*

The following tablespresent information by line of business for our total net reserves and thecorresponding direct less ceded (retained) reserves and assumed reserves as of December 31,2006 and December 31, 2005.

**NetReserves for Losses and LAE as of December 31, 2006**

| **Line of Business**           | ** ** | ** ** | ** ** | **Direct less Ceded** | ** ** | **Assumed** | ** ** | **Net**    | ** **  |
|------------------------------------------|------------|------------|------------|---------------------------------|------------|-------------|------------|------------|-------------|
| Private passenger  automobile            | ** ** |       | **$**      | **218,016**                     | ** ** |        | ** ** | ** ** | ** **  | ** ** |
| CAR assumed private passenger automobile | ** ** |       | ** ** | ** **                      |       | **$**       | **56,873** | ** ** | ** **  | ** ** |
| Net private passenger automobile         | ** ** |       | ** ** | ** **                      |       | ** **  | ** ** | **$**      | **274,889** | ** ** |
| Commercial  automobile                   | ** ** |       | **35,795** | ** **                      |       | ** **  | ** ** | ** ** | ** **  |
| CAR assumed commercial automobile        | ** ** |       | ** ** | ** **                      |       | **17,545**  | ** ** | ** ** | ** **  |
| Net commercial automobile                | ** ** |       | ** ** | ** **                      |       | ** **  | ** ** | **53,340** | ** **  |
| Homeowners                               | ** ** |       | **21,270** | ** **                      |       | ** **  | ** ** | ** ** | ** **  |
| FAIR Plan assumed homeowners             | ** ** |       | ** ** | ** **                      |       | **9,778**   | ** ** | ** ** | ** **  |
| Net homeowners                           | ** ** |       | ** ** | ** **                      |       | ** **  | ** ** | **31,048** | ** **  |
| All other                                | ** ** |       | **11,703** | ** **                      |       | **—**  | ** ** | **11,703** | ** **  |
| Total net reserves for  losses and LAE   | ** ** |       | **$**      | **286,784**                     | ** ** |        | **$**      | **84,196** | ** **  | **$** | **370,980** | ** ** |

 

51

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**NetReserves for Losses and LAE as of December 31, 2005**

| **Line of Business**           | ** ** | ** ** | ** ** | **Direct less Ceded** | ** ** | **Assumed** | ** ** | **Net** | ** ** |
|------------------------------------------|------------|------------|------------|---------------------------------|------------|-------------|------------|---------|------------|
| Private passenger  automobile            |       |       | $          | 211,327                         |       |        |       |    |       |   |
| CAR assumed private passenger automobile |       |       |       |                            |       | $           | 67,088     |    |       |   |
| Net private passenger automobile         |       |       |       |                            |       |        |       | $       | 278,415    |   |
| Commercial  automobile                   |       |       | 36,982     |                            |       |        |       |    |       |
| CAR assumed commercial automobile        |       |       |       |                            |       | 14,964      |       |    |       |
| Net commercial automobile                |       |       |       |                            |       |        |       | 51,946  |       |
| Homeowners                               |       |       | 23,497     |                            |       |        |       |    |       |
| FAIR Plan assumed homeowners             |       |       |       |                            |       | 7,248       |       |    |       |
| Net homeowners                           |       |       |       |                            |       |        |       | 30,745  |       |
| All other                                |       |       | 9,060      |                            |       | —      |       | 9,060   |       |
| Total net reserves for  losses and LAE   |       |       | $          | 280,866                         |       |        | $          | 89,300  |       | $ | 370,166 |   |

 

*CAR Loss and Loss AdjustmentExpense Reserves*

We are a participant in CAR and assume a significantportion of losses and LAE on business ceded by the industry participants toCAR. We estimate reserves for assumed losses and LAE that have not yet beenreported to us by CAR. Our estimations are based upon the same factors we usefor our own reserves, plus additional factors due to the nature of and theinformation we receive from CAR.

The CAR deficit, which consists of premium ceded toCAR less CAR losses and LAE, is allocated among every automobile insurancecompany writing business in Massachusetts based on a complex formula (the “ParticipationRatio”) that takes into consideration a company’s voluntary market share, theamount of business it cedes to CAR and credits the company earns under a systemCAR has designed to encourage carriers to voluntarily write business inselected under-priced classes and territories.

We receive a Settlement of Balances report from CARthat reports our share of CAR premium, losses and LAE, on a lagged basis,seventy-five days after the end of every quarter. CAR-published financial datais always at least one quarter behind the financial data we report. Forexample, when we reported our financial results for the year ended December 31,2006, we had nine months of reported 2006 CAR financial data, and we had toestimate and record as IBNR reserves what CAR would report to us for the lastthree months of the year.

We receive our final calendar year Participation Ratioreport from CAR eight months after the end of that year, and thus we have toestimate for six quarters our share of the CAR deficit. For example, for theyear ended December 31, 2005 we had to estimate our 2005 policy year CARParticipation Ratio beginning with the first quarter of 2005 through the secondquarter of 2006.

Because of the lag in CAR estimates, and in order totry to validate to the extent possible the information CAR does provide, wemust try to estimate the effects of the actions of our competitors in order toestablish our Participation Ratio. Before final Participation Ratios areavailable, we estimate the size of CAR and the resulting deficit based onhistorical analysis of CAR results, and estimations of our competitors’ currentcession strategies. Even after our final Participation Ratio is available fromCAR, we must continue to estimate the size of CAR, and the resulting deficitbased upon data published by CAR and our own continuing analysis. As a result,changes in our reserves for CAR may continue to occur until all claims arefinally settled. The Loss Reserving Committee at CAR meets 70 days after theend of each quarter to estimate the CAR deficit for all active policy years andpublishes estimations, which we use to estimate our share of the deficit. Theestimation that CAR calculates is based on data it collects from 19 servicingcarriers which settle, reserve and report claims using a variety of methods.Any delays or errors in the collection of this data could have a significantimpact on the accuracy of CAR’s estimations.

52

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Although we rely to asignificant extent in setting our reserves on the information CAR provides, weare cautious in our use of that information, both because of the delaysdescribed above and because the CAR estimates incorporate data CAR receivesfrom all other CAR servicing carriers in Massachusetts. We do not have directaccess to that data or firsthand knowledge of how those carriers are currentlyconducting their operations. As a result, we are cautious in recording CARreserves for the calendar years that we have to estimate our ParticipationRatio and these reserves are subject to significant judgments and estimates.

*SensitivityAnalysis*

Establishment of appropriate reserves is an inherentlyuncertain process. There can be no certainty that currently establishedreserves based on our key assumptions regarding frequency and severity in ourlines of business, or our assumptions regarding our share of the CAR loss willprove adequate in light of subsequent actual experience. To the extent thatreserves are inadequate and are strengthened, the amount of such increase istreated as a charge to earnings in the period that the deficiency isrecognized. To the extent that reserves are redundant and are released, theamount of the release is a credit to earnings in the period the redundancy isrecognized. For the year ended December 31, 2006, a 1 percentage-pointchange in the loss and LAE ratio would result in a change in reserves of$6,249. Each 1 percentage-point change in the loss and loss expense ratiowould have a $4,062 effect on net income, or $0.25 per diluted share.

53

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Ourassumptions consider that past experience, adjusted for the effects of currentdevelopments and anticipated trends, are an appropriate basis for establishingour reserves. Our individual key assumptions could each have a reasonablepossible range of plus or minus 5 percentage-points for each estimation,although there is no guarantee that our assumptions will not have more than a 5percentage point variation. The following sensitivity tables presentinformation for each of our primary lines of business on the effect each 1percentage-point change in each of our key assumptions on unpaid frequency andseverity could have on our direct minus ceded loss and LAE reserves and net incomefor the year ended December 31, 2006. In evaluating the information in thetable, it should be noted that a 1 percentage-point change in a singleassumption would change estimated reserves by 1 percentage-point. A 1percentage-point change in both our key assumptions would change estimatedreserves within a range of plus or minus 2 percentage-points.

| ** **                                                                 | ** ** | **–1 Percent** | ** ** | **No**             | ** ** | **+1 Percent** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                                                 | ** ** | **Change in**       | ** ** | **Change in** | ** ** | **Change in**  | ** ** |
| ** **                                                                 | ** ** | **Frequency**            | ** ** | **Frequency**      | ** ** | **Frequency**       | ** ** |
| **Private passenger automobile  direct minus ceded loss and LAE reserves** |       |                     |       |               |       |                |       |   |   |   |   |   |   |
| –1 percent change in  severity                                        |       |                     |       |               |       |                |       |   |   |   |   |   |   |
| Estimated decrease in  reserves                                            | ** ** | ** **               | **$**      | **(4,360**         | **)**      | ** **          | ** ** | **$** | **(2,180** | **)** | ** ** | ** ** | **$** | **—** | ** ** |   |
| Estimated increase in  net income                                          | ** ** | ** **               | **2,834**  | ** **         | ** ** | ** **          | **1,417**  | ** ** | ** ** | ** ** | **—** | ** ** |   |
| No change in severity                                                      | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated (decrease)  increase in reserves                                 | ** ** | ** **               | **(2,180** | **)**              | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **2,180** | ** ** |   |
| Estimated increase  (decrease) in net income                               | ** ** | ** **               | **1,417**  | ** **         | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **(1,417** | **)** |   |
| +1 percent change in  severity                                             | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated increase in  reserves                                            | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **2,180**  | ** ** | ** ** | ** ** | **4,360** | ** ** |   |
| Estimated decrease in  net income                                          | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **(1,417** | **)** | ** ** | ** ** | **(2,834** | **)** |   |
| **Commercial  automobile direct minus ceded loss and LAE reserves**        | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| –1 percent change in  severity                                        | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated decrease in  reserves                                            | ** ** | ** **               | **(716**   | **)**              | ** ** | ** **          | **(358**   | **)** | ** ** | ** ** | **—** | ** ** |   |
| Estimated increase in  net income                                          | ** ** | ** **               | **465**    | ** **         | ** ** | ** **          | **233**    | ** ** | ** ** | ** ** | **—** | ** ** |   |
| No change in severity                                                      | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated (decrease)  increase in reserves                                 | ** ** | ** **               | **(358**   | **)**              | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **358** | ** ** |   |
| Estimated increase  (decrease) in net income                               | ** ** | ** **               | **233**    | ** **         | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **(233** | **)** |   |
| +1 percent change in  severity                                             | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated increase in  reserves                                            | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **358**    | ** ** | ** ** | ** ** | **716** | ** ** |   |
| Estimated decrease in  net income                                          | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **(233**   | **)** | ** ** | ** ** | **(465** | **)** |   |
| **Homeowners  direct minus ceded loss and LAE reserves**                   | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| –1 percent change in  severity                                        | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated decrease in  reserves                                            | ** ** | ** **               | **(425**   | **)**              | ** ** | ** **          | **(213**   | **)** | ** ** | ** ** | **—** | ** ** |   |
| Estimated increase in  net income                                          | ** ** | ** **               | **277**    | ** **         | ** ** | ** **          | **138**    | ** ** | ** ** | ** ** | **—** | ** ** |   |
| No change in severity                                                      | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated (decrease)  increase in reserves                                 | ** ** | ** **               | **(213**   | **)**              | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **213** | ** ** |   |
| Estimated increase  (decrease) in net income                               | ** ** | ** **               | **138**    | ** **         | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **(138** | **)** |   |
| +1 percent change in  severity                                             | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated increase in  reserves                                            | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **213**    | ** ** | ** ** | ** ** | **425** | ** ** |   |
| Estimated decrease in  net income                                          | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **(138**   | **)** | ** ** | ** ** | **(277** | **)** |   |
| **All  other direct minus ceded loss and LAE reserves**                    | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| –1 percent change in  severity                                        | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated decrease in  reserves                                            | ** ** | ** **               | **(234**   | **)**              | ** ** | ** **          | **(117**   | **)** | ** ** | ** ** | **—** | ** ** |   |
| Estimated increase in  net income                                          | ** ** | ** **               | **152**    | ** **         | ** ** | ** **          | **76**     | ** ** | ** ** | ** ** | **—** | ** ** |   |
| No change in severity                                                      | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated (decrease)  increase in reserves                                 | ** ** | ** **               | **(117**   | **)**              | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **117** | ** ** |   |
| Estimated increase  (decrease) in net income                               | ** ** | ** **               | **76**     | ** **         | ** ** | ** **          | **—** | ** ** | ** ** | ** ** | **(76** | **)** |   |
| +1 percent change in  severity                                             | ** ** | ** **               | ** ** | ** **         | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Estimated increase in  reserves                                            | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **117**    | ** ** | ** ** | ** ** | **234** | ** ** |   |
| Estimated decrease in net income                                           | ** ** | ** **               | **—** | ** **         | ** ** | ** **          | **(76**    | **)** | ** ** | ** ** | **(152** | **)** |   |
|                                                                            |            |                          |            |                    |            |                     |            |  |  |  |  |  |  |  |  |  |

 

54

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Ourestimated share of CAR loss and LAE reserves is based on assumptions about ourParticipation Ratio, the size of CAR, and the resulting deficit (similarassumptions apply with respect to the FAIR Plan). Our assumptions consider thatpast experience, adjusted for the effects of current developments andanticipated trends, are an appropriate basis for establishing our CAR reserves.Each of our assumptions could have a reasonably possible range of plus or minus5 percentage-points for each estimation. The following sensitivity tablepresents information of the effect each 1 percentage-point change in ourassumptions on our share of reserves for CAR and other residual markets couldhave on our assumed loss and LAE reserves and net income for the year ended December 31,2006. In evaluating the information in the table, it should be noted that a 1percentage-point change in our assumptions would change estimated reserves by 1percentage-point.

| ** **                                    | ** ** | **-1 Percent** | ** ** | **No**             | ** ** | **+1 Percent** | ** ** |
|-----------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                    | ** ** | **Change in**  | ** ** | **Change in** | ** ** | **Change in**  | ** ** |
| ** **                                    | ** ** | **Estimation**      | ** ** | **Estimation**     | ** ** | **Estimation**      | ** ** |
| **CAR assumed private passenger  automobile** |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves     | ** ** | ** **          | **$**      | **(569**           | **)**      | ** **          | ** ** | **$** | **—** |   | ** ** | ** ** | **$** | **569** | ** ** | ** ** |
| Estimated increase (decrease) in net income   | ** ** | ** **          | **370**    | ** **         | ** ** | ** **          | **—** |   | ** ** | ** ** | **(370** | **)** | ** ** |
| **CAR assumed commercial  automobile**        | ** ** | ** **          | ** ** | ** **         | ** ** | ** **          | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Estimated (decrease) increase in reserves     | ** ** | ** **          | **(175**   | **)**              | ** ** | ** **          | **—** |   | ** ** | ** ** | **175** | ** ** | ** ** |
| Estimated increase (decrease) in net income   | ** ** | ** **          | **114**    | ** **         | ** ** | ** **          | **—** |   | ** ** | ** ** | **(114** | **)** | ** ** |
| **FAIR Plan assumed homeowners**              | ** ** | ** **          | ** ** | ** **         | ** ** | ** **          | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Estimated (decrease) increase in reserves     | ** ** | ** **          | **(98**    | **)**              | ** ** | ** **          | **—** |   | ** ** | ** ** | **98** | ** ** | ** ** |
| Estimated  increase (decrease) in net income  | ** ** | ** **          | **64**     | ** **         | ** ** | ** **          | **—** |   | ** ** | ** ** | **(64** | **)** | ** ** |
|                                               |            |                     |            |                    |            |                     |            |  |  |  |  |  |  |  |  |  |

 

*Reserve DevelopmentSummary*

The changes we have recorded in our reserves in thepast illustrate the uncertainty of estimating reserves. The Company’s prioryear reserves decreased by $42,747, $39,620 and $6,778 for the years ended December 31,2006, 2005 and 2004, respectively.

The following tablepresents a comparison of prior year development of our net reserves for lossesand LAE for the years ended December 31, 2006, 2005 and 2004. Eachaccident year represents all claims for an annual accounting period in whichloss events occurred, regardless of when the losses were actually reported,booked, or paid. Our financial statements reflect the aggregate results of thecurrent and all prior accident years.

**PriorYear Net Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **For the years ended December 31,** | ** **  |
|------------------------|------------|---------------------------------------------------------------|-------------|
| **Accident Year** | ** ** | ** **                                                    | ** **  | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| 1996 &  Prior | ** ** | **$**                                                         | **(110**    | **)** | $ | (11 | ) | $ | (129 | ) |
| 1997                   | ** ** | **(3**                                                        | **)**       | (5 | ) | (11 | ) |
| 1998                   | ** ** | **(28**                                                       | **)**       | 7 |   | (504 | ) |
| 1999                   | ** ** | **(208**                                                      | **)**       | (892 | ) | (12 | ) |
| 2000                   | ** ** | **238**                                                       |        | (276 | ) | 1,588 |   |
| 2001                   | ** ** | **(2,159**                                                    | **)**       | (317 | ) | 2,495 |   |
| 2002                   | ** ** | **(2,292**                                                    | **)**       | (3,489 | ) | (304 | ) |
| 2003                   | ** ** | **(6,029**                                                    | **)**       | (7,155 | ) | (9,901 | ) |
| 2004                   | ** ** | **(11,627**                                                   | **)**       | (27,482 | ) | — |   |
| 2005                   | ** ** | **(20,529**                                                   | **)**       | — |   | — |   |
| All Prior Years        | ** ** | **$**                                                         | **(42,747** | **)** | $ | (39,620 | ) | $ | (6,778 | ) |
|                        |            |                                                               |             |  |  |  |  |  |  |  |  |  |

 

55

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The decrease in prior year reserves during the 2006period resulted from re-estimations of prior year ultimate loss and LAEliabilities and is composed primarily of a reduction of $23,945 in the Company’sretained automobile reserves and a reduction of $14,006 in CAR assumedreserves. The decrease in prior year reserves during the 2005 period resultedfrom re-estimations of prior year ultimate loss and LAE liabilities and iscomposed primarily of a reduction of $22,162 in CAR assumed reserves and areduction of $14,600 in the Company’s retained automobile reserves. Thedecrease in prior year reserves during the 2004 period is composed primarily ofa reduction of $6,854 in CAR assumed reserves, a reduction of $2,523 in ourhomeowners line of business, and an increase of $2,928 in the Company’sretained automobile reserves.

Thefollowing table presents information by line of business for prior year developmentof our net reserves for losses and LAE for the year ended December 31,2006.

**PriorYear Net Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **Private Passenger** | ** **  | **Commercial** | ** ** | ** **     | ** ** | ** **     | ** ** | ** **         | ** ** |
|------------------------|------------|----------------------------|-------------|----------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| **Accident Year** | ** ** | ** **                 | ** **  | **Automobile** | ** ** | **Automobile** | ** ** | **Homeowners** | ** ** | **All Other** | ** ** | **Total** | ** ** |
| 1996 & prior  | ** ** |                       | **$**       | **(39**        | **)**      |           |       | **$**          | **(71**    | **)**              |       |   | **$** | **—** | ** ** |   |   | **$** | **—** | ** ** |   | **$** | **(110** | **)** |
| 1997                   | ** ** |                       | **(3**      | **)**          |       |           | **—** | ** **     |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **(3** | **)** |
| 1998                   | ** ** |                       | **(17**     | **)**          |       |           | **(11**    | **)**          |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **(28** | **)** |
| 1999                   | ** ** |                       | **(81**     | **)**          |       |           | **(129**   | **)**          |       |               | **2**      | ** ** |   |   | **—** | ** ** |   | **(208** | **)** |
| 2000                   | ** ** |                       | **(159**    | **)**          |       |           | **85**     | ** **     |       |               | **303**    | ** ** |   |   | **9** | ** ** |   | **238** | ** ** |
| 2001                   | ** ** |                       | **(1,862**  | **)**          |       |           | **(172**   | **)**          |       |               | **(112**   | **)** |   |   | **(13** | **)** |   | **(2,159** | **)** |
| 2002                   | ** ** |                       | **(1,174**  | **)**          |       |           | **(692**   | **)**          |       |               | **(355**   | **)** |   |   | **(71** | **)** |   | **(2,292** | **)** |
| 2003                   | ** ** |                       | **(4,103**  | **)**          |       |           | **(1,319** | **)**          |       |               | **(542**   | **)** |   |   | **(65** | **)** |   | **(6,029** | **)** |
| 2004                   | ** ** |                       | **(7,759**  | **)**          |       |           | **(2,733** | **)**          |       |               | **(1,036** | **)** |   |   | **(99** | **)** |   | **(11,627** | **)** |
| 2005                   | ** ** |                       | **(15,984** | **)**          |       |           | **(1,728** | **)**          |       |               | **(2,376** | **)** |   |   | **(441** | **)** |   | **(20,529** | **)** |
| All prior years        | ** ** |                       | **$**       | **(31,181**    | **)**      |           |       | **$**          | **(6,770** | **)**              |       |   | **$** | **(4,116** | **)** |   |   | **$** | **(680** | **)** |   | **$** | **(42,747** | **)** |
|                        |            |                            |             |                |            |                |            |                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

To further clarify the effects of changes in ourreserve estimates for CAR and other residual markets, the next two tables breakout the information in the table above by source of the business (i.e.,non-residual market vs. residual market).

The following tablepresents information by line of business for prior year development of directminus ceded reserves for losses and LAE for the year ended December 31,2006; that is, all our reserves except for business ceded or assumed from CARand other residual markets.

**Prior Year Net Directminus Ceded Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **Retained**               | ** ** | **Retained**   | ** ** | ** **     | ** ** | ** **     | ** ** | ** **         | ** ** |
|------------------------|------------|----------------------------|------------|----------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| ** **             | ** ** | **Private Passenger** | ** ** | **Commercial** | ** ** | **Retained**   | ** ** | **Retained**   | ** ** | ** **         | ** ** |
| **Accident Year** | ** ** | ** **                 | ** ** | **Automobile** | ** ** | **Automobile** | ** ** | **Homeowners** | ** ** | **All Other** | ** ** | **Total** | ** ** |
| 1996 & prior  | ** ** |                       | **$**      | **(39**        | **)**      |           |       | **$**          | **(71**    | **)**              |       |   | **$** | **—** | ** ** |   |   | **$** | **—** | ** ** |   | **$** | **(110** | **)** |
| 1997                   | ** ** |                       | **(3**     | **)**          |       |           | **—** | ** **     |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **(3** | **)** |
| 1998                   | ** ** |                       | **(17**    | **)**          |       |           | **(1**     | **)**          |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **(18** | **)** |
| 1999                   | ** ** |                       | **(81**    | **)**          |       |           | **(103**   | **)**          |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **(184** | **)** |
| 2000                   | ** ** |                       | **(159**   | **)**          |       |           | **101**    | ** **     |       |               | **300**    | ** ** |   |   | **9** | ** ** |   | **251** | ** ** |
| 2001                   | ** ** |                       | **(1,706** | **)**          |       |           | **(189**   | **)**          |       |               | **(98**    | **)** |   |   | **(13** | **)** |   | **(2,006** | **)** |
| 2002                   | ** ** |                       | **(859**   | **)**          |       |           | **(708**   | **)**          |       |               | **(320**   | **)** |   |   | **(71** | **)** |   | **(1,958** | **)** |
| 2003                   | ** ** |                       | **(3,510** | **)**          |       |           | **(1,190** | **)**          |       |               | **(476**   | **)** |   |   | **(65** | **)** |   | **(5,241** | **)** |
| 2004                   | ** ** |                       | **(3,719** | **)**          |       |           | **(2,530** | **)**          |       |               | **(860**   | **)** |   |   | **(99** | **)** |   | **(7,208** | **)** |
| 2005                   | ** ** |                       | **(7,722** | **)**          |       |           | **(1,439** | **)**          |       |               | **(1,976** | **)** |   |   | **(441** | **)** |   | **(11,578** | **)** |
| All prior years        | ** ** |                       | **$**      | **(17,815**    | **)**      |           |       | **$**          | **(6,130** | **)**              |       |   | **$** | **(3,430** | **)** |   |   | **$** | **(680** | **)** |   | **$** | **(28,055** | **)** |
|                        |            |                            |            |                |            |                |            |                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

56

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Thefollowing table presents information by line of business for prior yeardevelopment of reserves assumed from CAR and other residual markets for lossesand LAE for the year ended December 31, 2006.

**PriorYear assumed Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **CAR Assumed**       | ** ** | **CAR Assumed** | ** ** | ** **         | ** ** | ** **     | ** ** | ** **         | ** ** |       |
|------------------------|------------|----------------------------|------------|----------------------|------------|--------------------|------------|----------------|------------|--------------------|------------|------------|
| ** **             | ** ** | **Private Passenger** | ** ** | **Commercial**       | ** ** | **FAIR Plan** | ** ** | ** **     | ** ** | ** **         | ** ** |       |
| **Accident Year** | ** ** | ** **                 | ** ** | **Automobile**       | ** ** | **Automobile**     | ** ** | **Homeowners** | ** ** | **All Other** | ** ** | **Total**  | ** ** |   |
| 1996 &  prior | ** ** |                       | **$**      | **—**           | ** ** |               |       | **$**          | **—** | ** **         |       |       | **$** | **—** | ** ** |   |   | **$** | **—** | ** ** |   | **$** | **—** | ** ** |
| 1997                   | ** ** |                       | ** ** | ** **           |       |               | **—** | ** **     |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **—** | ** ** |
| 1998                   | ** ** |                       | **—** | ** **           |       |               | **(10**    | **)**          |       |               | **—** | ** ** |   |   | **—** | ** ** |   | **(10** | **)** |
| 1999                   | ** ** |                       | **—** | ** **           |       |               | **(26**    | **)**          |       |               | **2**      | ** ** |   |   | **—** | ** ** |   | **(24** | **)** |
| 2000                   | ** ** |                       | **—** | ** **           |       |               | **(16**    | **)**          |       |               | **3**      | ** ** |   |   | **—** | ** ** |   | **(13** | **)** |
| 2001                   | ** ** |                       | **(156**   | **)**                |       |               | **17**     | ** **     |       |               | **(14**    | **)**      |   |   | **—** | ** ** |   | **(153** | **)** |
| 2002                   | ** ** |                       | **(315**   | **)**                |       |               | **16**     | ** **     |       |               | **(35**    | **)**      |   |   | **—** | ** ** |   | **(334** | **)** |
| 2003                   | ** ** |                       | **(593**   | **)**                |       |               | **(129**   | **)**          |       |               | **(66**    | **)**      |   |   | **—** | ** ** |   | **(788** | **)** |
| 2004                   | ** ** |                       | **(4,040** | **)**                |       |               | **(203**   | **)**          |       |               | **(176**   | **)**      |   |   | **—** | ** ** |   | **(4,419** | **)** |
| 2005                   | ** ** |                       | **(8,262** | **)**                |       |               | **(289**   | **)**          |       |               | **(400**   | **)**      |   |   | **—** | ** ** |   | **(8,951** | **)** |
| All prior years        | ** ** |                       | **$**      | **(13,366**          | **)**      |               |       | **$**          | **(640**   | **)**              |       |       | **$** | **(686** | **)** |   |   | **$** | **—** | ** ** |   | **$** | **(14,692** | **)** |
|                        |            |                            |            |                      |            |                    |            |                |            |                    |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our private passenger automobile line of businessprior year reserves decreased by $31,181 for the year ended December 31,2006. The decrease was primarily due to reductions in our retained privatepassenger automobile reserves for the 2005, 2004 and 2003 accident years by$7,722, $3,719 and $3,510, respectively, primarily due to better thanpreviously estimated severity on our established bodily injury and propertydamage case reserves and fewer IBNR claims than previously estimated. Inaddition, the decrease was due to improved assumed CAR results for the privatepassenger automobile pool for the 2005 accident year of $8,262 and for the 2004accident year of $4,040. The improved CAR results were due primarily to improvedCAR private passenger loss ratios for 2005 and 2004 as published and reportedby the CAR Loss Reserving Committee at the December 4, 2006 meeting, ascompared to the published results at the September 6, 2006 meeting.

Our commercial automobile line of business prior yearreserves decreased by $6,770 for the year ended December 31, 2006. Thedecrease was primarily due to more favorable commercial automobile bodilyinjury severity than previously estimated for the 2005, 2004 and 2003 accidentyears and fewer IBNR claims than previously estimated.

Our Homeowners line of business prior year reservesdecreased by $4,116 for the year ended December 31, 2006, primarily as aresult of improved severity on our established case reserves for 2005 and 2004related to our retained homeowners business.

In estimating all our loss reserves, including CAR, wefollow the guidance prescribed by Statement of Financial Accounting Standards (“FAS”)No. 60, “Accounting and Reporting by Insurance Enterprises” and FAS No. 113,“Accounting and Reporting for Reinsurance of Short-Duration and Long-DurationContracts.”

For further information,see “Item 7—Management’s Discussion and Analysis of Financial Conditionand Results of Operations: *Losses and LossAdjustment Expenses.”*

*Other-Than-TemporaryImpairments.*

We use a systematic methodology to evaluate declinesin market values below cost or amortized cost of our investments. Thismethodology ensures that we evaluate available evidence concerning any declinesin a disciplined manner.

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In our determination of whether a decline in marketvalue below amortized cost is an other-than-temporary impairment, we considerand evaluate several factors and circumstances including the issuer’s overallfinancial condition, the issuer’s credit and financial strength ratings, aweakening of the general market conditions in the industry or geographic regionin which the issuer operates, a prolonged period (typically six months orlonger) in which the fair value of an issuer’s securities remains below ouramortized cost, our ability and intent to hold these investments for a periodof time sufficient to allow for recovery of our costs, and any other factorsthat may raise doubt about the issuer’s ability to continue as a going concern.

We record other-than-temporary impairments as realizedlosses, which serve to reduce net income and earnings per share. We recordtemporary losses as unrealized losses, which do not impact net income andearnings per share but reduce other comprehensive net income. The risksinherent in our assessment of other-than-temporary impairments include the riskthat market factors may differ from our expectations, or that the creditassessment could change in the near term, resulting in a charge to earnings.

For further information,see “Item 7—Management’s Discussion and Analysis of Financial Condition andResults of Operations: *Net RealizedInvestment Losses.”*

**Results ofOperations**

The following table shows certain of our selectedfinancial results:

| ** **                                    | ** ** | **For the Year Ended December 31,** | ** **  |
|-----------------------------------------------|------------|--------------------------------------------------------------|-------------|
| ** **                                    | ** ** | **2006**                                                     | ** **  | **2005** | ** ** | **2004** | ** ** |
| Direct written  premiums                      | ** ** | **$**                                                        | **629,511** |   | $ | 649,113 |   | $ | 628,295 |   |
| Net written  premiums                         | ** ** | **620,908**                                                  |        | 632,836 |   | 618,923 |   |
| Net earned  premiums                          | ** ** | **624,933**                                                  |        | 622,831 |   | 592,292 |   |
| Net investment  income                        | ** ** | **40,293**                                                   |        | 31,573 |   | 27,259 |   |
| Net realized  gains on investments            | ** ** | **358**                                                      |        | 305 |   | 1,274 |   |
| Finance and other  service income             | ** ** | **15,128**                                                   |        | 16,748 |   | 15,615 |   |
| Total revenue                                 | ** ** | **680,712**                                                  |        | 671,457 |   | 636,440 |   |
| Loss and loss  adjustment expenses            | ** ** | **353,906**                                                  |        | 385,593 |   | 425,061 |   |
| Underwriting,  operating and related expenses | ** ** | **162,220**                                                  |        | 146,669 |   | 145,075 |   |
| Interest expenses                             | ** ** | **86**                                                       |        | 948 |   | 672 |   |
| Total expenses                                | ** ** | **516,212**                                                  |        | 533,210 |   | 570,808 |   |
| Income before  income taxes                   | ** ** | **164,500**                                                  |        | 138,247 |   | 65,632 |   |
| Income tax  expense                           | ** ** | **52,559**                                                   |        | 43,065 |   | 20,642 |   |
| Net income                                    | ** ** | **$**                                                        | **111,941** |   | $ | 95,182 |   | $ | 44,990 |   |

 

**YEAR ENDED DECEMBER31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005**

*DirectWritten Premiums.**  *Directwritten premiums for the year ended December 31, 2006, decreased by$19,602, or 3.0% to $629,511 from $649,113 for 2005. The 2006 decrease occurredprimarily in our personal automobile line, which experienced a 6.8% decrease inaverage written premium and a 1.0% decrease in written exposures. Offsettingthese results, our commercial automobile line’s average written premiumincreased by 13.2% with a 12.3% increase in written exposures. Our homeownersline average written premium increased by 5.7% with a 0.3% decrease in writtenexposures.

*NetWritten Premiums.**  *Netwritten premiums for the year ended December 31, 2006, decreased by$11,928 or 1.9% to $620,908 from $632,836 for 2005. This was primarily due tothe factors that decreased direct written premiums offset with a decrease inpremiums ceded to CAR.

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*Net EarnedPremiums.**  *Netearned premiums for the year ended December 31, 2006, increased by $2,102,or 0.3%, to $624,933 from $622,831 for 2005, primarily due to a decrease inpremiums ceded to CAR.

*NetInvestment Income.**  *Investmentincome for the year ended December 31, 2006, was $40,293 compared to$31,573 for 2005, an increase of 27.6%. Average cash and investment securities(at amortized cost) increased by $80,780, or 9.6%, to $917,980 for the yearended December 31, 2006, from $837,200 for 2005. The net effective yieldon the investment portfolio increased to 4.4% during the year ended December 31,2006, compared to 3.8% during 2005. Our duration increased to 4.6 years atDecember 31, 2006, from 3.2 years at December 31, 2005.

*NetRealized Gains on Investments.**  *Net realized gains on investmentsincreased to $358 for the year ended December 31, 2006 from $305 for 2005.

Thegross unrealized appreciation (depreciation) of investments in fixed maturitysecurities, including redeemable preferred stocks that have characteristics offixed maturities, and equity securities, was as follows:

| ** **                                                               | ** ** | **December 31, 2006** | ** **  |
|--------------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                               | ** ** | ** **                      | ** **  | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | **Amortized**                   | ** **  | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** **  | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) | ** ** | **$**                           | **185,390** | ** ** |   | **$** | **929** | ** ** |   |   | **$** | **(2,883** | **)** |   | **$** | **183,436** | ** ** |
| Obligations of  states and political subdivisions                        | ** ** | **429,888**                     | ** **  |   | **6,485** | ** ** |   |   | **(2,014** | **)** |   | **434,359** | ** ** |
| Asset-backed  securities(1)                                              | ** ** | **180,294**                     | ** **  |   | **339** | ** ** |   |   | **(2,022** | **)** |   | **178,611** | ** ** |
| Corporate and  other securities                                          | ** ** | **140,962**                     | ** **  |   | **853** | ** ** |   |   | **(1,941** | **)** |   | **139,874** | ** ** |
| Subtotal, fixed  maturity securities                                     | ** ** | **936,534**                     | ** **  |   | **8,606** | ** ** |   |   | **(8,860** | **)** |   | **936,280** | ** ** |
| Equity securities                                                        | ** ** | **4,038**                       | ** **  |   | **287** | ** ** |   |   | **—** | ** ** |   | **4,325** | ** ** |
| Totals                                                                   | ** ** | **$**                           | **940,572** | ** ** |   | **$** | **8,893** | ** ** |   |   | **$** | **(8,860** | **)** |   | **$** | **940,605** | ** ** |

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(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC),Federal National Mortgage Association (FNMA) and Small Business Administration(SBA). The total of these fixed maturity securities was $175,394 at amortizedcost and $173,539 at fair value as of December 31, 2006. As such, theasset-backed securities presented exclude such issuers already presentedunder U.S. Treasury securities and obligations of U.S. Government Agencies.

As of December 31, 2006, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities (i.e., all our securities received a rating assigned by Moody’s ofBaa or higher, except the few securities not rated by Moody’s which receivedStandard & Poor’s ratings of A- or higher, as well as a ratingassigned by the Securities Valuation Office of the National Association ofInsurance Commissioners of 1 or 2).

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Thecomposition of our fixed income security portfolio by Moody’s rating was asfollows:

| ** **                                                            | ** ** | **December 31, 2006** | ** **  |
|-----------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                            | ** ** | **Estimated**                   | ** **  | ** ** | ** ** |
| ** **                                                            | ** ** | **Fair Value**             | ** **  | **Percent** | ** ** |
| U.S. Treasury securities  and obligations of U.S. Government agencies | ** ** | **$**                           | **183,436** | ** ** |   | **19.6** | **%** |   |
| Aaa/Aa                                                                | ** ** | **584,191**                     | ** **  |   | **62.4** | ** ** |   |
| A                                                                | ** ** | **106,092**                     | ** **  |   | **11.3** | ** ** |   |
| Baa                                                                   | ** ** | **39,845**                      | ** **  |   | **4.3** | ** ** |   |
| Not rated  (Standard & Poor’s rating of A- or higher)   | ** ** | **22,716**                      | ** **  |   | **2.4** | ** ** |   |
| Total                                                                 | ** ** | **$**                           | **936,280** | ** ** |   | **100.0** | **%** |   |

 

Ratings are assigned by Moody’s, or the equivalent, asdiscussed above. Such ratings are generally assigned upon the issuance of thesecurities and are subject to revision on the basis of ongoing evaluations.Ratings in the table are as of the date indicated.

In our determination of other-than-temporaryimpairments, we consider several factors and circumstances including the issuer’soverall financial condition, the issuer’s credit and financial strengthratings, a weakening of the general market conditions in the industry orgeographic region in which the issuer operates, a prolonged period (typicallysix months or longer) in which the fair value of an issuer’s securities remainsbelow our amortized cost, our ability and intent to hold these investments fora period of time sufficient to allow for recovery of our costs, and any otherfactors that may raise doubt about the issuer’s ability to continue as a goingconcern.

Other-than-temporary impairments are recorded asrealized losses, which serve to reduce net income and earnings per share.Temporary losses are recorded as unrealized losses, which do not impact netincome and earnings per share but reduce other comprehensive net income. Therisks inherent in the assessment of other-than-temporary impairments includethe risk that market factors may differ from our expectations; we may decide tosubsequently sell a security for unforeseen business needs; or the creditassessment could change in the near term, resulting in a charge to earnings.

Thefollowing table illustrates the gross unrealized losses included in theCompany’s investment portfolio and the fair value of those securities,aggregated by investment category. The table also illustrates the length oftime that they have been in a continuous unrealized loss position as ofDecember 31, 2006.

| ** **                                                            | ** ** | **As of December 31, 2006** | ** **  |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|-------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** **  | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | **EstimatedFair Value**                    | ** **  | **Unrealized  Losses** | ** ** | **EstimatedFair Value** | ** ** | **Unrealized  Losses** | ** ** | **EstimatedFair Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$**                                           | **5,850**   | ** ** | ** ** | **$** | **82** |   | ** ** | **$** | **104,796** | ** ** | ** ** | **$** | **2,801** |   | ** ** | **$** | **110,646** | ** ** | ** ** | **$** | **2,883** |   |   |
| Obligations of  states and political subdivisions                     | ** ** | **12,423**                                      | ** **  | ** ** | **43** |   | ** ** | **107,904** | ** ** | ** ** | **1,971** |   | ** ** | **120,327** | ** ** | ** ** | **2,014** |   |   |
| Asset-backed  securities                                              | ** ** | **62,362**                                      | ** **  | ** ** | **537** |   | ** ** | **74,521** | ** ** | ** ** | **1,485** |   | ** ** | **136,883** | ** ** | ** ** | **2,022** |   |   |
| Corporate and  other securities                                       | ** ** | **46,132**                                      | ** **  | ** ** | **778** |   | ** ** | **57,118** | ** ** | ** ** | **1,163** |   | ** ** | **103,250** | ** ** | ** ** | **1,941** |   |   |
| Total temporarily  impaired securities                                | ** ** | **$**                                           | **126,767** | ** ** | ** ** | **$** | **1,440** |   | ** ** | **$** | **344,339** | ** ** | ** ** | **$** | **7,420** |   | ** ** | **$** | **471,106** | ** ** | ** ** | **$** | **8,860** |   |   |

 

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The unrealized losses recorded on the fixed maturityinvestment portfolio at December 31, 2006 resulted from fluctuations inmarket interest rates as opposed to fundamental changes in the credit qualityof the issuers of such securities. Therefore, these decreases in values areviewed as being temporary as we have the intent and ability to retain suchinvestments for a period of time sufficient to allow for recovery in marketvalue.

Of the $8,860 gross unrealized losses as of December 31,2006, $4,897 relates to fixed maturity obligations of U.S. government agenciesand obligations of states and political subdivisions. The remaining $3,963 ofgross unrealized losses relates primarily to holdings of investment grade asset-backed,corporate and other fixed maturity securities.

During the years ended December 31, 2006 and2005, there was no significant deterioration in the credit quality of any ofthe Company’s holdings and no other-than-temporary impairment charges wererecorded related to the Company’s portfolio of investment securities

*Financeand Other Service Income.**  *Finance and other service income includes revenuesfrom premium installment charges, which we recognize when earned, and othermiscellaneous income and fees. Finance and other service income for the yearended December 31, 2006, was $15,128 compared to $16,748 for the 2005period. The decrease was primarily due to the decreases in direct premiumswritten..

*Lossesand Loss Adjustment Expenses.**  *Losses and loss adjustment expensesincurred for the year ended December 31, 2006, decreased by $31,687 or8.2%, to $353,906 from $385,593 for the comparable 2005 period. Our GAAP lossratio for the year ended December 31, 2006, decreased to 56.6% compared to61.9% for the comparable 2005 period. Our GAAP loss ratio excluding lossadjustment expenses for the year ended December 31, 2006, decreased to49.2% from 54.9% for the comparable 2005 period. The loss ratio improved as aresult of a decrease in personal and commercial automobile bodily injury and physicaldamage claim frequency due in part to very favorable weather in 2006 and anincrease in favorable development in our personal and commercial automobile andhomeowners lines prior years results. Total prior year favorable developmentincluded in the pre-tax results for the year ended December 31, 2006 was$42,747 compared to prior year favorable development of $39,620 for thecomparable 2005 period.

*Underwriting,Operating and Related Expenses.**  *Underwriting, operating and relatedexpense for the year ended December 31, 2006 increased by $15,551, or10.6%, to $162,220 from $146,669 for the comparable 2005 period. Our GAAPexpense ratios for the year ended December 31, 2006, increased to 26.0%compared to 23.5% for the comparable 2005 period. The increase was primarilydue to higher accrued agents’ contingent commissions and higher 2006 policyyear mandated personal automobile commissions. The increase in accrued agents’contingent commissions was due to the improved underwriting results for theyear ended December 31, 2006 compared to the year ended December 31, 2005.

*InterestExpenses.**  *Interestexpense for the year ended December 31, 2006 was $86 compared to $948 forthe comparable 2005 period due to the pay down of the balance outstanding underour credit facility of $19,956 on December 8, 2005.

*IncomeTax Expense.**  *Oureffective tax rates were 32.0% and 31.2% for the years ended December 31,2006 and 2005, respectively.  Theseeffective rates were lower than the statutory rate of 35% primarily due toadjustments for tax-exempt investment income and a $1,161 tax benefit recordedas a reduction to income tax expense for the year ended December 31, 2005.This tax benefit represents a reduction in federal income tax reserves for taxyears 2001 through 2003 during 2005 upon completion of an examination of theCompany’s federal income tax returns for the tax periods ended December 31,2003, 2002, and 2001 by the Internal Revenue Service.

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*Net Income.**  *Net income for the year ended December 31,2006 increased by $16,759, or 17.6%, to $111,941 from $95,182 for thecomparable 2005 period. This increase was primarily due to the decrease in theloss ratio and improved investment results as discussed above.

**YEAR ENDED DECEMBER31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004**

*DirectWritten Premiums.**  *Directwritten premiums for the year ended December 31, 2005, increased by$20,818, or 3.3% to $649,113 from $628,295 for 2004. The 2005 increase occurredprimarily in our personal automobile line, which experienced a 0.1% increase inaverage written premium and a 2.4% increase in written exposures. In addition,our commercial automobile line’s average written premium decreased by 0.3%,with a 7.6% increase in written exposures. Our homeowners line average writtenpremium increased by 7.3%, with a 2.9% decrease in written exposures.

*NetWritten Premiums.**  *Netwritten premiums for the year ended December 31, 2005, increased by$13,913 or 2.2% to $632,836 from $618,923 for 2004. This was primarily due tothe factors that increased direct written premiums combined with a decrease inpremiums ceded to CAR.

*NetEarned Premiums.**  *Netearned premiums for the year ended December 31, 2005, increased by$30,539, or 5.2%, to $622,831 from $592,292 for 2004. This was primarily due tothe factors that increased direct written premiums combined with a decrease inpremiums ceded to CAR.

*NetInvestment Income.**  *Investmentincome for the year ended December 31, 2005, was $31,573 compared to$27,259 for 2004. Average cash and investment securities (at amortized cost)increased by $102,624, or 14.0%, to $837,200 for the year ended December 31,2005, from $734,576 for 2004 due to a $72,871 increase in average cash and a$29,753 increase in average securities. Net effective yield on the investmentportfolio remained relatively unchanged at 3.8% during the year ended December 31,2005, compared to 3.7% during 2004. Our duration decreased to 3.2 years atDecember 31, 2005, from 3.4 years at December 31, 2004.

*NetRealized Gains on Investments.**  *Net realized gains on investmentsdecreased to $305 for the year ended December 31, 2005, from $1,274 for2004.

Thegross unrealized appreciation (depreciation) of investments in fixed maturitysecurities, including redeemable preferred stocks that have characteristics offixed maturities, and equity securities, was as follows:

| ** **                                                               | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) |       | $                               | 127,764    |   |   | $ | 142 |   |   |   | $ | (2,686 | ) |   | $ | 125,220 |   |
| Obligations of  states and political subdivisions                        |       | 321,250                         |       |   | 4,385 |   |   |   | (3,026 | ) |   | 322,609 |   |
| Asset-backed  securities(1)                                              |       | 124,531                         |       |   | 293 |   |   |   | (1,349 | ) |   | 123,475 |   |
| Corporate and  other securities                                          |       | 140,385                         |       |   | 2,309 |   |   |   | (1,460 | ) |   | 141,234 |   |
| Subtotal, fixed maturity securities                                      |       | 713,930                         |       |   | 7,129 |   |   |   | (8,521 | ) |   | 712,538 |   |
| Equity securities                                                        |       | 1,895                           |       |   | 110 |   |   |   | — |   |   | 2,005 |   |
| Totals                                                                   |       | $                               | 715,825    |   |   | $ | 7,239 |   |   |   | $ | (8,521 | ) |   | $ | 714,543 |   |

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(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) andFederal National Mortgage Association (FNMA). The total of these fixed maturitysecurities was $115,284 at fair value and $117,766 at amortized cost as of December 31,2005. As such, the asset-backed securities presented 

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exclude such issuersalready presented under U.S. Treasury securities and obligations of U.S. GovernmentAgencies.

As of December 31, 2005, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities (i.e., all our securities received a rating assigned by Moody’sInvestors Service, Inc. (“Moody’s”) of Baa or higher, except the fewsecurities not rated by Moody’s which received Standard & Poor’sratings of A- or higher, as well as a rating assigned by the Securities ValuationOffice of the National Association of Insurance Commissioners of 1 or 2).

Thecomposition of our fixed income security portfolio by Moody’s rating was asfollows:

| ** **                                                            | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                            | ** ** | **Estimated  Fair Value**  | ** ** | **Percent** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies |       | $                               | 122,237    |   |   | 17.2 | % |   |
| Aaa/Aa                                                                |       | 443,200                         |       |   | 62.1 |   |   |
| A                                                                     |       | 86,179                          |       |   | 12.1 |   |   |
| Baa                                                                   |       | 46,183                          |       |   | 6.5 |   |   |
| Not rated  (Standard & Poor’s rating of A- or higher)   |       | 14,739                          |       |   | 2.1 |   |   |
| Total                                                                 |       | $                               | 712,538    |   |   | 100.0 | % |   |

 

Ratings are assigned by Moody’s, or the equivalent, asdiscussed above. Such ratings are generally assigned upon the issuance of thesecurities and are subject to revision on the basis of ongoing evaluations.Ratings in the table are as of the date indicated.

In our determination of other-than-temporaryimpairments, we consider several factors and circumstances including the issuer’soverall financial condition, the issuer’s credit and financial strengthratings, a weakening of the general market conditions in the industry or geographicregion in which the issuer operates, a prolonged period (typically six monthsor longer) in which the fair value of an issuer’s securities remains below ouramortized cost, our ability and intent to hold these investments for a periodof time sufficient to allow for recovery of our costs, and any other factorsthat may raise doubt about the issuer’s ability to continue as a going concern.

Other-than-temporary impairments are recorded asrealized losses, which serve to reduce net income and earnings per share.Temporary losses are recorded as unrealized losses, which do not impact netincome and earnings per share but reduce other comprehensive net income. Therisks inherent in the assessment of other-than-temporary impairments includethe risk that market factors may differ from our expectations; we may decide tosubsequently sell a security for unforeseen business needs; or the creditassessment could change in the near term, resulting in a charge to earnings.

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Thefollowing table illustrates the gross unrealized losses included in the Company’sinvestment portfolio and the fair value of those securities, aggregated byinvestment category. The table also illustrates the length of time that theyhave been in a continuous unrealized loss position as of December 31,2005.

| ** **                                                            | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | **Estimated  Fair Value**                  | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies |       | $                                               | 52,119     |   |   | $ | 581 |   |   | $ | 65,746 |   |   | $ | 2,105 |   |   | $ | 117,865 |   |   | $ | 2,686 |   |   |
| Obligations of  states and political subdivisions                     |       | 53,872                                          |       |   | 872 |   |   | 97,361 |   |   | 2,154 |   |   | 151,233 |   |   | 3,026 |   |   |
| Asset-backed  securities                                              |       | 54,816                                          |       |   | 526 |   |   | 37,560 |   |   | 823 |   |   | 92,376 |   |   | 1,349 |   |   |
| Corporate and  other securities                                       |       | 38,830                                          |       |   | 603 |   |   | 31,707 |   |   | 857 |   |   | 70,537 |   |   | 1,460 |   |   |
| Total temporarily  impaired securities                                |       | $                                               | 199,637    |   |   | $ | 2,582 |   |   | $ | 232,374 |   |   | $ | 5,939 |   |   | $ | 432,011 |   |   | $ | 8,521 |   |   |

 

The unrealized losses recorded on the fixed maturityinvestment portfolio at December 31, 2005, resulted from fluctuations inmarket interest rates as opposed to fundamental changes in the credit qualityof the issuers of such securities. Therefore, these decreases in value areviewed as being temporary as we have the intent and ability to retain suchinvestments for a period of time sufficient to allow for recovery in marketvalue.

Of the $8,521 gross unrealized losses as of December 31,2005, $5,712 relates to fixed maturity obligations of U.S. government agenciesand obligations of states and political subdivisions. The remaining $2,809 ofgross unrealized losses relates primarily to holdings of investment grade asset-backed,corporate and other fixed maturity securities.

During the years ended December 31, 2005 and2004, there was no significant deterioration in the credit quality of any ofthe Company’s holdings and no other-than-temporary impairment charges wererecorded related to the Company’s portfolio of investment securities

*Financeand Other Service Income.**  *Finance and other service income includes revenuesfrom premium installment charges, which we recognize when earned, and othermiscellaneous income and fees. Finance and other service income for the yearended December 31, 2005 were $16,748 compared to $15,615 for the 2004period. This resulted from increases in premium installment billing feesprimarily due to growth in the number of policies combined with an increase inmiscellaneous income from CAR.

*Lossesand Loss Adjustment Expenses.**  *Losses and loss adjustment expensesincurred for the year ended December 31, 2005, decreased by $39,468, or9.3%, to $385,593 from $425,061 for the comparable 2004 period. Our GAAP lossratio for the year ended December 31, 2005, decreased to 61.9% compared to71.8% for the comparable 2004 period. Our GAAP loss ratio excluding lossadjustment expenses for the year ended December 31, 2005, decreased to54.9% from 64.6% for the comparable 2004 period. The loss ratio improved as aresult of favorable loss development of $22,162 in CAR assumed prior yearsreserves, favorable loss development of $14,600 in the Company’s prior yearsretained automobile reserves, a decrease in personal and commercial bodilyinjury claim frequency in our automobile lines of business, favorable loss developmentof $1,872 in FAIR Plan assumed prior years reserves, and favorable lossdevelopment of $986 in retained homeowners prior years reserves in 2005compared to favorable loss development of $6,854 in CAR assumed prior yearsreserves, $2,523 in retained homeowner prior years reserves, $329 in FAIR Planassumed prior years reserves, and an increase of $2,928 in the Company’sretained automobile prior years reserves in 2004.

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*Underwriting,Operating and Related Expenses.**  *Underwriting, operating and relatedexpense for the year ended December 31, 2005 increased by $1,594, or 1.1%,to $146,669 from $145,075 for the comparable 2004 period. Our GAAP expenseratios for the year ended December 31, 2005 decreased to 23.5% compared to24.5% for the comparable 2004 periods and is partly due to a decrease inexpenses related to assessments from the Massachusetts Insurers Insolvency Fund. The Company received a $50 assessmentrefund of prior years assessments in 2005 compared to a $2,538 assessment paidand expensed in 2004.

*InterestExpenses.**  *Interestexpense for the year ended December 31, 2005 was $948 compared to $672 forthe comparable 2004 period due to increased LIBOR rates on our credit facilityadvances in 2005.

*IncomeTax Expense.**  *Oureffective tax rates were 31.2% and 31.5% for the year ended December 31,2005 and 2004, respectively.  Theseeffective rates were lower than the statutory rate of 35% primarily due toadjustments for tax-exempt investment income and a $1,161 tax benefit recordedas a reduction to income tax expense for the year ended December 31, 2005.This tax benefit represents a reduction in federal income tax reserves for taxyears 2001 through 2003 during 2005 upon completion of an examination of theCompany’s federal income tax returns for the tax periods ended December 31,2003, 2002, and 2001 by the Internal Revenue Service.

*Net Income.**  *Net income for the year ended December 31,2005, increased by $50,192, or 111.6%, to $95,182 from $44,990 for thecomparable 2004 period. This increase was primarily due to the increase inpremiums and decrease in the loss ratio, as discussed above.

**Liquidity andCapital Resources**

As a holding company, Safety’s assets consistprimarily of the stock of our direct and indirect subsidiaries. Our principalsource of funds to meet our obligations and pay dividends to shareholders,therefore, is dividends and other permitted payments from our subsidiaries,principally Safety Insurance. Safety is the borrower under our creditfacilities.

Safety Insurance’s sources of funds primarily includepremiums received, investment income and proceeds from sales and redemptions ofinvestments. Safety Insurance’s principal uses of cash are the payment ofclaims, operating expenses and taxes, the purchase of investments and paymentof dividends to Safety.

Net cash provided by operating activities was$101,227, $116,417, and $126,176 during the years ended December 31, 2006,2005 and 2004, respectively. Our operations typically generate substantialpositive cash flows from operations as most premiums are received in advance ofthe time when claim and benefit payments are required. These positive operatingcash flows are expected to continue to meet our liquidity requirements.

Net cash used for investing activities was $230,397and $82,770 during the years ended December 31, 2006 and 2005, whichresulted primarily from purchases of fixed maturities in excess of sales andmaturities of fixed maturities. Net cash provided by investing activities was$7,820 during the year ended December 31, 2004, which resulted primarilyfrom sales  and maturities of fixedmaturities in excess of purchases of fixed maturities.

Net cash used forfinancing activities was $7,574, $26,293, and $4,607 during the years ended December 31,2006, 2005, and 2004, respectively. Net cash used for financing activities isprimarily comprised of dividend payments to shareholders during 2006 and 2004and of the pay down of the revolving credit facility and dividend payments toshareholders in 2005.

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*Credit Facility*

Safety has a $30,000 revolving credit facility withCitizens Bank of Massachusetts which expires on June 17, 2008. Loans underthe credit facility bear interest at our option at either (i) the LIBORrate plus 1.5% per annum or (ii) the higher of Citizens Bank ofMassachusetts’ prime rate or 0.5% above the federal funds rate plus 1.5% perannum. Interest only is payable prior to maturity. The obligations of Safetyunder the credit facility are secured by pledges of Safety’s assets and thecapital stock of our operating subsidiaries. The credit facility is guaranteedby our non-insurance company subsidiaries. The credit facility containscovenants including requirements to maintain minimum risk based capital ratiosand statutory surplus of Safety Insurance as well as limitations orrestrictions on indebtedness, liens, dividends, and other matters. As of December 31,2006, we were in compliance with all such covenants.

We paid down the balanceof $19,956 on December 8, 2005, and had no amounts outstanding on our creditfacility at December 31, 2006 and 2005. The credit facility commitment feeincluded in interest expenses was computed at a rate of 0.25% on the $30,000commitment at December 31, 2006 and 2005.

*Regulatory Matters*

Our insurance subsidiaries are subject to variousregulatory restrictions that limit the maximum amount of dividends available tobe paid to their parent without prior approval of the Commissioner. TheMassachusetts statute limits the dividends an insurer may pay in any twelve-monthperiod, without the prior permission of the Commissioner, to the greater of (i) 10%of the insurer’s surplus as of the preceding December 31 or (ii) theinsurer’s net income for the twelve-month period ending the preceding December 31,in each case determined in accordance with statutory accounting practices. Ourinsurance company subsidiaries may not declare an “extraordinary dividend”(defined as any dividend or distribution that, together with otherdistributions made within the preceding twelve months, exceeds the limitsestablished by Massachusetts statute) until thirty days after the Commissionerhas received notice of the intended dividend and has not objected. Ashistorically administered by the Commissioner, this provision requires theCommissioner’s prior approval of an extraordinary dividend. Under Massachusettslaw, an insurer may pay cash dividends only from its unassigned funds, alsoknown as earned surplus, and the insurer’s remaining surplus must be bothreasonable in relation to its outstanding liabilities and adequate to itsfinancial needs. At year-end 2006, the statutory surplus of Safety Insurancewas $457,505, and its net income for 2006 was $110,075. As a result, a maximumof $110,075 is available in 2007 for such dividends without prior approval ofthe Division. During the year ended December 31, 2006, Safety Insurancerecorded dividends to Safety of $7,859.

The maximum dividend permitted by law is notindicative of an insurer’s actual ability to pay dividends, which may beconstrained by business and regulatory considerations, such as the impact ofdividends on surplus, which could affect an insurer’s ratings or competitiveposition, the amount of premiums that can be written and the ability to payfuture dividends.

On February 15, 2007, our Board approved aquarterly cash dividend on our common stock of $0.25 per share payable on March 15,2007 to shareholders of record on March 1, 2007. On November 3, 2006,our Board approved a quarterly cash dividend on our common stock of $0.25 pershare, or $4,010, which was paid on December 15, 2006. On August 10,2006, our Board approved a quarterly cash dividend on our common stock of $0.25per share, or $4,003, which was paid on September 15, 2005. On May 5,2006, our Board approved a quarterly cash dividend on our common stock of $0.18per share, or $2,876, which was paid on June 15, 2006. On February 16,2006, our Board approved a quarterly cash dividend on our common stock of $0.18per share, or $2,844, which was paid on March 15, 2006. On November 3,2005, our Board approved a quarterly cash dividend on our common stock of $0.18per share, or $2,835, which was paid on December 15, 2005. On August 18,2005, our Board approved a quarterly cash dividend on our common stock of $0.18per share, or $2,832, which was paid on September 15, 2005. On May 19,2005, our 

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Board approved a quarterlycash dividend on our common stock of $0.12 per share, or $1,881, which was paidon June 15, 2005. On February 17, 2005, our Board approved aquarterly cash dividend on our common stock of $0.12 per share, or $1,861,which was paid on March 15, 2005. We plan to continue to declare and payquarterly cash dividends in 2007, depending on our financial position and theregularity of our cash flows.

Management believes that thecurrent level of cash flow from operations provides us with sufficientliquidity to meet our operating needs over the next 12 months. We expectto be able to continue to meet our operating needs after the next12 months from internally generated funds. Since our ability to meet ourobligations in the long term (beyond such twelve-month period) isdependent upon such factors as market changes, insurance regulatory changes andeconomic conditions, no assurance can be given that the available net cash flowwill be sufficient to meet our operating needs. We expect that we would need toborrow or issue capital stock if we needed additional funds, for example, topay for an acquisition or a significant expansion of our operations. There canbe no assurance that sufficient funds for any of the foregoing purposes wouldbe available to us at such time.

*Off-Balance SheetArrangements*

We have no materialobligations under a guarantee contract meeting the characteristics identifiedin paragraph 3 of Financial Accounting Standards Board (“FASB”)Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and DisclosureRequirements, Including Indirect Guarantees of Indebtedness of Others”. We haveno material retained or contingent interests in assets transferred to an unconsolidatedentity. We have no material obligations, including contingent obligations,under contracts that would be accounted for as derivative instruments. We haveno obligation, including contingent obligations, arising out of a variableinterest in an unconsolidated entity held by, and material to, us, where suchentity provides financing, liquidity, market risk or credit risk support to, orengages in leasing, hedging or research and development services with us. Wehave no direct investments in real estate and no holdings of mortgages securedby commercial real estate. Accordingly, we have no material off-balance sheetarrangements.

*ContractualObligations*

Wehave obligations to make future payments under contracts and credit-relatedfinancial instruments and commitments. At December 31, 2006, certainlong-term aggregate contractual obligations and credit-relatedcommitments are summarized as follows:

| ** **                     | ** ** | **Payments Due by Period** | ** **  |
|--------------------------------|------------|-------------------------------------------|-------------|
| ** **                     | ** ** | **Within  One Year**                 | ** **  | **Two to Three  Years** | ** ** | **Four to Five  Years** | ** ** | **After five  Years** | ** ** | **Total** | ** ** |
| Loss and LAE  reserves         | ** ** | **$**                                     | **220,228** | ** ** |   | **$** | **197,755** | ** ** |   |   | **$** | **26,967** | ** ** |   |   | **$** | **4,494** | ** ** |   | **$** | **449,444** | ** ** |
| Capital lease  obligations     | ** ** | **39**                                    | ** **  |   | **—** | ** ** |   |   | **—** | ** ** |   |   | **—** | ** ** |   | **39** | ** ** |
| Operating leases               | ** ** | **3,073**                                 | ** **  |   | **3,263** | ** ** |   |   | **105** | ** ** |   |   | **8** | ** ** |   | **6,449** | ** ** |
| Total contractual  obligations | ** ** | **$**                                     | **223,340** | ** ** |   | **$** | **201,018** | ** ** |   |   | **$** | **27,072** | ** ** |   |   | **$** | **4,502** | ** ** |   | **$** | **455,932** | ** ** |

 

As of December 31,2006, the Company had loss and LAE reserves of $449,444, reinsurancerecoverables of $78,464 and net loss and LAE reserves of $370,980. Our loss andLAE reserves are estimates as described in more detail under “CriticalAccounting Policies and Estimates”. The specific amounts and timing ofobligations related to case reserves, IBNR reserves and related LAE reservesare not set contractually, and the amounts and timing of these obligations areunknown. Nonetheless, based upon our cumulative claims paid over the last tenyears, the Company estimates that its loss and LAE reserves will be paid in theperiod shown above. While management believes that historical performance ofloss payment patterns is a reasonable source for projecting future claimspayments, there is inherent 

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uncertaintyin this estimated projected settlement of loss and LAE reserves, and as aresult these estimates will differ, perhaps significantly, from actual futurepayments. Our operations typically generate substantial positive cash flowsfrom operations as most premiums are received in advance of the time when claimand benefit payments are required. These positive operating cash flows areexpected to continue to meet our liquidity requirements, including anyunexpected variations in the timing of claim settlements.

**Forward-LookingStatements**

Forward-lookingstatements might include one or more of the following, among others:

·       Projectionsof revenues, income, earnings per share, capital expenditures, dividends,capital structure or other financial items;

·       Descriptionsof plans or objectives of management for future operations, products orservices;

·       Forecastsof future economic performance, liquidity, need for funding and income; and

·       Descriptionsof assumptions underlying or relating to any of the foregoing.

Forward-looking statements can be identified bythe fact that they do not relate strictly to historical or current facts. Theyoften include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,”“estimate,” “aim,” “projects,” or words of similar meaning and expressions thatindicate future events and trends, or future or conditional verbs such as “will,”“would,” “should,” “could,” or “may”. All statements that address expectationsor projections about the future, including statements about the Company’sstrategy for growth, product development, market position, expenditures andfinancial results, are forward-looking statements.

Forward-looking statements are not guarantees offuture performance. By their nature, forward-looking statements aresubject to risks and uncertainties. There are a number of factors, many ofwhich are beyond our control, that could cause actual future conditions,events, results or trends to differ significantly and/or materially fromhistorical results or those projected in the forward-looking statements.These factors include but are not limited to the competitive nature of ourindustry and the possible adverse effects of such competition. Although anumber of national insurers that are much larger than we are do not currentlycompete in a material way in the Massachusetts private passenger automobilemarket, if one or more of these companies decided to aggressively enter themarket it could have a material adverse effect on us. Other significant factorsinclude conditions for business operations and restrictive regulations inMassachusetts, the possibility of losses due to claims resulting from severeweather, the possibility that the Commissioner may approve future Rule changesthat change the operation of the residual market, our possible need for andavailability of additional financing, and our dependence on strategicrelationships, among others, and other risks and factors identified from timeto time in our reports filed with the SEC. Refer to Part 1, Item 1A—RiskFactors.

Some other factors, such as market, operational,liquidity, interest rate, equity and other risks, are described elsewhere inthis Annual Report on Form 10-K. Factors relating to the regulationand supervision of our Company are also described or incorporated in thisreport. There are other factors besides those described or incorporated in thisreport that could cause actual conditions, events or results to differ fromthose in the forward-looking statements.

Readers are cautioned notto place undue reliance on these forward-looking statements, which speakonly as of the date on which they are made. We do not undertake any obligationto update publicly or revise any forward-looking statements to reflectcircumstances or events that occur after the date the forward-lookingstatements are made.

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***ITEM 7A.****            QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK*

*MarketRisk.**  *Marketrisk is the risk that we will incur losses due to adverse changes in marketrates and prices. We have exposure to market risk through our investmentactivities and our financing activities. Our primary market risk exposure is tochanges in interest rates. We use both fixed and variable rate debt as sourcesof financing. We have not entered, and do not plan to enter, into anyderivative financial instruments for trading or speculative purposes.

*InterestRate Risk.**  *Interestrate risk is the risk that we will incur economic losses due to adverse changesin interest rates. Our exposure to interest rate changes primarily results fromour significant holdings of fixed rate investments and from our financingactivities. Our fixed maturity investments include U.S. and foreign governmentbonds, securities issued by government agencies, obligations of state and localgovernments and governmental authorities, corporate bonds and asset-backedsecurities, most of which are exposed to changes in prevailing interest rates.

We manage our exposure to risks associated withinterest rate fluctuations through active review of our investment portfolio byour management and Board and consultation with third-party financialadvisors. As a general matter, we do not attempt to match the durations of ourassets with the durations of our liabilities, and the majority of ourliabilities are “short tail.” Our goal is to maximize the total after-taxreturn on all of our investments. An important strategy that we employ toachieve this goal is to try to hold enough in cash and short-term investmentsin order to avoid liquidating longer-term investments to pay claims.

Basedupon the results of interest rate sensitivity analysis, the following table showsthe interest rate risk of our investments in fixed maturities, includingpreferred stocks with characteristics of fixed maturities, measured in terms offair value (which is equal to the carrying value for all our fixed maturitysecurities).

| ** **                                   | ** ** | **-100 Basis  Point Change** | ** ** | **No Change** | ** ** | **+100 Basis  Point Change** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|--------------------|------------|----------------------------------------|------------|
| **As of December 31, 2006**             | ** ** |                                   | ** ** | ** **         |       |                                   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Estimated fair  value                        | ** ** |                                   | **$**      | **980,493**        | ** ** |                                   |       | **$** | **936,280** | ** ** |   |   | **$** | **890,038** | ** ** |   |
| Estimated  increase (decrease) in fair value | ** ** |                                   | **$**      | **44,213**         | ** ** |                                   |       | **$** | **—** | ** ** |   |   | **$** | **(46,242** | **)** |   |
| **As of December 31, 2005**             | ** ** |                                   | ** ** | ** **         |       |                                   | ** ** | ** ** |   |   |   |   |   |
| Estimated fair  value                        |       |                                   | $          | 740,163            | ** ** |                                   |       | $ | 712,538 | ** ** |   |   | $ | 684,924 |   |   |
| Estimated  increase (decrease) in fair value |       |                                   | $          | 27,625             | ** ** |                                   |       | $ | — | ** ** |   |   | $ | (27,614 | ) |   |

 

With respect to floating rate debt, we are exposed tothe effects of changes in prevailing interest rates. At December 31, 2006,we had no debt outstanding under our credit facility. Assuming the fullutilization of our current available credit facility, a 2.0% increase in theprevailing interest rate on our variable rate debt would result in interestexpense increasing approximately $600 for 2007, assuming that all of such debtis outstanding for the entire year.

*EquityRisk.**  *Equityrisk is the risk that we will incur economic losses due to adverse changes inequity prices. In the past, our exposure to changes in equity prices primarilyresulted from our holdings of common stocks, mutual funds and other equities.While we have in the past held common equity securities in our investmentportfolio, presently we hold none, except for interests in mutual funds to fundthe executive deferred compensation plan. We continuously evaluate marketconditions and we expect in the future to purchase equity securities. Weprincipally managed equity price risk through industry and issuerdiversification and asset allocation techniques.

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***ITEM 8.****                 FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA*

**SAFETYINSURANCE GROUP, INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**
|                                                          | ** ** | **Page(s)** | ** ** |
|----------------------------------------------------------|------------|-------------|------------|
| **Consolidated Financial  Statements:**                  |       |        |       |   |   |
| Report of Independent Registered Public Accounting  Firm |       |        | 71         |   |   |
| Balance Sheets                                           |       |        | 73         |   |   |
| Statements of Operations                                 |       |        | 74         |   |   |
| Statements of Changes in Shareholders’ Equity       |       |        | 75         |   |   |
| Statements of Comprehensive Income                       |       |        | 76         |   |   |
| Statements of Cash Flows                                 |       |        | 77         |   |   |
| Notes to  Consolidated Financial Statements              |       |        | 78         |   |   |

 

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**Reportof Independent Registered Public Accounting Firm**

To the Board of Directors and Shareholders of SafetyInsurance Group, Inc.:

We have completedintegrated audits of Safety Insurance Group, Inc.’s consolidated financialstatements and of its internal control over financial reporting as of December 31,2006, in accordance with the standards of the Public Company AccountingOversight Board (United States). Our opinions, based on our audits, arepresented below.

*Consolidatedfinancial statements and financial statement schedules*

In our opinion, theconsolidated financial statements listed in the accompanying index presentfairly, in all material respects, the financial position of Safety InsuranceGroup, Inc. at December 31, 2006 and 2005, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2006 in conformity with accounting principles generallyaccepted in the United States of America. In addition, in our opinion, thefinancial statement schedules listed in the index appearing under 15(a)(2) presentfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedules are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements and financial statement schedules based on ouraudits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control over Financial Reportingappearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of December 31, 2006 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for 

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external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that (i) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/PricewaterhouseCoopers LLP

Boston,Massachusetts

March 1, 2007

72

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**Safety InsuranceGroup, Inc. and Subsidiaries**

**Consolidated Balance Sheets** (Dollars in thousands, except share data)

| ** **                                                                                                                                | ** ** | **December 31,** | ** **    |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|---------------|
| ** **                                                                                                                                | ** ** | **2006**              | ** **    | **2005** | ** ** |
| **Assets**                                                                                                                                | ** ** | ** **            | ** **    | ** ** | ** ** |
| Investment securities  available for sale:                                                                                                |       |                  |          |   |   |
| Fixed maturities, at fair value (amortized cost:  $936,534 and $713,930)                                                                  | ** ** | **$**                 | **936,280**   |   | $ | 712,538 |   |
| Equity securities, at fair value (cost: $4,038 and  $1,895)                                                                               | ** ** | **4,325**             |          | 2,005 |   |
| Total investment securities                                                                                                               | ** ** | **940,605**           |          | 714,543 |   |
| Cash and cash  equivalents                                                                                                                | ** ** | **26,283**            |          | 163,027 |   |
| Accounts  receivable, net of allowance for doubtful accounts                                                                              | ** ** | **158,190**           |          | 154,421 |   |
| Accrued  investment income                                                                                                                | ** ** | **9,776**             |          | 7,856 |   |
| Taxes recoverable                                                                                                                         | ** ** | **1,781**             |          | 318 |   |
| Receivable from  reinsurers related to paid loss and loss adjustment expenses                                                             | ** ** | **13,282**            |          | 18,750 |   |
| Receivable from  reinsurers related to unpaid loss and loss adjustment expenses                                                           | ** ** | **78,464**            |          | 80,550 |   |
| Ceded unearned  premiums                                                                                                                  | ** ** | **33,042**            |          | 37,174 |   |
| Deferred policy  acquisition costs                                                                                                        | ** ** | **47,404**            |          | 45,480 |   |
| Deferred income  taxes                                                                                                                    | ** ** | **16,868**            |          | 18,120 |   |
| Equity and  deposits in pools                                                                                                             | ** ** | **26,166**            |          | 14,631 |   |
| Other assets                                                                                                                              | ** ** | **3,887**             |          | 2,805 |   |
| **Total assets**                                                                                                                          | ** ** | **$**                 | **1,355,748** |   | $ | 1,257,675 |   |
| **Liabilities**                                                                                                                           | ** ** | ** **            | ** **    | ** ** | ** ** |
| Loss and loss  adjustment expense reserves                                                                                                | ** ** | **$**                 | **449,444**   |   | $ | 450,716 |   |
| Unearned premium  reserves                                                                                                                | ** ** | **333,404**           |          | 341,562 |   |
| Accounts payable  and accrued liabilities                                                                                                 | ** ** | **48,666**            |          | 44,372 |   |
| Outstanding  claims drafts                                                                                                                | ** ** | **16,279**            |          | 19,825 |   |
| Payable to  reinsurers                                                                                                                    | ** ** | **11,568**            |          | 12,985 |   |
| Capital lease  obligations                                                                                                                | ** ** | **39**                |          | 266 |   |
| **Total liabilities**                                                                                                                     | ** ** | **859,400**           |          | 869,726 |   |
| **Commitments  and contingencies (Note 6)**                                                                                               | ** ** | ** **            | ** **    | ** ** | ** ** |
| **Shareholders’  equity**                                                                                                            | ** ** | ** **            | ** **    | ** ** | ** ** |
| Common stock:  $0.01 par value; 30,000,000 shares authorized; 16,096,004 and 15,787,947  shares issued and outstanding, respectively | ** ** | **161**               |          | 158 |   |
| Additional  paid-in capital                                                                                                               | ** ** | **129,785**           |          | 120,451 |   |
| Accumulated other  comprehensive income (loss), net of taxes                                                                              | ** ** | **21**                |          | (833 | ) |
| Retained earnings                                                                                                                         | ** ** | **366,381**           |          | 268,173 |   |
| **Total shareholders’ equity**                                                                                                       | ** ** | **496,348**           |          | 387,949 |   |
| **Total liabilities and  shareholders’ equity**                                                                                      | ** ** | **$**                 | **1,355,748** |   | $ | 1,257,675 |   |

 

The accompanying notes are an integral part of these financial statements.

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**Safety Insurance Group, Inc. and Subsidiaries**

**Consolidated Statements of Operations(Dollars in thousands, except per share and share data)**

| ** **                                                 | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                 | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Net earned  premiums                                       | ** ** | **$**                                                         | **624,933** | ** ** | $ | 622,831 |   | $ | 592,292 | ** ** |
| Net investment  income                                     | ** ** | **40,293**                                                    |        | 31,573 |   | 27,259 |   |
| Net realized  gains on investments                         | ** ** | **358**                                                       |        | 305 |   | 1,274 |   |
| Finance and other  service income                          | ** ** | **15,128**                                                    |        | 16,748 |   | 15,615 |   |
| Total revenue                                              | ** ** | **680,712**                                                   |        | 671,457 |   | 636,440 |   |
| Losses and loss adjustment expenses                        | ** ** | **353,906**                                                   |        | 385,593 |   | 425,061 |   |
| Underwriting,  operating and related expenses              | ** ** | **162,220**                                                   |        | 146,669 |   | 145,075 |   |
| Interest expenses                                          | ** ** | **86**                                                        |        | 948 |   | 672 |   |
| Total expenses                                             | ** ** | **516,212**                                                   |        | 533,210 |   | 570,808 |   |
| Income before income taxes                                 | ** ** | **164,500**                                                   |        | 138,247 |   | 65,632 |   |
| Income tax  expense                                        | ** ** | **52,559**                                                    |        | 43,065 |   | 20,642 |   |
| **Net income**                                             | ** ** | **$**                                                         | **111,941** |   | $ | 95,182 |   | $ | 44,990 |   |
| **Earnings  per weighted average common share:**           | ** ** | ** **                                                    |        |   |   |   |   |
| Basic                                                      | ** ** | **$**                                                         | **7.07**    | ** ** | $ | 6.11 |   | $ | 2.94 | ** ** |
| Diluted                                                    | ** ** | **$**                                                         | **6.99**    | ** ** | $ | 5.97 |   | $ | 2.90 | ** ** |
| **Cash dividends paid per common share**                   | ** ** | **$**                                                         | **0.86**    | ** ** | $ | 0.60 |   | $ | 0.44 | ** ** |
| **Weighted  average number of common shares outstanding:** | ** ** | ** **                                                    | ** **  |   |   |   | ** ** |
| Basic                                                      | ** ** | **15,838,335**                                                | ** **  | 15,578,039 |   | 15,315,877 | ** ** |
| Diluted                                                    | ** ** | **16,005,913**                                                | ** **  | 15,953,737 |   | 15,526,892 | ** ** |

 

The accompanying notes are an integral part of these financial statements.

74

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**Safety InsuranceGroup, Inc. and Subsidiaries**

**Consolidated Statements of Changes in Shareholders’Equity(Dollars in thousands)**

| ** **                                                                                                                  | ** ** | ** ** | ** ** | ** **     | ** ** | **Accumulated**            | ** ** | **Promissory** | ** **  | ** **   | ** ** | ** **             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|----------------------------|------------|----------------|-------------|--------------|------------|------------------------|------------|
| ** **                                                                                                                  | ** ** | ** ** | ** ** | ** **     | ** ** | **Other**                  | ** ** | **Notes**      | ** **  | ** **   | ** ** | ** **             | ** ** |
| ** **                                                                                                                  | ** ** | ** ** | ** ** | **Additional** | ** ** | **Comprehensive**          | ** ** | **Receivable** | ** **  | ** **   | ** ** | **Total**              | ** ** |
| ** **                                                                                                                  | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Income/(Loss),**         | ** ** | **From**       | ** **  | **Retained** | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                                                  | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Net of Taxes** | ** ** | **Management** | ** **  | **Earnings** | ** ** | **Equity**             | ** ** |
| Balance at December 31, 2003                                                                                           |       |       | $          | 153            |       |                       |       | $              | 111,074     |         |       |                   | $          | 12,650 |   |   |   | $ | (34 | ) |   | $ | 144,177 |   |   | $ | 268,020 |   |   |
| Net income                                                                                                                  |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | 44,990 |   |   | 44,990 |   |   |
| Payments on promissory notes from management                                                                                |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   | 34 |   |   |   |   |   | 34 |   |   |
| Other comprehensive loss, net of deferred  federal income taxes                                                        |       |       |       |           |       |                       |       |           |        |         | (3,941     | )                      |       |   |   |   |   |   |   |   | (3,941 | ) |   |
| Exercise of options and unearned compensation on  restricted stock, net of deferred federal income taxes     |       |       | 2          |           |       |                       | 2,996      |           |        |         |       |                   |       |   |   |   |   |   |   |   | 2,998 |   |   |
| Dividends paid                                                                                                              |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | (6,767 | ) |   | (6,767 | ) |   |
| Balance at December 31, 2004                                                                                           |       |       | 155        |           |       |                       | 114,070    |           |        |         | 8,709      |                   |       |   | — |   |   | 182,400 |   |   | 305,334 |   |   |
| Net income                                                                                                                  |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | 95,182 |   |   | 95,182 |   |   |
| Other comprehensive loss, net of deferred  federal income taxes                                                        |       |       |       |           |       |                       |       |           |        |         | (9,542     | )                      |       |   |   |   |   |   |   |   | (9,542 | ) |   |
| Exercise of options and unearned compensation on  restricted stock, net of deferred federal income taxes     |       |       | 3          |           |       |                       | 5,926      |           |        |         |       |                   |       |   |   |   |   |   |   |   | 5,929 |   |   |
| Tax contingency reserve adjustment                                                                                          |       |       |       |           |       |                       | 455        |           |        |         |       |                   |       |   |   |   |   |   |   |   | 455 |   |   |
| Dividends paid                                                                                                              |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | (9,409 | ) |   | (9,409 | ) |   |
| Balance at December 31, 2005                                                                                           |       |       | 158        |           |       |                       | 120,451    |           |        |         | (833       | )                      |       |   | — |   |   | 268,173 |   |   | 387,949 |   |   |
| **Net income**                                                                                                              | ** ** | ** ** | ** ** |           | ** ** | ** **                 | ** ** |           | ** **  | ** **   | ** ** |                   | ** ** | ** ** | ** ** |   | ** ** | **111,941** | ** ** | ** ** | **111,941** | ** ** | ** ** |
| **Other comprehensive gain, net of deferred  federal income taxes**                                                    | ** ** | ** ** | ** ** |           | ** ** | ** **                 | ** ** |           | ** **  | ** **   | **854**    |                   | ** ** | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | **854** | ** ** | ** ** |
| **Exercise of options and unearned compensation  on restricted stock, net of deferred federal income taxes** | ** ** | ** ** | **3**      |           | ** ** | ** **                 | **9,334**  |           | ** **  | ** **   | ** ** |                   | ** ** | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | **9,337** | ** ** | ** ** |
| **Dividends paid**                                                                                                          | ** ** | ** ** | ** ** |           | ** ** | ** **                 | ** ** |           | ** **  | ** **   | ** ** |                   | ** ** | ** ** | ** ** |   | ** ** | **(13,733** | **)** | ** ** | **(13,733** | **)** | ** ** |
| **Balance  at December 31, 2006**                                                                                      | ** ** | ** ** | **$**      | **161**        |       | ** **                 | ** ** | **$**          | **129,785** |         | ** ** | ** **             | **$**      | **21** |   | ** ** | ** ** | **$** | **—** |   | ** ** | **$** | **366,381** | ** ** | ** ** | **$** | **496,348** | ** ** | ** ** |

 

The accompanying notes are an integral part of these financial statements.

75

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**Safety Insurance Group, Inc. and SubsidiariesConsolidated Statements of Comprehensive Income(Dollars in thousands)**

| ** **                                                                                                      | ** ** | **For the Years Ended December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                                                      | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Net  income**                                                                                                 | ** ** | **$**                                                         | **111,941** |   | $ | 95,182 |   | $ | 44,990 |   |
| **Other  comprehensive gain (loss), net of taxes:**                                                             |       |                                                          |        |   |   |   |   |
| Change in unrealized holding gains, net of tax  (benefit) expense of $585, $(5,031), and $(1,676)               |       | **1,087**                                                     |        | (9,344 | ) | (3,113 | ) |
| Reclassification adjustment for gains included in net  income, net of tax benefit of $(125), $(107), and $(446) |       | **(233**                                                      | **)**       | (198 | ) | (828 | ) |
| Unrealized gains (losses) on securities available  for sale                                                     | ** ** | **854**                                                       |        | (9,542 | ) | (3,941 | ) |
| **Comprehensive  income**                                                                                       | ** ** | **$**                                                         | **112,795** |   | $ | 85,640 |   | $ | 41,049 |   |

 

The accompanying notes are an integral part of these financial statements.

76

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**Safety Insurance Group, Inc. and SubsidiariesConsolidated Statements of Cash Flows(Dollars in thousands)**

| ** **                                                                         | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                         | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating activities:**                                          | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         | ** ** | **$**                                                         | **111,941** |   | $ | 95,182 |   | $ | 44,990 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                                          |        |   |   |   |   |
| Depreciation and  amortization, net                                                | ** ** | **8,493**                                                     |        | 8,312 |   | 8,041 |   |
| Provision (benefit) for  deferred income taxes                                     | ** ** | **792**                                                       |        | (303 | ) | (1,865 | ) |
| Gains on sale of fixed  assets                                                     | ** ** | **(23**                                                       | **)**       | — |   | (4 | ) |
| Net realized gains on  investments                                                 | ** ** | **(358**                                                      | **)**       | (305 | ) | (1,274 | ) |
| Changes in assets and liabilities:                                                 |       |                                                          |        |   |   |   |   |
| Accounts receivable                                                                | ** ** | **(3,769**                                                    | **)**       | (3,970 | ) | (16,306 | ) |
| Accrued investment  income                                                         | ** ** | **(1,920**                                                    | **)**       | (848 | ) | 216 |   |
| Receivable from  reinsurers                                                        | ** ** | **7,554**                                                     |        | 3,847 |   | 17,895 |   |
| Ceded unearned premiums                                                            | ** ** | **4,132**                                                     |        | 6,228 |   | (9,928 | ) |
| Deferred policy  acquisition costs                                                 | ** ** | **(1,924**                                                    | **)**       | (2,561 | ) | (2,742 | ) |
| Other assets                                                                       | ** ** | **(13,365**                                                   | **)**       | 8,883 |   | 4,717 |   |
| Loss and loss adjustment  expense reserves                                         | ** ** | **(1,272**                                                    | **)**       | (181 | ) | 67,346 |   |
| Unearned premium  reserves                                                         | ** ** | **(8,158**                                                    | **)**       | 3,776 |   | 36,559 |   |
| Accounts payable and  accrued liabilities                                          | ** ** | **4,294**                                                     |        | 688 |   | 6,187 |   |
| Payable to reinsurers                                                              | ** ** | **(1,417**                                                    | **)**       | (4,005 | ) | (28,348 | ) |
| Other liabilities                                                                  | ** ** | **(3,773**                                                    | **)**       | 1,674 |   | 692 |   |
| Net cash provided by  operating activities                                         | ** ** | **101,227**                                                   |        | 116,417 |   | 126,176 |   |
| **Cash flows from investing activities:**                                          | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Fixed maturities  purchased                                                        | ** ** | **(355,158**                                                  | **)**       | (155,647 | ) | (101,281 | ) |
| Equity securities  purchased                                                       | ** ** | **(2,607**                                                    | **)**       | (1,290 | ) | (1,279 | ) |
| Proceeds from sales of  fixed maturities                                           | ** ** | **113,564**                                                   |        | 63,365 |   | 103,043 |   |
| Proceeds from maturities  of fixed maturities                                      | ** ** | **14,300**                                                    |        | 11,125 |   | 7,520 |   |
| Proceed from sales of  equity securities                                           | ** ** | **485**                                                       |        | 443 |   | 245 |   |
| Fixed assets purchased                                                             | ** ** | **(1,004**                                                    | **)**       | (766 | ) | (432 | ) |
| Proceeds from sales of  fixed assets                                               | ** ** | **23**                                                        |        | — |   | 4 |   |
| Net cash (used for)  provided by investing activities                              | ** ** | **(230,397**                                                  | **)**       | (82,770 | ) | 7,820 |   |
| **Cash flows from financing activities:**                                          | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Payments on revolving  credit facility                                             | ** ** | **—**                                                    |        | (19,956 | ) | — |   |
| Payments on promissory  notes from management                                      | ** ** | **—**                                                    |        | — |   | 34 |   |
| Proceeds and excess tax  benefits from exercise of stock  options                  | ** ** | **6,159**                                                     |        | 3,072 |   | 2,126 |   |
| Dividends paid to  shareholders                                                    | ** ** | **(13,733**                                                   | **)**       | (9,409 | ) | (6,767 | ) |
| Net cash used for  financing activities                                            | ** ** | **(7,574**                                                    | **)**       | (26,293 | ) | (4,607 | ) |
| **Net  (decrease) increase in cash and cash equivalents**                          | ** ** | **(136,744**                                                  | **)**       | 7,354 |   | 129,389 |   |
| Cash and cash  equivalents, beginning of year                                      | ** ** | **163,027**                                                   |        | 155,673 |   | 26,284 |   |
| **Cash and cash equivalents, end  of year**                                        | ** ** | **$**                                                         | **26,283**  |   | $ | 163,027 |   | $ | 155,673 |   |
| **Supplemental disclosure of cash flow  information:**                             | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the year for:                                                     |       |                                                          |        |   |   |   |   |
| Federal and state income  taxes                                                    | ** ** | **$**                                                         | **50,000**  | ** ** | **$** | **44,776** |   | $ | 16,900 |   |
| Interest                                                                           | ** ** | **$**                                                         | **77**      | ** ** | **$** | **1,030** |   | $ | 785 |   |

 

The accompanying notes are an integral part of these financial statements.

77

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**1.**                 Basis ofPresentation

The consolidated financial statements have beenprepared on the basis of accounting principles generally accepted in the UnitedStates of America (“GAAP”). The consolidated financial statements includeSafety Insurance Group, Inc. and its subsidiaries (the “Company”). Thesubsidiaries consist of Safety Insurance Company, Safety Indemnity InsuranceCompany, Safety Property and Casualty Insurance Company (“Safety P&C”),Whiteshirts Asset Management Corporation (“WAMC”), and Whiteshirts ManagementCorporation, which is WAMC’s holding company. All intercompany transactionshave been eliminated.

The Company was incorporated on June 25, 2001, inthe State of Delaware. On October 16, 2001, the Company acquired (the “Acquisition”)all of the issued and outstanding common stock of Thomas Black Corporation (“TBC”)and its property and casualty subsidiaries. TBC subsequently merged with andinto Safety Insurance Group, Inc. with Safety Insurance Group, Inc.being the corporation surviving the merger.

The Company is a leadingprovider of personal lines property and casualty insurance focused exclusivelyon the Massachusetts market. The Company’s principal product line is privatepassenger automobile insurance, which accounted for 76.0% of its direct writtenpremiums in 2006. The Company operates through its insurance companysubsidiaries, Safety Insurance Company and Safety Indemnity Insurance Company(together with Safety P&C referred to as the “Insurance Subsidiaries”). In2007, the Company intends to commence operations through Safety P&C, athird insurance company subsidiary formed in December 2006.

**2.**                 Summaryof Significant Accounting Policies

**Investments**

Investments in fixed maturities available for sale,which include taxable and non-taxable bonds and redeemable preferred stocks,are reported at fair value. Investments in equity securities available forsale, which include interests in mutual funds, are reported at fair value. Fairvalues are derived from external market quotations. Unrealized gains or losseson fixed maturity and equity securities, reported at fair value, are excludedfrom earnings and reported in a separate component of shareholders’ equity,known as “Accumulated other comprehensive income (loss), net of taxes”, untilrealized. Realized gains or losses on the sale or maturity of investments aredetermined on the basis of the specific cost identification method. Fixedmaturities and equity securities that experience declines in value that areother-than-temporary are written down to fair value with a corresponding chargeto net realized losses on investments.

Investment income isrecognized on an accrual basis of accounting. Bonds not backed by other loansare amortized using the interest method. Loan-backed bonds and structuredsecurities are amortized using the interest method and significant changes inestimated cash flows from the original purchase assumptions are accounted forusing the retrospective method.

**Cash Equivalents**

Cash equivalents,consisting of money market accounts and United States (“U.S.”) Treasury billswith original maturities of three months or less, are stated at cost, whichapproximates fair value.

78

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Accounts Receivable**

Amounts included inaccounts receivable represent premiums as well as finance charges, the majorityof which are both billed on a monthly installment basis. Accounts receivableare stated net of allowances for doubtful accounts. At December 31, 2006and 2005, these allowances were $153 and $220, respectively. Uncollectedpremium balances over ninety days past due are written off.

**Deferred PolicyAcquisition Costs**

Amounts that vary with andare primarily related to acquiring new and renewal business, principallycommissions and premium taxes, are deferred and amortized ratably over theeffective period of the policies. All other acquisition expenses are expensedas incurred. Deferred policy acquisition costs are reviewed to determine ifthey are recoverable from future income, and if not, are charged to expense.Future investment income attributable to related premiums is taken into accountin measuring the recoverability of the carrying value of this asset. Amortizationof acquisition costs in the amount of $97,274, $93,515 and $88,425 were chargedto underwriting expenses for the years ended December 31, 2006, 2005 and2004, respectively.

**Equity and Depositsin Pools**

Equity and deposits inpools represents the net receivable cash amounts due from the residual marketmechanisms, Commonwealth Automobile Reinsurers (“CAR”), for automobile andMassachusetts Property Insurance Underwriting Association (“FAIR Plan”), forhomeowner insurance in Massachusetts. See Note 8 for a discussion of theCompany’s accounting for amounts assumed from residual markets.

**Equipment andLeasehold Improvements**

Purchases of equipment and leasehold improvements arecarried at cost less accumulated depreciation. Maintenance and repairs arecharged to expense as incurred; improvements are capitalized.

Methodsof depreciation and useful lives by asset category are as follows:

| ** **                 | ** ** | **Life**        | ** ** | **Depreciation Method** |
|----------------------------|------------|-----------------|------------|------------------------------|
| Automobiles                |       | 3 years         |       | Straight-line                |
| Data processing  equipment |       | 3-5 years       |       | Double-declining balance     |
| Equipment                  |       | 5 years         |       | Straight-line                |
| Furniture and fixtures     |       | 7 years         |       | Straight-line                |
| Leasehold improvements     |       | Over lease term |       | Straight-line                |

 

**Losses and LossAdjustment Expenses**

Liabilities for losses andloss adjustment expenses (“LAE”) include case basis estimates for open claimsreported prior to year-end and estimates of unreported claims and claimadjustment expenses. The estimates are continually reviewed and modified toreflect current conditions, and any resulting adjustments are reflected incurrent operating results. Adjustments for anticipated salvage and subrogationare recorded on incurred and reported and incurred but not reported losses.

79

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Premiums andUnearned Premiums**

Premiums are earned over the terms of the respectivepolicies, which are generally one year. Unearned premiums represent the portionof premiums written applicable to the unexpired terms of the policies.

Ceded premiums are charged to income over the terms ofthe respective policies and the applicable term of the reinsurance contractswith third party reinsurers. Ceded unearned premiums represent the unexpiredportion of premiums ceded to CAR and other reinsurers.

Premiums received inadvance of the policy effective date are recorded as a liability and notrecognized as income until earned. Such amounts are included in accountspayable and accrued liabilities and totaled $17,335 and $20,437 at December 31,2006 and 2005, respectively.

**Reinsurance**

Liabilities for unearned premiums and unpaid lossesare stated before deductions for ceded reinsurance. The ceded amounts arecarried as receivables. Earned premiums are stated net of deductions for cededreinsurance.

The Company, as primaryinsurer, will be required to pay losses in their entirety in the event that thereinsurers are unable to discharge their obligations under the reinsuranceagreements.

**Promissory NotesReceived From Management**

In connection with the Acquisition, the Companyobtained promissory notes from the executive management team to financemanagement’s purchase of the Company’s common stock, including the restrictedstock purchased by management.

In accordance with the provisions of the FinancialAccounting Standards Board’s Emerging Issues Task Force (“EITF”) No. 85-1,“Classifying Notes Received for Capital Stock,” all outstanding principal andaccrued interest related to these notes are recorded as contra-equity inthe consolidated financial statements.

See Note 10 for termsof promissory notes received from management.

**Finance and OtherService Income**

Finance and other serviceincome includes revenues from premium installment charges, which are recognizedwhen earned.

**Income Taxes**

The Company and its subsidiaries file aconsolidated U.S. federal income tax return. The method of allocation amongmembers of the consolidated group is subject to a written agreement approved bythe Board. The consolidated tax liability is allocated on the basis of the members’proportionate contribution to consolidated taxable income.

Deferred income taxes aregenerally recognized when assets and liabilities have different values forfinancial statement and tax reporting purposes, and for other temporary taxableand deductible differences 

80

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

asdefined by Statement of Financial Accounting Standards (“FAS”) No. 109, “Accountingfor Income Taxes”. A valuation allowance is established where management hasassessed that it is more likely than not that the Company will not be able to utilizethe full deferred tax asset.

**Earnings per Weighted Average Common Share**

Basicearnings per weighted average common share (“EPS”) are calculated by dividingnet income by the weighted average number of basic common shares outstandingduring the period. Diluted EPS are calculated by dividing net income by theweighted average number of basic common shares outstanding and the net effectof potentially dilutive common shares. At December 31,2006, 2005 and 2004, the Company’s potentially dilutive instruments were commonshares under options of 373,996, 496,086 and 711,410, respectively, and commonshares under restriction of 118,790, 94,417 and 70,271, respectively.

| ** **                                             | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Earnings per weighted  average common share:           | ** ** |                                                          |       |   |   |   |   |
| Basic                                                  |       | **$**                                                         | **7.07**   | ** ** | $ | 6.11 |   | $ | 2.94 |   |
| Diluted                                                |       | **$**                                                         | **6.99**   |   | $ | 5.97 |   | $ | 2.90 |   |
| Weighted average  number of common shares outstanding: |       |                                                          |       |   |   |   |   |
| Basic                                                  |       | **15,838,335**                                                | ** ** | 15,578,039 |   | 15,315,877 |   |
| Effect of dilutive securities                          |       |                                                          |       |   |   |   |   |
| Stock options                                          |       | **126,235**                                                   |       | 351,681 |   | 196,655 |   |
| Restricted stock                                       |       | **41,343**                                                    |       | 24,017 |   | 14,360 |   |
| Weighted average  number of common shares outstanding: |       |                                                          |       |   |   |   |   |
| Diluted                                                |       | **16,005,913**                                                |       | 15,953,737 |   | 15,526,892 |   |

 

Diluted EPS excludes stockoptions with exercise prices and exercise tax benefits greater than the averagemarket price of the Company’s common stock during the period because theirinclusion would be anti-dilutive. There were 186,225 anti-dilutive stockoptions for the year ended December 31, 2006 and no anti-dilutive stockoptions for the years ended December 31, 2005 and 2004.

**Share-BasedCompensation**

Prior to January 1, 2006, the Company accountedfor share-based compensation to employees and non-employee directors inaccordance with the recognition and measurement principles of AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees”, as allowed by FAS 123, “Accounting for Stock-Based Compensation”and as amended by FAS 148, “Accounting for Stock-Based Compensation—Transitionand Disclosure”. Accordingly, no compensation cost related to stock options wasreflected in net income, as all options granted under this plan had an exerciseprice equal to the market value of the underlying common stock on the date ofgrant. The Company historically reported pro forma results under thedisclosure-only provisions of FAS 123.

Effective January 1, 2006, the Company adoptedFAS 123R (revised 2004), “Share-Based Payment,” which requires the Company tomeasure and recognize the cost of employee services received in exchange for anaward of equity instruments. Under the provisions of FAS 123R, share-basedcompensation cost is 

81

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

measured at the grantdate, based on the fair value of the award, and is recognized as an expenseover the requisite service period (generally the vesting period of the equitygrant).

As permitted by FAS 123R, the Company elected themodified prospective transition method. Under the modified prospectivetransition method, (i) compensation expense for share-based awards grantedprior to January 1, 2006 is recognized over the remaining service periodusing the compensation cost calculated for pro forma disclosure purposes underFAS 123 as adjusted to incorporate forfeiture assumptions under FAS 123R, and (ii) compensationexpense for all share-based awards granted subsequent to December 31, 2005is based on the grant date fair value estimated in accordance with theprovisions of FAS 123R. Results for periods prior to January 1, 2006 havenot been restated.

See Note 5 for furtherinformation regarding share-based compensation.

**Use of Estimates**

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

**FinancialInstruments**

In the normal course ofbusiness, the Company enters into transactions involving various types offinancial instruments, including investments in fixed maturities and equitysecurities. Investment transactions have credit exposure to the extent that acounter party may default on an obligation to the Company. Credit risk is aconsequence of carrying, trading and investing in securities. To manage creditrisk, the Company focuses on higher quality fixed income securities, reviewsthe credit strength of all companies in which it invests, limits its exposurein any one investment and monitors the portfolio quality, taking into accountcredit ratings assigned by recognized statistical rating organizations.

**StatutoryAccounting Practices**

The Company’s insurancesubsidiaries, domiciled in the Commonwealth of Massachusetts, prepare statutoryfinancial statements in accordance with the accounting practices prescribed orpermitted by the Commonwealth of Massachusetts Division of Insurance (“theDivision”). Prescribed statutory accounting practices are those practices thatare incorporated directly or by reference in state laws, regulations, andgeneral administrative rules applicable to all insurance enterprisesdomiciled in a particular state. Permitted statutory accounting practicesinclude practices not prescribed by the Division, but allowed by the Division.See Note 12 for further information.

**Recent AccountingPronouncements**

In February 2006, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 155,“Accounting for Certain Hybrid Financial Instruments—an amendment of FASBStatements No. 133 and 140” (“FAS 155”). This statement permits fair valueremeasurement for any hybrid financial instrument that contains an embeddedderivative that otherwise would require bifurcation. This statement also addsclarity regarding interest-only strips and principal-only strips that are notsubject 

82

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

to the requirements ofStatement No. 133, and requires companies to evaluate interests insecuritized financial assets to identify interests that are freestandingderivatives or that are hybrid financial instruments containing an embeddedderivative that requires bifurcation. FAS 155 is effective for all financialinstruments acquired or issued after the beginning of an entity’s first fiscalyear that begins after September 15, 2006. The Company does not believeFAS 155 will have a material impact on its consolidated results of operationsor financial position.

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes—an Interpretation of FASB Statement 109” (“FIN 48”). Thisinterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. This interpretation also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition. FIN 48 is effective for fiscalyears beginning after December 15, 2006. The Company does not believe theadoption of FIN 48 will have a material impact on its consolidated results ofoperations or financial position.

**Reclassifications**

Prior period amounts havebeen reclassified to conform to the current year presentation.

**Segments**

The Company comprises onebusiness segment: property and casualty insurance operations. Managementorganizes the business around private passenger automobile insurance inMassachusetts sold exclusively through independent agents and offers otherpersonal and commercial insurance as complementary products. In accordance withFAS 131, “Disclosures AboutSegments of an Enterprise and Related Information”, the financialinformation of the segment is presented consistent with the way results areregularly evaluated by the chief operating decision maker in deciding how toallocate resources and in assessing performance.

**3.**                 Investments

The gross unrealizedappreciation (depreciation) of investments in fixed maturity securities,including redeemable preferred stocks that have characteristics of fixedmaturities, and equity securities, including interests in mutual funds, was asfollows:

| ** **                                                               | ** ** | **December 31, 2006** | ** **  |
|--------------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                               | ** ** | ** **                      | ** **  | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | **Amortized**                   | ** **  | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** **  | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury securities and obligations of U.S.  Government agencies(1) | ** ** | **$**                           | **185,390** | ** ** |   | **$** | **929** |   | ** ** | ** ** | **$** | **(2,883** | **)** | ** ** | **$** | **183,436** |   |
| Obligations of states and political subdivisions                         | ** ** | **429,888**                     | ** **  |   | **6,485** |   | ** ** | ** ** | **(2,014** | **)** | ** ** | **434,359** |   |
| Asset-backed securities(1)                                               | ** ** | **180,294**                     | ** **  |   | **339** |   | ** ** | ** ** | **(2,022** | **)** | ** ** | **178,611** |   |
| Corporate and other securities                                           | ** ** | **140,962**                     | ** **  |   | **853** |   | ** ** | ** ** | **(1,941** | **)** | ** ** | **139,874** |   |
| Subtotal, fixed maturity securities                                      | ** ** | **936,534**                     | ** **  |   | **8,606** |   | ** ** | ** ** | **(8,860** | **)** | ** ** | **936,280** |   |
| Equity securities                                                        | ** ** | **4,038**                       | ** **  |   | **287** |   | ** ** | ** ** | **—** | ** ** | ** ** | **4,325** |   |
| Totals                                                                   | ** ** | **$**                           | **940,572** | ** ** |   | **$** | **8,893** |   | ** ** | ** ** | **$** | **(8,860** | **)** | ** ** | **$** | **940,605** |   |

 

83

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

 

| ** **                                                               | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | **Amortized**                   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury securities  and obligations of U.S. Government agencies(1) |       | $                               | 127,764    |   |   | $ | 142 |   |   |   | $ | (2,686 | ) |   | $ | 125,220 |   |
| Obligations of states  and political subdivisions                        |       | 321,250                         |       |   | 4,385 |   |   |   | (3,026 | ) |   | 322,609 |   |
| Asset-backed  securities(1)                                              |       | 124,531                         |       |   | 293 |   |   |   | (1,349 | ) |   | 123,475 |   |
| Corporate and other  securities                                          |       | 140,385                         |       |   | 2,309 |   |   |   | (1,460 | ) |   | 141,234 |   |
| Subtotal, fixed maturity  securities                                     |       | 713,930                         |       |   | 7,129 |   |   |   | (8,521 | ) |   | 712,538 |   |
| Equity securities                                                        |       | 1,895                           |       |   | 110 |   |   |   | — |   |   | 2,005 |   |
| Totals                                                                   |       | $                               | 715,825    |   |   | $ | 7,239 |   |   |   | $ | (8,521 | ) |   | $ | 714,543 |   |

----

(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC),Federal National Mortgage Association (FNMA) and Small Business Administration(SBA). The total of these fixed maturity securities was $175,394 and $117,766at amortized cost and $173,539 and $115,284 at fair value as of December 31,2006 and 2005, respectively. As such, the asset-backed securitiespresented exclude such issuers already presented under U.S. Treasury securitiesand obligations of U.S. Government Agencies.

The amortized cost and the estimated fair value offixed maturity securities, by maturity, at December 31, 2006, are shownbelow. Expected maturities will differ from contractual maturities becauseborrowers may have the right to call or prepay obligations with or without callor prepayment penalties.

| ** **                                | ** ** | **December 31, 2006** | ** **  |
|-------------------------------------------|------------|---------------------------------|-------------|
| ** **                                | ** ** | **Amortized  Cost**             | ** **  | **Estimated  Fair Value** | ** ** |
| Due in one year  or less                  | ** ** | **$**                           | **24,777**  | ** ** | **$** | **24,589** | ** ** |
| Due after one  year through five years    | ** ** | **168,560**                     | ** **  | **167,133** | ** ** |
| Due after five  years through ten years   | ** ** | **160,460**                     | ** **  | **160,940** | ** ** |
| Due after ten  years through twenty years | ** ** | **214,737**                     | ** **  | **218,783** | ** ** |
| Due after twenty  years                   | ** ** | **12,312**                      | ** **  | **12,685** | ** ** |
| Asset-backed  securities                  | ** ** | **355,688**                     | ** **  | **352,150** | ** ** |
| Totals                                    | ** ** | **$**                           | **936,534** | ** ** | **$** | **936,280** | ** ** |

 

84

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Thegross realized gains (losses) on sales of fixed maturities and equitysecurities were as follows for the periods indicated:

| ** **                         | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                         | ** ** | **   2006   **                  | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| Gross realized gains               |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Fixed maturity securities          | ** ** | ** **                                                    | **$**      | **1,058** |   |   |   | 478 |   |   |   | 1,535 |   |   |
| Equity securities                  | ** ** | ** **                                                    | **31**     |   |   |   | 12 |   |   |   | 2 |   |   |
| Gross realized losses              |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Fixed maturity securities          | ** ** | ** **                                                    | **(722**   | **)** |   |   | (185 | ) |   |   | (263 | ) |   |
| Equity securities                  | ** ** | ** **                                                    | **(9**     | **)** |   |   | 0 |   |   |   | 0 |   |   |
| Net realized  gains on investments | ** ** | ** **                                                    | **$**      | **358** |   |   |   | $ | 305 |   |   |   | $ | 1,274 |   |   |
|                                    |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Proceeds from fixed maturities maturing were $14,300,$11,125, and $7,520 for the years ended December 31, 2006, 2005, and 2004,respectively.

Thefollowing tables illustrate the gross unrealized losses included in the Company’sinvestment portfolio and the fair value of those securities aggregated byinvestment category. The tables also illustrate the length of time that theyhave been in a continuous unrealized loss position.

| ** **                                                            | ** ** | **As of December 31, 2006** | ** **  |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|-------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** **  | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | **Estimated**                                   | ** **  | **Unrealized** | ** ** | **Estimated** | ** ** | **Unrealized** | ** ** | **Estimated** | ** ** | **Unrealized** | ** ** |
| ** **                                                            | ** ** | **Fair Value**                             | ** **  | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$**                                           | **5,850**   | ** ** | ** ** | **$** | **82** |   | ** ** | **$** | **104,796** | ** ** | ** ** | **$** | **2,801** |   | ** ** | **$** | **110,646** | ** ** | ** ** | **$** | **2,883** |   |   |
| Obligations of  states and political subdivisions                     | ** ** | **12,423**                                      | ** **  | ** ** | **43** |   | ** ** | **107,904** | ** ** | ** ** | **1,971** |   | ** ** | **120,327** | ** ** | ** ** | **2,014** |   |   |
| Asset-backed  securities                                              | ** ** | **62,362**                                      | ** **  | ** ** | **537** |   | ** ** | **74,521** | ** ** | ** ** | **1,485** |   | ** ** | **136,883** | ** ** | ** ** | **2,022** |   |   |
| Corporate and  other securities                                       | ** ** | **46,132**                                      | ** **  | ** ** | **778** |   | ** ** | **57,118** | ** ** | ** ** | **1,163** |   | ** ** | **103,250** | ** ** | ** ** | **1,941** |   |   |
| Total temporarily impaired securities                                 | ** ** | **$**                                           | **126,767** | ** ** | ** ** | **$** | **1,440** |   | ** ** | **$** | **344,339** | ** ** | ** ** | **$** | **7,420** |   | ** ** | **$** | **471,106** | ** ** | ** ** | **$** | **8,860** |   |   |

 

| ** **                                                            | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | **Estimated**                                   | ** ** | **Unrealized** | ** ** | **Estimated** | ** ** | **Unrealized** | ** ** | **Estimated** | ** ** | **Unrealized** | ** ** |
| ** **                                                            | ** ** | **Fair Value**                             | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies |       | $                                               | 52,119     |   |   | $ | 581 |   |   | $ | 65,746 |   |   | $ | 2,105 |   |   | $ | 117,865 |   |   | $ | 2,686 |   |   |
| Obligations of  states and political subdivisions                     |       | 53,872                                          |       |   | 872 |   |   | 97,361 |   |   | 2,154 |   |   | 151,233 |   |   | 3,026 |   |   |
| Asset-backed  securities                                              |       | 54,816                                          |       |   | 526 |   |   | 37,560 |   |   | 823 |   |   | 92,376 |   |   | 1,349 |   |   |
| Corporate and  other securities                                       |       | 38,830                                          |       |   | 603 |   |   | 31,707 |   |   | 857 |   |   | 70,537 |   |   | 1,460 |   |   |
| Total temporarily  impaired securities                                |       | $                                               | 199,637    |   |   | $ | 2,582 |   |   | $ | 232,374 |   |   | $ | 5,939 |   |   | $ | 432,011 |   |   | $ | 8,521 |   |   |

 

85

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

The Company’s investment portfolio included 222securities in an unrealized loss position at December 31, 2006. TheCompany’s methodology of assessing other-than-temporary impairment is basedupon analysis of each security as of the balance sheet date and considersvarious factors including the length of time and the extent to which fair valuehas been less than the cost, the financial condition and the near term prospectsof the issuer, whether the debtor is current on its contractually obligatedinterest and principal payments, and the Company’s intent to hold theinvestment for a period of time sufficient to allow for recovery of its costs.

As of December 31, the Company’s fixed incomesecurities portfolio was comprised entirely of investment grade securities asdefined by Moody’s Investor Services, Inc., Standard and Poor’s, or theSecurities Valuation Office of the National Association of InsuranceCommissioners. The unrealized losses recorded on the fixed maturity investmentportfolio at December 31, 2006, resulted from fluctuations in marketinterest rates as opposed to fundamental changes in the credit quality of theissuers of such securities. Therefore, these decreases in values are viewed asbeing temporary as the Company has the intent and ability to retain suchinvestments for a period of time sufficient to allow for recovery in marketvalue.

During the years ended December 31,2006, 2005 and 2004, there was no significant deterioration in the creditquality of any of the Company’s holdings and no other-than-temporary impairmentcharges were recorded related to the Company’s portfolio of investmentsecurities.

**Net InvestmentIncome**

Thecomponents of net investment income were as follows:

| ** **                                  | ** ** | **For the Years Ended December 31,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Interest and  dividends on fixed maturities | ** ** | **$**                                                         | **38,875** |   | $ | 28,201 |   | $ | 27,161 |   |
| Dividends on  equity securities             | ** ** | **163**                                                       |       | 44 |   | 23 |   |
| Interest on cash  and cash equivalents      | ** ** | **2,466**                                                     |       | 4,400 |   | 1,078 |   |
| Total investment income                     | ** ** | **41,504**                                                    |       | 32,645 |   | 28,262 |   |
| Investment  expenses                        | ** ** | **1,211**                                                     |       | 1,072 |   | 1,003 |   |
| Net investment  income                      | ** ** | **$**                                                         | **40,293** |   | $ | 31,573 |   | $ | 27,259 |   |

 

**4.**                 Equipmentand Leasehold Improvements

At December 31, 2006and 2005, the Company held equipment and leasehold improvements with a carryingvalue of $1,196 and $1,041, which is net of accumulated depreciation of $2,638and $1,881, respectively. Depreciation and amortization expense for the yearsended December 31, 2006, 2005 and 2004 was $850, $699 and $767,respectively.

**5.**                 EmployeeBenefit Plans

**The SafetyInsurance 401(k) Retirement Plan**

The Company sponsors theSafety Insurance Company 401(k) qualified defined contribution retirementplan (the “Retirement Plan”). The Retirement Plan is available to all eligibleemployees of the Company. An employee must be 21 years of age to beeligible to participate in the Retirement Plan, and is 

86

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

allowedto contribute on a pre-tax basis up to the maximum allowed under federal law.The Retirement Plan is administered by the Company and is subject to theprovisions of the Employee Retirement Income Security Act of 1974. At the closeof each Retirement Plan year, the Company makes a matching contribution equalto 100% of the amount each participant contributed during the plan year fromtheir total pay, up to a maximum amount of 8% of the participant’s base salary,to those participants who have contributed to the Retirement Plan and wereemployed on the last day of the Retirement Plan year. Compensation expense relatedto the Retirement Plan was $1,661, $1,066 and $1,074 for the years ended December 31,2006, 2005 and 2004, respectively.

**Management OmnibusIncentive Plan**

Long-term incentive compensation is provided under theCompany’s 2002 Management Omnibus Incentive Plan (“the Incentive Plan”) whichprovides for a variety of stock-based compensation awards, includingnonqualified stock options (“NQSOs”), incentive stock options, stockappreciation rights and restricted stock (“RS”) awards.

On March 10, 2006, the Board of Directors (“Board”)of the Company approved amendments to the Incentive Plan, subject toshareholder approval, to (i) increase the number of shares of common stockavailable for issuance by 1,250,000 shares, (ii) remove obsoleteprovisions, and (iii) make other non-material changes. A total of1,250,000 shares of common stock had previously been authorized for issuanceunder the Incentive Plan. The Incentive Plan, as amended, was approved by theshareholders at the 2006 Annual Meeting of Shareholders which was held on May 19,2006. Under the Incentive Plan, as amended, the maximum number of shares ofcommon stock with respect to which awards may be granted is 2,500,000. At December 31,2006, there were 1,289,991 shares available for future grant. The Board and theCompensation Committee intend to issue more awards under the Incentive Plan inthe future.

Grantsmade under the Incentive Plan are as follows:

| ** **       | ** ** | ** **               | ** ** | ** **         | ** **  | **Exercise**           | ** ** | ** **             | ** ** | ** **               | ** ** |
|------------------|------------|--------------------------|------------|--------------------|-------------|------------------------|------------|------------------------|------------|--------------------------|------------|
| **Type of** | ** ** | ** **               | ** ** | **Number of** | ** **  | **Price(1) or**   | ** ** | ** **             | ** ** | ** **               | ** ** |
| **Equity**       | ** ** | ** **               | ** ** | **Awards**         | ** **  | **Fair Value(2)** | ** ** | ** **             | ** ** | ** **               | ** ** |
| **Awarded**      | ** ** | **Effective Date**  | ** ** | **Granted**        | ** **  | **per Share**     | ** ** | **Vesting Terms** | ** ** | **Expiration Date** | ** ** |
| NQSOs            |       | November 27,  2002  |       |               | 379,000     |                   |       |                   | $          | 12.00(1)                 |       |   | 5  years, 20% annually |   | November 27,  2012 |   |
| NQSOs            |       | February 20,  2003  |       |               | 99,000      |                   |       |                   | $          | 13.30(1)                 |       |   | 5  years, 20% annually |   | February 20,  2013 |   |
| NQSOs            |       | March 31,  2003     |       |               | 292,000     |                   |       |                   | $          | 13.03(1)                 |       |   | 3  years, 30%-30%-40% |   | March 31,  2013 |   |
| NQSOs            |       | August 21,  2003    |       |               | 10,000      |                   |       |                   | $          | 15.89(1)                 |       |   | 5  years, 20% annually |   | August 21,  2013 |   |
| NQSOs            |       | March 25,  2004     |       |               | 111,000     |                   |       |                   | $          | 18.50(1)                 |       |   | 5  years, 20% annually |   | March 25,  2014 |   |
| RS               |       | March 25,  2004     |       |               | 70,271      |                   |       |                   | $          | 18.50(2)                 |       |   | 3  years, 30%-30%-40% |   | N/A |   |
| NQSOs            |       | August 30,  2004    |       |               | 10,000      |                   |       |                   | $          | 21.40(1)                 |       |   | 5  years, 20% annually |   | August 30,  2014 |   |
| NQSOs            |       | March 16,  2005     |       |               | 78,000      |                   |       |                   | $          | 35.23(1)                 |       |   | 5  years, 20% annually |   | March 16,  2015 |   |
| RS               |       | March 16,  2005     |       |               | 56,770      |                   |       |                   | $          | 35.23(2)                 |       |   | 3  years, 30%-30%-40% |   | N/A |   |
| RS               |       | March 16,  2005     |       |               | 4,000       |                   |       |                   | $          | 35.23(2)                 |       |   | No  vesting period(3) |   | N/A |   |
| **NQSOs**        | ** ** | **March 10, 2006**  | ** ** | ** **         | **126,225** |                   | ** ** | ** **             | **$**      | **42.85(1)**             | ** ** | ** ** | **5 years, 20% annually** | ** ** | **March 10, 2016** | ** ** |
| **RS**           | ** ** | **March 10, 2006**  | ** ** | ** **         | **58,342**  |                   | ** ** | ** **             | **$**      | **42.85(2)**             | ** ** | ** ** | **3 years, 30%-30%-40%** | ** ** | **N/A** | ** ** |
| **RS**           | ** ** | **March 10,  2006** | ** ** | ** **         | **4,000**   |                   | ** ** | ** **             | **$**      | **42.85(2)**             | ** ** | ** ** | **No  vesting period(3)** | ** ** | **N/A** | ** ** |

----

(1)          The exercise price ofthe stock option grant is equal to the closing price of the Company’s commonstock on the grant effective date.

87

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

(2)          The fair value of therestricted stock grant is equal to the closing price of the Company’s commonstock on the grant effective date.

(3)          Theshares cannot be sold, assigned, pledged, or otherwise transferred, encumberedor disposed of until the recipient is no longer a member of the Board ofDirectors.

**Stock Options**

Thefollowing table summarizes stock option activity under the Incentive Plan.

| ** **                        | ** ** | **2006**     | ** ** | **2005**                | ** ** | **2004**   | ** ** |
|-----------------------------------|------------|--------------|------------|-------------------------|------------|------------|------------|
| ** **                        | ** ** | **Shares**   | ** ** | **Weighted**            | ** ** | **Shares** | ** ** | **Weighted** | ** ** | **Shares** | ** ** | **Weighted** | ** ** |
| ** **                        | ** ** | **Under**    | ** ** | **Average**             | ** ** | **Under**  | ** ** | **Average** | ** ** | **Under** | ** ** | **Average** | ** ** |
| ** **                        | ** ** | **Option**   | ** ** | **Exercise Price** | ** ** | **Option** | ** ** | **Exercise Price** | ** ** | **Option** | ** ** | **Exercise Price** | ** ** |
| Outstanding at  beginning of year | ** ** | **496,086**  | ** ** |                    | **$**      | **17.04**  |       |   | 711,410 |   |   | $ | 13.60 |   |   | 771,000 |   |   | $ | 12.59 |   |   |
| Granted during  the year          | ** ** | **126,225**  | ** ** |                    | **42.85**  |       |       | 78,000 |   |   | 35.23 |   |   | 121,000 |   |   | 18.74 |   |   |
| Forfeited during  the year        | ** ** | **(2,600**   | **)**      |                    | **27.07**  |       |       | (54,656 | ) |   | 16.38 |   |   | (10,800 | ) |   | 16.19 |   |   |
| Exercised during  the year        | ** ** | **(245,715** | **)**      |                    | **14.23**  |       |       | (238,668 | ) |   | 12.87 |   |   | (169,790 | ) |   | 12.52 |   |   |
| Outstanding at  end of year       | ** ** | **373,996**  | ** ** |                    | **27.53**  |       |       | 496,086 |   |   | 17.04 |   |   | 711,410 |   |   | 13.60 |   |   |
| Exercisable at end of  year       | ** ** | **26,275**   | ** ** |                    | **$**      | **17.82**  |       |   | 49,640 |   |   | $ | 13.98 |   |   | 134,690 |   |   | $ | 12.62 |   |   |

 

At December 31, 2006, the aggregate intrinsicvalue of outstanding shares under option was $8,668 with a weighted averageremaining contractual term of 7.7 years. At December 31, 2006, theaggregate intrinsic value of outstanding shares under option and exercisablewas $864 with a weighted average remaining contractual term of 6.7 years. Aggregateintrinsic value represents the total pretax intrinsic value, based upon theCompany’s closing stock price of $50.71 on December 31, 2006, which wouldhave been received by the option holders had all option holders exercised theiroptions as of that date. The range of exercise prices on stock optionsoutstanding under the Incentive Plan was $12.00 to $42.85 at December 31,2006, $12.00 to $35.23 at December 31, 2005 and $12.00 to $21.40 at December 31,2004. The weighted average grant-date fair value of options granted during thetwelve months ended December 31, 2006, 2005 and 2004 was estimated at$16.05, $12.62 and $5.13, respectively. The total intrinsic value of optionsexercised during the twelve months ended December 31, 2006, 2005 and 2004was $8,963, $6,563 and $3,193, respectively.

Cash received from options exercised was $3,497,$3,072, and $2,126 for the years ended December 31, 2006, 2005, and 2004,respectively.

Asummary of the status of non-vested options as of December 31, 2006, ispresented below:

| ** **                            | ** ** | ** **         | ** **   | **Weighted Average** | ** ** |
|---------------------------------------|------------|--------------------|--------------|---------------------------|------------|
| ** **                            | ** ** | **Number of** | ** **   | **Grant Date**       | ** ** |
| ** **                            | ** ** | **Shares**         | ** **   | **Exercise Price**   | ** ** |
| Non-vested at  January 1, 2006   | ** ** |               | **446,446**  | ** **                |       |   | **$** | **17.39** | ** ** |   |
| Granted during  the year              | ** ** |               | **126,225**  | ** **                |       |   | **42.85** | ** ** |   |
| Vested during the  year               | ** ** |               | **(222,350** | **)**                     |       |   | **14.71** | ** ** |   |
| Forfeited during  the year            | ** ** |               | **(2,600**   | **)**                     |       |   | **27.07** | ** ** |   |
| Non-vested at December 31,  2006 | ** ** |               | **347,721**  | ** **                |       |   | **$** | **28.27** | ** ** |   |

 

88

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

As of December 31, 2006, there was $2,265 ofunrecognized compensation expense related to non-vested option awards that isexpected to be recognized over a weighted average period of 3.4 years.

As a result of adopting FAS 123R on January 1,2006, the Company’s net income for the twelve months ended December 31,2006 was lowered by $554, net of income tax benefit of $299. The impact onbasic and diluted EPS for the twelve months ended December 31, 2006 was areduction of $0.04 and $0.03 per share.

FAS123R requires the disclosure of pro forma information for periods prior toadoption. The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofFAS 123 to these stock options.

| ** **                                                                                                                           | ** ** | **For the Years Ended December 31,**                                                                    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **          2005          ** | ** ** | **          2004          ** | ** ** |
| Net income, as  reported                                                                                                             |       |                                                                                                                             | $          | 95,182 |   |   |   | $ | 44,990 |   |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       |                                                                                                                             | (537       | ) |   |   | (457 | ) |   |
| Pro forma net  income                                                                                                                |       |                                                                                                                             | $          | 94,645 |   |   |   | $ | 44,533 |   |   |
| Earnings per  weighted average share:                                                                                                |       |                                                                                                                             |       |   |   |   |   |   |   |
| Basic—as reported                                                                                                               |       |                                                                                                                             | $          | 6.11 |   |   |   | $ | 2.94 |   |   |
| Basic—pro forma                                                                                                                 |       |                                                                                                                             | $          | 6.08 |   |   |   | $ | 2.91 |   |   |
| Diluted—as reported                                                                                                             |       |                                                                                                                             | $          | 5.97 |   |   |   | $ | 2.90 |   |   |
| Diluted—proforma                                                                                                                |       |                                                                                                                             | $          | 5.95 |   |   |   | $ | 2.90 |   |   |

 

Thefair value of stock options used to compute both pro forma and actual netincome and earnings per share disclosures for the years ended December 31,2006, 2005 and 2004 is the estimated fair value at grant date using the Black-Scholesoption-pricing model with the following assumptions:

| ** **               | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------|------------|---------------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected dividend  yield | ** ** | **1.36% - 2.52%**                                   |       | 1.36% - 2.52% |   | 1.87% - 2.52% |   |
| Expected  volatility     | ** ** | **0.20 - 0.36**                                     |       | 0.20 - 0.31 |   | 0.20 - 0.31 |   |
| Risk-free  interest rate | ** ** | **3.23% - 4.76%**                                   |       | 3.23% - 4.35% |   | 3.23% - 4.07% |   |
| Expected holding period  | ** ** | **6.5-7  years**                                              |       | 7 years |   | 7 years |   |

 

Expected dividend yield isthe Company’s dividend yield on the measurement date and is based on theassumption that the current yield will continue in the future. Expectedvolatility is based on historical volatility of the Company’s common stock aswell as the volatility of a peer group of property and casualty insurers measuredfor a period equal to the expected holding period of the option. The risk-freeinterest rate is based upon the yield on the measurement date of a zero-couponU.S. Treasury bond with a maturity period equal to the expected holding periodof the option. The expected holding period is based upon the simplified methodprovided in SEC Staff Accounting Bulletin No. 107 “Share-Based Payment”,which utilizes the mid-points between the vesting dates and the expiration dateof the option award to calculate the overall expected term.

89

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Restricted Stock**

Restricted stock awarded to employees in the form ofunvested shares is recorded at the market value of the Company’s common stockon the grant date and amortized ratably as expense over the requisite serviceperiod.

Thefollowing table summarizes restricted stock activity under the Incentive Plan.

| ** **                                    | ** ** | **2006**        | ** **  | **2005**            | ** ** | **2004**        | ** ** |
|-----------------------------------------------|------------|-----------------|-------------|---------------------|------------|-----------------|------------|
| ** **                                    | ** ** | **Shares**      | ** **  | **Weighted**        | ** ** | **Shares**      | ** ** | **Weighted** | ** ** | **Shares** | ** ** | **Weighted** | ** ** |
| ** **                                    | ** ** | **Under**       | ** **  | **Average**         | ** ** | **Under**       | ** ** | **Average** | ** ** | **Under** | ** ** | **Average** | ** ** |
| ** **                                    | ** ** | **Restriction** | ** **  | **Fair Value** | ** ** | **Restriction** | ** ** | **Fair Value** | ** ** | **Restriction** | ** ** | **Fair Value** | ** ** |
| Outstanding at  beginning of year             | ** ** |            | **98,417**  | ** **          |       |            | **$**      | **27.77** |   |   |   | 70,271 |   |   |   | $ | 18.50 |   |   |   | — |   |   |   | $ | — |   |   |
| Granted during  the year                      | ** ** |            | **62,342**  | ** **          |       |            | **42.85**  |   |   |   | 60,770 |   |   |   | 35.23 |   |   |   | 70,271 |   |   |   | 18.50 |   |   |
| Forfeited during  the year                    | ** ** |            | **—**  | ** **          |       |            | **—** |   |   |   | (11,543 | ) |   |   | 27.55 |   |   |   | — |   |   |   | — |   |   |
| Vested and  unrestricted during the year | ** ** |            | **(33,969** | **)**               |       |            | **25.97**  |   |   |   | (21,081 | ) |   |   | 18.50 |   |   |   | — |   |   |   | — |   |   |
| Outstanding at end of  year                   | ** ** |            | **126,790** | ** **          |       |            | **$**      | **35.67** |   |   |   | 98,417 |   |   |   | $ | 27.77 |   |   |   | 70,271 |   |   |   | $ | 18.50 |   |   |

 

As of December 31,2006, there was $2,829 of unrecognized compensation expense related tonon-vested restricted stock awards that is expected to be recognized over aweighted average period of 1.4 years. The total fair value of the sharesthat were vested and unrestricted during the twelve months ended December 31,2006 was $882. For the years ended December 31, 2006, 2005 and 2004, theCompany recorded compensation expense related to restricted stock of $1,146,$586 and $195 net of income tax benefits of $617, $316 and $105, respectively.

**6.**                 Commitmentsand Contingencies

**Lease Commitments**

TheCompany has various noncancelable long-term operating leases. The approximateminimum annual rental payments due under these lease agreements as ofDecember 31, 2006 are as follows:

| 2007                          | ** ** | **$**     | **3,073**  | ** ** |
|-------------------------------|------------|-----------|------------|------------|
| 2008                          | ** ** | **3,128** | ** ** |
| 2009                          | ** ** | **135**   | ** ** |
| 2010                          | ** ** | **60**    | ** ** |
| 2011 and after                | ** ** | **53**    | ** ** |
| Total minimum lease  payments | ** ** | **$**     | **6,449**  | ** ** |

 

Certain lease agreementscontain renewal options and, in addition to the minimum annual rentals,generally provide for payment of a share of the real estate taxes and operatingexpenses in excess of a base amount. Rental expense was $3,147, $3,042 and$2,826 for the years ended December 31, 2006, 2005 and 2004, respectively.All leases expire prior to 2013. The Company expects that in the normal courseof business, leases that expire will be renewed.

90

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Contingencies**

Various claims, generally incidental to the conduct ofnormal business, are pending or alleged against the Company from time to time.In the opinion of management, based in part on the advice of legal counsel, theultimate resolution of such claims will not have a material adverse effect onthe Company’s consolidated financial statements. However, liabilities relatedto those proceedings could be established in the near term if estimates of theultimate resolutions of those proceedings are revised.

Massachusetts law requires that insurers licensed todo business in Massachusetts participate in the Massachusetts InsurersInsolvency Fund (“Insolvency Fund”). Members of the Insolvency Fund areassessed a proportionate share of the obligations and expenses of theInsolvency Fund in connection with an insolvent insurer. In 2006, the Companyreceived notice of assessments from the Insolvency Fund amounting to $464 whichit expensed for the year ended December 31, 2006. In 2005 the Companyreceived a refund of prior years’ assessments from the Insolvency Fund of $50,which was credited for the year ended December 31, 2005. In 2004, theCompany received notice of assessments from the Insolvency Fund amounting to$2,538 which it expensed for the year ended December 31, 2004.

It is anticipated thatthere will be additional assessments from time to time relating to variousinsolvencies. Although the timing and amounts of any future assessments are notknown, based upon existing knowledge, management’s opinion is that such futureassessments will not have a material effect upon the financial position of theCompany.

**7.**                 Debt

**Secured RevolvingCredit Facility**

The Company has a $30,000 revolving credit facilitywith Citizens Bank of Massachusetts which expires on June 17, 2008. Loansunder the credit facility bear interest at the Company’s option at either (i) theLIBOR rate plus 1.5% per annum or (ii) the higher of Citizens Bank ofMassachusetts’ prime rate or 0.5% above the federal funds rate plus 1.5% perannum. Interest only is payable prior to maturity. The obligations of theCompany under the credit facility are secured by pledges of the Company’sassets and the capital stock of its operating subsidiaries. The credit facilityis guaranteed by the non-insurance company subsidiaries of the Company. Thecredit facility contains covenants including requirements to maintain minimumrisk based capital ratios and statutory surplus of Safety Insurance Company aswell as limitations or restrictions on indebtedness, liens, dividends, andother matters. As of December 31, 2006, the Company was in compliance withall such covenants.

The Company paid down thebalance of $19,956 on December 8, 2005, and had no amounts outstanding onits credit facility at December 31, 2006, and at December 31, 2005. Thecredit facility commitment fee included in interest expenses was computed at arate of 0.25% on the $30,000 commitment at December 31, 2006 and December 31,2005.

**Capital LeaseObligation**

During 2003, the Company entered in to a three-yearterm lease agreement to finance the acquisition of new equipment. Minimumpayments due under this capital lease obligation as of December 31, 2006are $39.

91

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

The Company incurredinterest expense of $86, $948 and $672 for the years ended December 31,2006, 2005 and 2004, respectively, related to all current outstandingobligations during these periods.

**8.**                 Reinsurance

The Company cedes insurance to CAR and to otherreinsurers. The Company has a property catastrophe excess of loss agreement anda casualty excess of loss agreement that qualify as reinsurance treaties andare designed to protect against large or unusual loss and LAE activity.Reinsurance contracts do not relieve the Company from its obligations topolicyholders. Failure of reinsurers to honor their obligations could result inlosses to the Company. The Company evaluates the financial condition of itsreinsurers and monitors economic characteristics of the reinsurers to minimizeits exposure to significant losses from reinsurer insolvencies.

The Company is subject to concentration of credit riskwith respect to reinsurance ceded to CAR. At December 31, 2006 and 2005,respectively, reinsurance receivables on paid and unpaid loss and LAE  with a carrying value of $77,246 and $84,099and ceded unearned premiums of $29,937 and $32,186 were associated with CAR.The Company assumes a proportionate share of the obligations from CAR. TheCompany makes an estimate of its share of assumed activity from the most recentquarter reported by CAR and records adjustments to the reported activity toreflect its anticipated final assumed obligations. The Company’s participationin CAR resulted in assumed net losses of $4,753, $5,771 and $39,038 for theyears ended December 31, 2006, 2005 and 2004, respectively.

CAR is, with few exceptions, required by law to issuea policy to any applicant who seeks it. As a servicing carrier of CAR, thisrequirement applies to the Company.

Theeffect of reinsurance on net written and earned premiums and losses and LAE isas follows:

| ** **            | ** ** | **For the Years Ended December 31,** | ** **  |
|-----------------------|------------|---------------------------------------------------------------|-------------|
| ** **            | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Written Premiums**  | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Direct                | ** ** | **$**                                                         | **629,511** |   | $ | 649,113 |   | $ | 628,295 |   |
| Assumed               | ** ** | **68,934**                                                    |        | 66,772 |   | 86,505 |   |
| Ceded                 | ** ** | **(77,537**                                                   | **)**       | (83,049 | ) | (95,877 | ) |
| Net written  premiums | ** ** | **$**                                                         | **620,908** |   | $ | 632,836 |   | $ | 618,923 |   |
| **Premiums  Earned**  | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Direct                | ** ** | **$**                                                         | **636,953** |   | $ | 638,142 |   | $ | 599,608 |   |
| Assumed               | ** ** | **69,650**                                                    |        | 73,966 |   | 78,634 |   |
| Ceded                 | ** ** | **(81,670**                                                   | **)**       | (89,277 | ) | (85,950 | ) |
| Net premiums  earned  | ** ** | **$**                                                         | **624,933** |   | $ | 622,831 |   | $ | 592,292 |   |
| **Loss  and LAE**     | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Direct                | ** ** | **$**                                                         | **368,933** |   | $ | 411,184 |   | $ | 434,053 |   |
| Assumed               | ** ** | **52,247**                                                    |        | 57,546 |   | 94,136 |   |
| Ceded                 | ** ** | **(67,274**                                                   | **)**       | (83,137 | ) | (103,128 | ) |
| Net loss and LAE      | ** ** | **$**                                                         | **353,906** |   | $ | 385,593 |   | $ | 425,061 |   |

 

92

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**9.**                 Lossand Loss Adjustment Expense Reserves

Thefollowing table sets forth a reconciliation of beginning and ending reservesfor losses and LAE as shown in the Company’s consolidated financial statementsfor the years indicated:

| ** **                                              | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                              | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Reserves for  losses and LAE, beginning of year         | ** ** | **$**                                                         | **450,716** |   | $ | 450,897 |   | $ | 383,551 |   |
| Less reinsurance  recoverable on unpaid losses and LAE  | ** ** | **(80,550**                                                   | **)**       | (84,167 | ) | (73,539 | ) |
| Net reserves for  losses and LAE, beginning of year     | ** ** | **370,166**                                                   |        | 366,730 |   | 310,012 |   |
| Incurred losses  and LAE related to:                    |       |                                                          |        |   |   |   |   |
| Current year                                            | ** ** | **396,653**                                                   |        | 425,213 |   | 431,839 |   |
| Prior years                                             | ** ** | **(42,747**                                                   | **)**       | (39,620 | ) | (6,778 | ) |
| Total incurred  losses and LAE                          | ** ** | **353,906**                                                   |        | 385,593 |   | 425,061 |   |
| Paid losses and  LAE related to:                        |       |                                                          |        |   |   |   |   |
| Current year                                            | ** ** | **219,879**                                                   |        | 237,557 |   | 217,989 |   |
| Prior years                                             | ** ** | **133,213**                                                   |        | 144,600 |   | 150,354 |   |
| Total paid losses and LAE                               | ** ** | **353,092**                                                   |        | 382,157 |   | 368,343 |   |
| Net reserves for  losses and LAE, end of year           | ** ** | **370,980**                                                   |        | 370,166 |   | 366,730 |   |
| Plus reinsurance  recoverables on unpaid losses and LAE | ** ** | **78,464**                                                    |        | 80,550 |   | 84,167 |   |
| Reserves for losses and  LAE, end of year               | ** ** | **$**                                                         | **449,444** |   | $ | 450,716 |   | $ | 450,897 |   |

 

At the end of each period, the reserves werere-estimated for all prior accident years. The Company’s prior year reservesdecreased by $42,747, $39,620, and $6,778 for the years ended December 31,2006, 2005, and 2004, respectively. The decrease in prior year reserves during2006 resulted from re-estimations of prior years ultimate loss and LAEliabilities and is primarily composed of reductions of $23,945 in the Company’sretained automobile reserves, $14,006 in CAR assumed reserves, and $3,430 inthe Company’s retained homeowners reserves, and $686 in FAIR Plan assumedreserves. The decrease in prior year reserves during 2005 resulted fromre-estimations of prior years ultimate loss and LAE liabilites and is composedof reductions of $22,162 in CAR assumed reserves, $14,600 in the Company’sretained automobile reserves, $1,872 in FAIR Plan assumed reserves and $986 inthe Company’s retained homeowners reserves. The decrease in prior year reservesduring 2004 resulted from re-estimations of prior years ultimate loss and LAEliabilities and is composed of reductions of $6,854 in CAR assumed reserves, $2,523in the Company’s retained homeowner reserves, $329 in FAIR Plan assumedreserves, and an increase of $2,928 in the Company’s retained automobilereserves for 2004.

Due to the nature of therisks that the Company underwrites and has historically underwritten,management does not believe that it has an exposure to asbestos orenvironmental pollution liabilities.

**10.**          RelatedParty Transactions

In connection with theAcquisition, each member of the executive management team issued a recoursepromissory note to, and entered into a pledge agreement with the Company.Pursuant to the notes, the Company loaned management an aggregate of $695 inorder to purchase common stock in connection with the Acquisition and theRestricted Stock Plan. Pursuant to pledge agreements, the 

93

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

managementteam pledged the common stock back to the Company as security for the loansmade under the promissory notes. The notes bore interest at a rate of 5%annually and were due and payable on the earlier of December 31, 2011 or90 days after any management team member ceases to be an employee of theCompany. Each member could prepay his note at any time without penalty. At December 31,2003, the loans were carried in the financial statements at $34, whichrepresents the outstanding principal and accrued interest on the notes. During2004 the Company received $34 representing prepayments of all outstanding loanprincipal and accrued interest through the dates of final payments. Such loanshad been recorded as contra-equity in accordance with the accountingpolicy described in Note 2.

**11.**          IncomeTaxes

Provisionfor income taxes has been calculated in accordance with the provision ofStatement No. 109. A summary of the income tax expense in the ConsolidatedStatements of Income is shown below:

| ** **                 | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------|------------|---------------------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Current  Income Taxes:** | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal                    | ** ** | **$**                                                         | **51,760** |   | $ | 43,366 |   | $ | 22,505 |   |
| State                      | ** ** | **7**                                                         |       | 2 |   | 2 |   |
|                       | ** ** | **51,767**                                                    |       | 43,368 |   | 22,507 |   |
| **Deferred Income Taxes:** | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal                    | ** ** | **792**                                                       |       | (303 | ) | (2,702 | ) |
| State                      | ** ** | **—**                                                    |       | — |   | 837 |   |
|                       | ** ** | **792**                                                       |       | (303 | ) | (1,865 | ) |
| Total income tax expense   | ** ** | **$**                                                         | **52,559** |   | $ | 43,065 |   | $ | 20,642 |   |

 

Theincome tax expense attributable to the consolidated results of operations isdifferent from the amounts determined by multiplying income before federalincome taxes by the statutory federal income tax rate. The sources of thedifference and the tax effects of each were as follows:

| ** **                                     | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal income  tax expense, at statutory rate | ** ** | **$**                                                         | **57,575** |   | $ | 48,387 |   | $ | 22,971 |   |
| Tax-exempt  investment income, net             | ** ** | **(5,148**                                                    | **)**      | (4,013 | ) | (3,424 | ) |
| State taxes, net                               | ** ** | **5**                                                         |       | — |   | 544 |   |
| Changes in tax  estimates                      | ** ** | **—**                                                    |       | (1,161 | ) | 85 |   |
| Other, net                                     | ** ** | **127**                                                       |       | (148 | ) | 466 |   |
| Total income tax expense                       | ** ** | **$**                                                         | **52,559** |   | $ | 43,065 |   | $ | 20,642 |   |

 

94

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Thedeferred income tax asset (liability) represents the tax effects of temporarydifferences attributable to the Company’s consolidated federal tax return group.Its components were as follows:

| ** **                                             | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Deferred tax assets:**                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Discounting of loss reserves                           | ** ** | **$**                 | **9,201**  |   | $ | 9,803 |   |
| Discounting of unearned premium reserve                | ** ** | **21,319**            |       | 21,715 |   |
| Bad debt allowance                                     | ** ** | **297**               |       | 322 |   |
| Depreciation                                           | ** ** | **749**               |       | 716 |   |
| Employee benefits                                      | ** ** | **2,831**             |       | 1,515 |   |
| Transaction related costs                              | ** ** | **—**            |       | 174 |   |
| State loss carryforwards                               | ** ** | **2,543**             |       | 4,060 |   |
| Net unrealized losses on investments                   | ** ** | **—**            |       | 449 |   |
| Other                                                  | ** ** | **636**               |       | 681 |   |
| Total deferred  tax assets before valuation allowance  | ** ** | **37,576**            |       | 39,435 |   |
| Valuation  allowance for deferred tax assets           | ** ** | **(3,178**            | **)**      | (4,742 | ) |
| Total deferred  tax assets, net of valuation allowance | ** ** | **34,398**            |       | 34,693 |   |
| **Deferred  tax liabilities:**                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Deferred acquisition costs                             | ** ** | **(16,591**           | **)**      | (15,918 | ) |
| Investments                                            | ** ** | **(638**              | **)**      | (655 | ) |
| Net unrealized gains on investments                    | ** ** | **(11**               | **)**      | — |   |
| Other                                                  | ** ** | **(290**              | **)**      | — |   |
| Total deferred  tax liabilities                        | ** ** | **(17,530**           | **)**      | (16,573 | ) |
| Net deferred tax asset                                 | ** ** | **$**                 | **16,868** |   | $ | 18,120 |   |

 

The Company believes, based upon consideration ofobjective and verifiable evidence, including its recent earnings history andits future expectations, that the Company’s taxable income in future years willbe sufficient to realize all federal deferred tax assets. A valuation allowanceof $3,178 and $4,742 was established against state deferred tax assets at December 31,2006 and 2005, respectively. This valuation allowance is based upon management’sassessment that it is more likely than not that the Company will not be able toutilize these state deferred tax assets.

During the year ended December 31,2005, an examination of the Company’s federal income tax returns for the taxperiods ended December 31, 2003, 2002, and 2001 by the Internal RevenueService (“IRS”) was completed. The Company recorded a $1,616 tax benefitrepresenting a reduction in federal income tax reserves for tax years 2001through 2003, resulting from a settlement reached with the IRS in August 2005.Of this total tax benefit, $455 was recorded as an increase to additionalpaid-in capital and $1,161 was recorded as a reduction to income tax expensefor the year ended December 31, 2005. The Company is not currently underexamination by the IRS.

95

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**12.**          StatutoryNet Income and Surplus

**StatutoryAccounting Practices**

The Company’s insurancecompany subsidiaries, domiciled in the Commonwealth of Massachusetts, preparestatutory financial statements in accordance with the accounting practicesprescribed or permitted by the Division. Statutory net income of the Company’sinsurance company subsidiaries was $116,073, $97,337 and $44,575 for the yearsended December 31, 2006, 2005 and 2004, respectively. Statutory capitaland surplus of the Company’s insurance subsidiaries was $457,505 and $350,833at December 31, 2006 and 2005, respectively.

**Dividends**

The Company’s InsuranceSubsidiaries are subject to various regulatory restrictions that limit themaximum amount of dividends available to be paid to their parent without priorapproval of the Commonwealth of Massachusetts Commissioner of Insurance (the “Commissioner”).Massachusetts statute limits the dividends an insurer may pay in any twelvemonth period, without the prior permission of the Commissioner, to the greaterof (i) 10% of the insurer’s surplus as of the preceding December 31or (ii) the insurer’s net income for the twelve-month period endingthe preceding December 31, in each case determined in accordance withstatutory accounting practices. The Company’s Insurance Subsidiaries may notdeclare an “extraordinary dividend” (defined as any dividend or distribution that,together with other distributions made within the preceding twelve months,exceeds the limits established by Massachusetts statute) until thirty daysafter the Commissioner has received notice of the intended dividend and has notobjected. As historically administered by the Commissioner, this provisionrequires the Commissioner’s prior approval of an extraordinary dividend. UnderMassachusetts law, an insurer may pay cash dividends only from its unassignedfunds, also known as earned surplus, and the insurer’s remaining surplus mustbe both reasonable in relation to its outstanding liabilities and adequate toits financial needs. At year-end 2006, the statutory surplus of SafetyInsurance was $457,505 and its net income for 2006 was $110,075. As a result, amaximum of $110,075 is available in 2007 for such dividends without priorapproval of the Commissioner.

**13.**          FairValue of Financial Instruments

The Company uses various financial instruments in thenormal course of its business. Certain insurance contracts are excluded byStatement of Financial Accounting Standards No. 107, “Disclosures aboutFair Value of Financial Instruments,” and, therefore, are not included in theamounts discussed.

At December 31, 2006 and 2005, investments infixed maturities and equity securities had a fair value, which equaled carryingvalue, of $940,605 and $714,543, respectively. There were no investments infixed maturities and equity securities for which a quoted market price ordealer price was not available at December 31, 2006 or 2005, respectively.

The carrying values of cash and cash equivalents andinvestment income accrued approximate fair value.

At December 31, 2006and 2005 the Company had no amounts outstanding on its secured credit facility.

96

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**14.**          QuarterlyResults of Operations

Anunaudited summary of the Company’s 2006 and 2005 quarterly performance, andaudited annual performance, is as follows:

| ** **                                   | ** ** | **Year ended December 31, 2006** | ** **  |
|----------------------------------------------|------------|------------------------------------------------------|-------------|
| ** **                                   | ** ** | **First**                                            | ** **  | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **Quarter**                                          | ** **  | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Year** | ** ** |
| Total revenue                                | ** ** | **$**                                                | **170,941** | ** ** | **$** | **169,628** | ** ** | **$** | **170,829** | ** ** | **$** | **169,314** | ** ** | **$** | **680,712** | ** ** |
| Net income                                   | ** ** | **30,802**                                           | ** **  | **29,138** | ** ** | **29,105** | ** ** | **22,896** | ** ** | **111,941** | ** ** |
| Earnings per weighted  average common share: |       |                                                 |        |   |   |   |   |   |   |   |   |
| Basic                                        | ** ** | **1.96**                                             | ** **  | **1.84** | ** ** | **1.83** | ** ** | **1.44** | ** ** | **7.07** | ** ** |
| Diluted                                      | ** ** | **1.94**                                             | ** **  | **1.81** | ** ** | **1.81** | ** ** | **1.42** | ** ** | **6.99** | ** ** |
| Cash dividends paid per  common share        | ** ** | **0.18**                                             | ** **  | **0.18** | ** ** | **0.25** | ** ** | **0.25** | ** ** | **0.86** | ** ** |
|                                              |            |                                                      |             |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **Year ended December 31, 2005** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                   | ** ** | **First**                                            | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **Quarter**                                          | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Year** | ** ** |
| Total revenue                                |       | $                                                    | 168,251    |   | $ | 168,133 |   | $ | 169,840 |   | $ | 165,233 |   | $ | 671,457 |   |
| Net income                                   |       | 14,502                                               |       | 23,246 |   | 30,475 |   | 26,959 |   | 95,182 |   |
| Earnings per weighted  average common share: |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | 0.94                                                 |       | 1.49 |   | 1.95 |   | 1.72 |   | 6.11 |   |
| Diluted                                      |       | 0.92                                                 |       | 1.46 |   | 1.92 |   | 1.69 |   | 5.97 |   |
| Cash dividends paid per  common share        |       | 0.12                                                 |       | 0.12 |   | 0.18 |   | 0.18 |   | 0.60 |   |
|                                              |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

97

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

None.

***ITEM 9A.****            CONTROLSAND PROCEDURES*

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

Under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this report. Based on thatevaluation, our CEO and CFO have concluded that our disclosure controls andprocedures are adequate and effective and ensure that all information requiredto be disclosed is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and that information required to bedisclosed in such reports is accumulated and communicated to management,including our Chief Executive Officer and Chief Financial Officer, to allowtimely decisions regarding required disclosures.

**Management’s Reporton Internal Control over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as defined inExchange Act Rules 13a-15(f) and 15d-15(f). Under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, we conducted an evaluation ofthe effectiveness of our internal control over financial reporting based on theframework in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Based on our evaluation under the framework in *Internal Control—Integrated Framework*, ourmanagement concluded that our internal control over financial reporting waseffective as of December 31, 2006.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2006 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which is included herein.

**Changes in InternalControl over Financial Reporting**

There have been nosignificant changes in our internal control over financial reporting identifiedin connection with the evaluation required by Exchange Act Rules 13a-15and 15d-15 that occurred during our last fiscal quarter that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

***ITEM 9B.****            OTHERINFORMATION*

The followingdisclosures relate to actions taken by the Board of Directors of the Company(the “Board”), the Compensation Committee of the Board and the Board ofDirectors of Safety Insurance Company and would otherwise have been filed duringthe first fiscal quarter of 2007 on a Form 8-K under the heading “Item1.01. Entry into a Material Definitive Agreement.”

·       Uponrecommendation from the Compensation Committee, on February 26, 2007, the Boardapproved the 2006 annual executive cash bonus pool in the total amount of$2,309 pusuant to the Annual Performance Incentive Plan. Of the total pool, thefollowing amounts were allocated to the Company’s CEO and Named ExecutiveOfficers; David F. Brussard, $858; Daniel D. Loranger, $314; Edward N.Patrick, Jr., $276; William J. Begley, Jr., $238; David E. Krupa, $176.

98

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·       Upon recommendation fromthe Compensation Committee, on February 26, 2007, the Board approved executivelong-term incentive awards to certain members of senior management pursuant toour 2002 Management Omnibus Incentive Plan, as Amended. The long-term incentiveawards were granted in a total amount of $3,000 in the form of restrictedstock, to be effective on and given a fair value of the closing price of ourcommon stock on February 26, 2007. The restricted stock vests in three annualinstallments of 30% on February 26, 2008, 30% on February 26, 2009, and 40% onFebruary 26, 2010. Of the total award, the following amounts were allocated tothe Company’s CEO and Named Executive Officers; David F. Brussard, $1,200worth of restricted stock; Daniel D. Loranger, $375 worth of restricted stock; EdwardN. Patrick, Jr., $375 worth of restricted stock; William J. Begley, Jr., $375worth of restricted stock; and David E. Krupa $163 worth of restricted stock. Theform of restricted stock agreement that will be entered into is attached heretoas Exhibit 10.22.

•     Uponrecommendation from the Compensation Committee, on February 26, 2007, the Boardapproved executive deferred compensation awards pursuant to the ExecutiveIncentive Compensation Plan in a total amount of $1,923. Of the total award,the following amounts were allocated to the Company’s CEO and Named ExecutiveOfficers; David F. Brussard, $750; Daniel D. Loranger, $309; EdwardN. Patrick, Jr., $262; William J. Begley, Jr., $225; David E. Krupa, $140.

**PART III**

***ITEM 10.****          DIRECTORS,EXECUTIVE OFFICERS OF THE REGISTRANT AND CORPORATE GOVERNANCE*

The information called forby Item 401 of Regulation S-K, regarding directors, executive officers,promoters and control persons, and not provided in Part I. Item 1, “Business”,will be contained in the Company’s Proxy Statement for its Annual Meeting ofShareholders, to be held on May, 18, 2007, in Boston, MA, which the Companyintends to file with the U.S. Securities and Exchange Commission within120 days after December 31, 2006, (the Company’s fiscal year end),and such information is incorporated herein by reference.

The information called forby Item 405 of Regulation S-K regarding compliance with Section 16(a) ofthe Exchange Act and disclosures relating to delinquent filers will becontained in the Company’s Proxy Statement for its Annual Meeting ofShareholders, to be held on May 18, 2007, in Boston, MA, which the Companyintends to file with the U.S. Securities and Exchange Commission within120 days after December 31, 2006, (the Company’s fiscal year end),and such information is incorporated herein by reference.

***ITEM 11.****          EXECUTIVECOMPENSATION*

The information called forby Item 402 of Regulation S-K regarding Executive and Directorcompensation will be contained in the Company’s Proxy Statement for its AnnualMeeting of Shareholders, to be held on May, 18, 2007, in Boston, MA, which theCompany intends to file with the U.S. Securities and Exchange Commissionwithin 120 days after December 31, 2006, (the Company’s fiscal yearend), and such information is incorporated herein by reference.

The information called forby Items 407(e)(4) and (e)(5) of Regulation S-K regarding CorporateGovernance will be contained in the Company’sProxy Statement for its Annual Meeting of Shareholders, to be held on May, 18,2007, in Boston, MA, which the Company intends to file with the U.S. Securitiesand Exchange Commission within 120 days after December 31, 2006, (theCompany’s fiscal year end), and such information is incorporated herein byreference except for the Compensation Committee Report, which shall notbe deemed to be “filed”.

99

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***ITEM 12.****          SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS*

The information called forby Item 403 of Regulation S-K regarding Stock Ownership of CertainBeneficial Owners and Stock Ownership of Directors and Executive Officers will be contained in the Company’s Proxy Statementfor its Annual Meeting of Shareholders, to be held on May, 18, 2007, in Boston, MA,which the Company intends to file with the U.S. Securities and ExchangeCommission within 120 days after December 31, 2006, (the Company’sfiscal year end), and such information is incorporated herein by reference.

***ITEM 13.****          CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE*

The information called for by Item 404 ofRegulation S-K regarding Transactions with Related Persons, Promoters andCertain Control Persons will be contained inthe Company’s Proxy Statement for its Annual Meeting of Shareholders, to beheld on May, 18, 2007, in Boston, MA, which the Company intends to file withthe U.S. Securities and Exchange Commission within 120 days after December 31,2006, (the Company’s fiscal year end), and such information is incorporatedherein by reference.

The information called forby Item 407(a) of Regulation S-K regarding Corporate Governance related toDirector Independence will be contained in the Company’s Proxy Statement forits Annual Meeting of Shareholders, to be held on May, 18, 2007, in Boston, MA,which the Company intends to file with the U.S. Securities and ExchangeCommission within 120 days after December 31, 2006, (the Company’sfiscal year end), and such information is incorporated herein by reference.

***ITEM 14.****          PRINCIPALACCOUNTANT FEES AND SERVICES*

The information called forby Item 9(e) of Schedule 14A regarding fees for services performed bythe Company’s independent public accountants will be contained in the Company’sProxy Statement for its Annual Meeting of Shareholders, to be held on May 18,2007, in Boston, MA, which the Company intends to file with the U.S. Securitiesand Exchange Commission within 120 days after December 31, 2006, (theCompany’s fiscal year end), and such information is incorporated herein byreference.

**PART IV.**

***ITEM 15.****          EXHIBITS,FINANCIAL STATEMENT SCHEDULES.*

(a)           The following documentsare filed as a part of this report:

1.                FinancialStatements: The Consolidated Financial Statements for the year ended December 31,2006 are contained herein as listed in the Index to Consolidated FinancialStatements on page 70.

2.                FinancialStatement Schedules: The Financial Statement Schedules are contained herein aslisted in the Index to Financial Statement Schedules on page 101.

3.                Exhibits: Theexhibits are contained herein as listed in the Index to Exhibits on page 110.

100

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**SAFETY INSURANCEGROUP, INC.**

**INDEXTO FINANCIAL STATEMENT SCHEDULES**

|            | ** **    | ** **                                                                      | ** ** | **Page**   |       |
|------------|---------------|---------------------------------------------------------------------------------|------------|------------|------------|
| ** ** | **Schedules** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** |   |
| I          |          | Summary  of Investments—Other than Investments in Related Parties          |       | 102        |       |
| II         |          | Condensed  Financial Information of the Registrant                              |       | 103        |       |
| III        |          | Supplementary  Insurance Information                                            |       | 105        |       |
| IV         |          | Reinsurance                                                                     |       | 106        |       |
| V          |          | Valuation  and Qualifying Accounts                                              |       | 107        |       |
| VI         |          | Supplemental Information Concerning Property and  Casualty Insurance Operations |       | 108        |       |
|            |               |                                                                                 |            |            |            |  |  |  |

 

101

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**Safety InsuranceGroup, Inc.**

**Summary ofInvestments—Other than Investments in Related Parties**

**Schedule I**

**AtDecember 31, 2006**

**(Dollarsin thousands)**

| ** **                                               | ** ** | ** **  | ** **  | ** **          | ** ** | **Amount at**           | ** **  |
|----------------------------------------------------------|------------|-------------|-------------|---------------------|------------|------------------------------|-------------|
| ** **                                               | ** ** | ** **  | ** **  | ** **          | ** ** | **which shown**         | ** **  |
| ** **                                               | ** ** | ** **  | ** **  | ** **          | ** ** | **in the Balance** | ** **  |
| ** **                                               | ** ** | **Cost**    | ** **  | **Fair Value** | ** ** | **Sheet**                    | ** **  |
| **Fixed maturities:**                                    |       |        |        |                |       |                         |        |   |   |
| Bonds:                                                   |       |        |        |                |       |                         |        |   |   |
| U.S. government and government agencies and  authorities | ** ** | **$**       | **185,390** | ** **          | **$**      | **183,436**                  | ** **  | ** ** | **$** | **183,436** |   |   |
| States, municipalities and political subdivisions        | ** ** | **429,888** | ** **  | **434,359**         | ** ** | ** **                   | **434,359** |   |   |
| Corporate bonds                                          | ** ** | **318,400** | ** **  | **315,601**         | ** ** | ** **                   | **315,601** |   |   |
| Redeemable preferred stocks                              | ** ** | **2,856**   | ** **  | **2,884**           | ** ** | ** **                   | **2,884**   |   |   |
| **Total fixed maturities**                               | ** ** | **936,534** | ** **  | **936,280**         | ** ** | ** **                   | **936,280** |   |   |
| **Equity  securities:**                                  | ** ** | ** **  | ** **  | ** **          | ** ** | ** **                   | ** **  |   |   |
| Common Stocks  Industrial, miscellaneous and all other   | ** ** | **4,038**   | ** **  | **4,325**           | ** ** | ** **                   | **4,325**   |   |   |
| **Total equity securities**                              | ** ** | **4,038**   | ** **  | **4,325**           | ** ** | ** **                   | **4,325**   |   |   |
| **Total  investments**                                   | ** ** | **$**       | **940,572** | ** **          | **$**      | **940,605**                  | ** **  | ** ** | **$** | **940,605** |   |   |

 

102

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**Safety InsuranceGroup, Inc.**

**Condensed FinancialInformation of the Registrant**

**Condensed BalanceSheets**

**Schedule II**

**(Dollarsin thousands)**

| ** **                                           | ** ** | **December 31,** | ** **  | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** **  | **2005**              | ** ** |
| **Assets**                                           |       |                  |        |                  |       |   |   |   |   |
| Investments in  consolidated affiliates              |       | ** **            | **$**       | **499,371**           |       |   |   | $ | 389,469 |   |   |
| Other                                                |       | ** **            | **77**      |                  |       |   | — |   |   |
| **Total assets**                                     |       | ** **            | **$**       | **499,448**           |       |   |   | $ | 389,469 |   |   |
| **Liabilities**                                      |       |                  |        |                  |       |   |   |   |   |
| Accounts payable  and other liabilities              |       | ** **            | **$**       | **3,100**             |       |   |   | $ | 1,520 |   |   |
| **Total liabilities**                                |       | ** **            | **3,100**   |                  |       |   | 1,520 |   |   |
| **Shareholders’  equity**                       |       | ** **            | **496,348** |                  |       |   | 387,949 |   |   |
| **Total liabilities and  shareholders’ equity** |       | ** **            | **$**       | **499,448**           |       |   |   | $ | 389,469 |   |   |

 

**Safety InsuranceGroup, Inc.**

**Condensed FinancialInformation of the Registrant**

**CondensedStatements of Income and Comprehensive Income**

**Schedule II**

**(Dollarsin thousands)**

| ** **                                            | ** ** | **For the Years Ended December 31,** | ** **  |
|-------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                            | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Revenues, net of  income taxes                        | ** ** | **$**                                                         | **—**  |   | $ | — |   | $ | — |   |
| Expenses                                              | ** ** | **1,742**                                                     |        | 2,007 |   | 1,542 |   |
| Net loss                                              | ** ** | **(1,742**                                                    | **)**       | (2,007 | ) | (1,542 | ) |
| Earnings from  consolidated affiliates                | ** ** | **113,683**                                                   |        | 97,189 |   | 46,532 |   |
| **Consolidated net income**                           | ** ** | **111,941**                                                   |        | 95,182 |   | 44,990 |   |
| Other net  comprehensive gains (losses), net of taxes | ** ** | **854**                                                       |        | (9,542 | ) | (3,941 | ) |
| **Consolidated  comprehensive net income**            | ** ** | **$**                                                         | **112,795** |   | $ | 85,640 |   | $ | 41,049 |   |

103

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**Safety InsuranceGroup, Inc.**

**Condensed FinancialInformation of the Registrant**

**CondensedStatements of Cash Flows**

**Schedule II**

**(Dollarsin thousands)**

| ** **                                                                         | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                         | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Consolidated  net income**                                                       |       | **$**                                                         | **111,941** | ** ** | $ | 95,182 |   | $ | 44,990 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       | ** **                                                    | ** **  |   |   |   |   |
| Undistributed earnings in consolidated subsidiaries                                |       | **(113,683**                                                  | **)**       | (97,189 | ) | (46,532 | ) |
| Amortization                                                                       |       | **2,616**                                                     | ** **  | 903 |   | 301 |   |
| Dividends received from consolidated subsidiaries                                  |       | **7,859**                                                     | ** **  | 24,900 |   | 8,201 |   |
| Changes in assets  and liabilities:                                                |       | ** **                                                    | ** **  |   |   |   |   |
| Other assets                                                                       |       | **(77**                                                       | **)**       | 2,070 |   | (101 | ) |
| Accounts payable and accrued liabilities                                           |       | **1,580**                                                     | ** **  | 427 |   | 222 |   |
| **Net  cash provided by operating activities**                                     |       | **10,236**                                                    | ** **  | 26,293 |   | 7,081 |   |
| Contribution to subsidiaries                                                       |       | **—**                                                    | ** **  | — |   | (2,474 | ) |
| **Net cash  used for investing activities**                                        |       | **—**                                                    | ** **  | — |   | (2,474 | ) |
| Payments on  revolving credit facility                                             |       | **—**                                                    | ** **  | (19,956 | ) | — |   |
| Proceeds from  exercise of stock options                                           |       | **3,497**                                                     | ** **  | 3,072 |   | 2,126 |   |
| Dividends paid                                                                     |       | **(13,733**                                                   | **)**       | (9,409 | ) | (6,767 | ) |
| Payments on promissory  notes from management                                      |       | **—**                                                    | ** **  | — |   | 34 |   |
| **Net cash used for financing activities**                                         |       | **(10,236**                                                   | **)**       | (26,293 | ) | (4,607 | ) |
| **Net  increase (decrease) in cash and cash equivalents**                          |       | **—**                                                    | ** **  | — |   | — |   |
| **Cash  and cash equivalents, beginning of year**                                  |       | **—**                                                    | ** **  | — |   | — |   |
| **Cash and cash equivalents, end  of year**                                        |       | **$**                                                         | **—**  | ** ** | $ | — |   | $ | — |   |

 

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**Safety InsuranceGroup, Inc.**

**SupplementaryInsurance Information**

**Schedule III**

**(Dollars in thousands)**

|                         | ** ** | ** **      | ** **        | **Future Policy**        | ** ** | ** **   | ** **         | **Other**           | ** ** | ** **  | ** **         | ** **     | ** ** | **Benefits,**        | ** **        | **Amortization**     | ** ** | ** **    | ** **         | ** **   | ** ** |
|-------------------------|------------|-----------------|-------------------|-------------------------------|------------|--------------|--------------------|---------------------|------------|-------------|--------------------|----------------|------------|----------------------|-------------------|----------------------|------------|---------------|--------------------|--------------|------------|
| ** **              | ** ** | **Deferred**    | ** **        | **Benefits,**                 | ** ** | ** **   | ** **         | **Policy**          | ** ** | ** **  | ** **         | ** **     | ** ** | **Claims,**          | ** **        | **of Deferred** | ** ** | ** **    | ** **         | ** **   | ** ** |
| ** **              | ** ** | **Policy**      | ** **        | **Losses,**                   | ** ** | ** **   | ** **         | **Claims and** | ** ** | ** **  | ** **         | **Net**        | ** ** | **Losses, and** | ** **        | **Policy**           | ** ** | **Other**     | ** **         | ** **   | ** ** |
| ** **              | ** ** | **Acquisition** | ** **        | **Claims and Loss** | ** ** | **Unearned** | ** **         | **Benefits**        | ** ** | **Premium** | ** **         | **Investment** | ** ** | **Settlement**       | ** **        | **Acquisition**      | ** ** | **Operating** | ** **         | **Premiums** | ** ** |
| **Segment**             | ** ** | ** **      | ** **        | **Costs**                     | ** ** | **Expenses** | ** **         | **Premiums**        | ** ** | **Payable** | ** **         | **Revenue**    | ** ** | **Income**           | ** **        | **Expenses**         | ** ** | **Costs**     | ** **         | **Expenses** | ** ** | **Written** | ** ** |
| Years Ended:            |       |            |              |                          |       |         |               |                |       |        |               |           |       |                 |              |                 |       |          |               |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| December 31, 2006  | ** ** | ** **      | **$ 47,404** |                          | ** ** | ** **   | **$ 449,444** |                | ** ** | ** **  | **$ 333,404** |           | ** ** | ** **           | **$ —** |                 | ** ** | ** **    | **$ 624,933** |         | ** ** | ** ** | **$ 40,293** |   | ** ** | ** ** | **$ 353,906** |   | ** ** | ** ** | **$ 97,274** |   | ** ** | ** ** | **$ 64,946** |   | ** ** | ** ** | **$ 620,908** |   |   |
| December 31, 2005  |       |            | 45,480            |                          |       |         | 450,716            |                |       |        | 341,562            |           |       |                 | —            |                 |       |          | 622,831            |         |       |   | 31,573 |   |   |   | 385,593 |   |   |   | 93,515 |   |   |   | 53,154 |   |   |   | 632,836 |   |   |
| December 31,  2004 |       |            | 42,919            |                          |       |         | 450,897            |                |       |        | 337,786            |           |       |                 | —            |                 |       |          | 592,292            |         |       |   | 27,259 |   |   |   | 425,061 |   |   |   | 88,425 |   |   |   | 56,650 |   |   |   | 618,923 |   |   |
|                         |            |                 |                   |                               |            |              |                    |                     |            |             |                    |                |            |                      |                   |                      |            |               |                    |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Safety InsuranceGroup, Inc.**

**Reinsurance**

**Schedule IV**

**(Dollarsin thousands)**

| ** **              | ** ** | ** ** | ** **  | ** **                   | ** ** | ** **            | ** ** | ** **    | ** ** | **Percentage**     | ** ** |
|-------------------------|------------|------------|-------------|------------------------------|------------|-----------------------|------------|---------------|------------|--------------------|------------|
| ** **              | ** ** | ** ** | ** **  | ** **                   | ** ** | **Assumed from** | ** ** | ** **    | ** ** | **of Amount** | ** ** |
| ** **              | ** ** | **Gross**  | ** **  | **Ceded to Other** | ** ** | **Other**             | ** ** | **Net**       | ** ** | **Assumed**        | ** ** |
| **Total Premiums** | ** ** | ** ** | ** **  | **Amount**                   | ** ** | **Companies**         | ** ** | **Companies** | ** ** | **Amount**         | ** ** | **to Net** | ** ** |
| Years ended:            |       |       |        |                         |       |                  |       |          |       |               |       |   |   |   |   |   |   |
| December 31,  2006 | ** ** | **$**      | **636,953** | ** **                   | ** ** | **$**                 | **81,670** |          | ** ** | ** **         | **$**      | **69,650** |   | ** ** | **$** | **624,933** | ** ** | ** ** | **11.1** | **%** | ** ** |
| December 31,  2005 |       | 638,142    |        |                         | 89,277     |                  |       |          | 73,966     |               |       | 622,831 |   |   | 11.9 |   |   |
| December 31, 2004  |       | 599,608    |        |                         | 85,950     |                  |       |          | 78,634     |               |       | 592,292 |   |   | 13.3 |   |   |
|                         |            |            |             |                              |            |                       |            |               |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Safety InsuranceGroup, Inc.**

**Valuation andQualifying Accounts**

**Schedule V**

**(Dollarsin thousands)**

| ** **                       | ** ** | **Balance at** | ** ** | **Charged to Costs**    | ** ** | **Charged to**         | ** ** | ** **              | ** ** | **Balance at** | ** ** |
|----------------------------------|------------|---------------------|------------|-----------------------------------|------------|-----------------------------|------------|-------------------------|------------|---------------------|------------|
| **Description**                  | ** ** | ** **          | ** ** | **Beginning of Period** | ** ** | ** and Expenses** | ** ** | **Other Accounts** | ** ** | **Deductions(1)**   | ** ** | **End of Period** | ** ** |
| December 31, 2006           |       |                |       |                              |       |                        |       |                    |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  Doubtful Accounts | ** ** | ** **          | **$**      | **220**                           |       | ** **                  | ** ** | **$**                   | **806**    |                | ** ** | ** ** | **$** | **—** |   | ** ** | ** ** | **$** | **873** |   | ** ** | ** ** | **$** | **153** |   |   |
| December 31, 2005           |       |                |       |                              |       |                        |       |                    |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  Doubtful Accounts |       |                | 183        |                              |       |                        | 901        |                    |       |                | —     |   |   |   | 864 |   |   |   | 220 |   |   |
| December 31, 2004           |       |                |       |                              |       |                        |       |                    |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for Doubtful  Accounts |       |                | 484        |                              |       |                        | 442        |                    |       |                | —     |   |   |   | 743 |   |   |   | 183 |   |   |
|                                  |            |                     |            |                                   |            |                             |            |                         |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Deductions representwrite-offs of accounts determined to be uncollectible

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**Safety Insurance Group, Inc.Supplemental Information Concerning Property and Casualty Insurance OperationsSchedule VI(Dollars in thousands)**

| ** **       | ** ** | ** **      | ** ** | **Reserves for**  | ** ** | ** **           | ** ** | ** **        | ** ** | ** **   | ** ** | ** **     | ** ** | **Claims and Claims**                             | ** ** | **Amortization**                                          | ** ** | ** **           | ** ** | ** **     | ** ** |
|------------------|------------|-----------------|------------|------------------------|------------|----------------------|------------|-------------------|------------|--------------|------------|----------------|------------|-------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------|------------|----------------|------------|
| ** **       | ** ** | **Deferred**    | ** ** | **Unpaid Claims** | ** ** | **Discount,**        | ** ** | ** **        | ** ** | ** **   | ** ** | ** **     | ** ** | **Adjustment Expenses**                                | ** ** | **of Deferred**                                      | ** ** | **Paid Claims** | ** ** | ** **     | ** ** |
| **Affiliations** | ** ** | **Policy**      | ** ** | **and Claims**    | ** ** | **if any,**     | ** ** | ** **        | ** ** | ** **   | ** ** | **Net**        | ** ** | **Incurred Related to**                           | ** ** | **Policy**                                                | ** ** | **and Claims**  | ** ** | ** **     | ** ** |
| **With**         | ** ** | **Acquisition** | ** ** | **Adjustment**         | ** ** | **deducted in** | ** ** | **Unearned**      | ** ** | **Earned**   | ** ** | **Investment** | ** ** | **    Current    ** | ** ** | **    Prior    ** | ** ** | **Acquisition**      | ** ** | **Adjustment** | ** ** | **Premiums** | ** ** |
| **Registrant**   | ** ** | ** **      | ** ** | **Costs**              | ** ** | **Expenses**         | ** ** | **Column C** | ** ** | **Premiums** | ** ** | **Premiums**   | ** ** | **Income**                                                  | ** ** | **Year**                                                  | ** ** | **Year**             | ** ** | **Costs**      | ** ** | **Expenses** | ** ** | **Written** | ** ** |
|                  |            |                 |            |                        |            |                      |            |                   |            |              |            |                |            |                                                             |            |                                                           |            |                      |            |                |            |  |  |  |  |

| Consolidated Property &  Casualty Subsidiaries |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   |   |   |   |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
|----------------------------------------------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|--------|--------|--------|--------|------------|--------|--------|--------|------------|--------|--------|--------|------------|--------|

| 2006 | ** ** |   | **$**  | **47,404** | ** ** |   |    | **$**      | **449,444** | ** ** |   |       | **$**  | **—** | ** ** |       |   | **$**  | **333,404** | ** ** |   |   | **$**  | **624,933** | ** ** |   |    | **$**      | **40,293** | ** ** |    |   | **$**  | **396,653** | ** ** |       |   | **$**  | **(42,747** | **)**      |   |   | **$**   | **97,274** | ** ** |   |   | **$** | **353,092** | ** ** |   |   | **$** | **620,908** | ** ** |   |
|------|------------|--------|--------|------------|------------|--------|---------|------------|-------------|------------|--------|------------|--------|------------|------------|------------|--------|--------|-------------|------------|--------|--------|--------|-------------|------------|--------|---------|------------|------------|------------|---------|--------|--------|-------------|------------|------------|--------|--------|-------------|------------|--------|--------|---------|------------|------------|--------|--------|-------|-------------|------------|--------|--------|-------|-------------|------------|--------|
| 2005 |       |   | 45,480 | ** ** |       |   | 450,716 | ** ** |        |       | — | ** ** |   |       | 341,562    | ** ** |   |   | 622,831     | ** ** |   |   | 31,573 | ** **  |       |   | 425,213 | ** ** |       |       | (39,620 | )      |   |        | 93,515     | ** ** |   |   | 382,157     | ** ** |   |   | 632,836 | ** ** |       |
| 2004 |       |   | 42,919 | ** ** |       |   | 450,897 | ** ** |        |       | — | ** ** |   |       | 337,786    | ** ** |   |   | 592,292     | ** ** |   |   | 27,259 | ** **  |       |   | 431,839 | ** ** |       |       | (6,778  | )      |   |        | 88,425     | ** ** |   |   | 368,343     | ** ** |   |   | 618,923 | ** ** |       |

 

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**SIGNATURES**

Pursuantto the requirements of the Section 13 or 15(d) Securities ExchangeAct of 1934, as amended, the Registrant has duly caused this report to besigned on its behalf by the undersigned, thereunto duly authorized on the firstday of March, 2007.
|          |     | SAFETY INSURANCE  GROUP, INC.                                                |
|----------|----------|-----------------------------------------------------------------------------------|
| By:      |     | /s/ David F. Brussard                                                             |
| * * | * * | David F. Brussard,*President, Chief Executive Officer and  Chairman of the Board* |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints David F. Brussard andWilliam J. Begley, Jr., and each of them individually, his true and lawfulattorney-in-fact and agent with full power of substitution and resubstitutionfor him and in his name, place and stead, in any and all capacities, to signany and all amendments to this Annual Report, and to file the same, with allexhibits thereto, and other documents in connection therewith, with theSecurities and Exchange Commission, granting unto each such attorney-in-factand agent, or his substitutes, full power and authority to do and perform eachand every act and thing requisite and necessary to be done in and about thepremises, to all intents and purposes and as fully as he might or could do inperson, hereby ratifying and confirming all that each such attorney-in-fact andagent, or his substitutes, may lawfully do or cause to be done by virtuehereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Annual Reporthas been signed by the following persons in the capacities and on the dateindicated:

|                                  | **Signature** | ** **                                                            | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------------|---------------|-----------------------------------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/ DAVID F.  BRUSSARD           |          | President, Chief  Executive Officer and                               |       | March 1, 2007 |
| David  F. Brussard               |          | Chairman of the Board  (Principal Executive Officer)                  |       |               |
| /s/ WILLIAM J.  BEGLEY, JR. |          | Chief Financial  Officer, Vice                                        |       | March 1, 2007 |
| William  J. Begley, Jr.     |          | President and Secretary  (Principal Financial and Accounting Officer) |       |               |
| /s/ A. RICHARD  CAPUTO, JR. |          | Director                                                              |       | March 1, 2007 |
| A. Richard  Caputo, Jr.     |          |                                                                  |       |               |
| /s/ FREDERIC  H. LINDEBERG       |          | Director                                                              |       | March 1, 2007 |
| Frederic  H. Lindeberg           |          |                                                                  |       |               |
| /s/ PETER J.  MANNING            |          | Director                                                              |       | March 1, 2007 |
| Peter  J. Manning                |          |                                                                  |       |               |
| /s/ DAVID K.  MCKOWN             |          | Director                                                              |       | March 1, 2007 |
| David K. McKown                  |          |                                                                  |       |               |

 

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**SAFETY INSURANCEGROUP, INC.**

**INDEX TO EXHIBITS**
| Exhibit    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                        |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 3.1        |       | Form of Amended and Restated Certificate of  Incorporation of Safety Insurance Group, Inc.**                                                                                                                                                                                                                                                                                                                            |
| 3.2        |       | Form of Amended and Restated Bylaws of Safety  Insurance Group, Inc.**                                                                                                                                                                                                                                                                                                                                                  |
| 4          |       | Form of Stock Certificate for the Common  Stock**                                                                                                                                                                                                                                                                                                                                                                            |
| 10.1       |       | Lease Agreement between Thomas Black Corporation and  Aman, Inc. for the lease of office space located on the 1st through 6th,  11th and 12th floors of 20 Custom House Street, Boston, Massachusetts, dated  June 11, 1987, and as amended on October 11, 1988,  September 14, 1989, September 19, 1990, February 23, 1994,  December 20, 1996, June 24, 2002, and July 26, 2004.** |
| 10.2       |       | Tax Indemnity Agreement by and among Safety  Holdings, Inc. and the Management Team, dated October 16, 2001.**                                                                                                                                                                                                                                                                                                          |
| 10.3       |       | Management Consulting Agreement by and among TJC  Management Corporation and Safety Holdings, Inc., dated October 16,  2001.**                                                                                                                                                                                                                                                                                          |
| 10.4       |       | Form of First Amendment to the Management  Consulting Agreement by and among TJC Management Corporation and Safety  Group.**                                                                                                                                                                                                                                                                                                 |
| 10.5       |       | 2001 Restricted Stock Plan(1)**                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.6       |       | Executive Incentive Compensation Plan(1)**                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.7       |       | 2002 Management Omnibus Incentive Plan, as Amended(4)                                                                                                                                                                                                                                                                                                                                                                             |
| 10.8       |       | Reinsurance Terms Sheet between Safety Insurance  Company and Swiss Re America Corporation, effective January 1, 2002.**                                                                                                                                                                                                                                                                                                     |
| 10.9       |       | Excess Catastrophe Reinsurance Program Terms Sheet  between Safety Insurance Company, Safety Indemnity Insurance Company and  Benfield Blanch Inc., effective January 1, 2002.**                                                                                                                                                                                                                                             |
| 10.10      |       | Property Risk Excess of Loss Reinsurance Program  Terms Sheet between Safety Insurance Company, Safety Indemnity Insurance  Company and Benfield Blanch Inc. , effective January 1, 2002.**                                                                                                                                                                                                                             |
| 10.11      |       | Reinsurance Agreement between Safety Insurance  Company, Safety Indemnity Insurance Company and the Hartford Steam Boiler  Inspection and Insurance Company, effective July 1, 2003.(4).                                                                                                                                                                                                                                |
| 10.12      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and David F. Brussard, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                                                               |
| 10.13      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and William J. Begley, Jr., dated November 8,  2004.(1)*                                                                                                                                                                                                                                                                                    |
| 10.14      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Edward N. Patrick, Jr., dated November 8,  2004.(1)*                                                                                                                                                                                                                                                                                         |
| 10.15      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Daniel F. Crimmins, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                                                                   |
| 10.16      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Daniel D. Loranger, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                                                              |
| 10.17      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Robert J. Kerton, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                                                                |
| 10.18      |       | Employment Agreement by and between Safety Insurance  Group, Inc. and David E. Krupa, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                                                                  |
| 10.19      |       | Safety Insurance Company Executive Incentive  Compensation Plan—Basic Document(1)(2)                                                                                                                                                                                                                                                                                                                                         |
| 10.20      |       | Safety Insurance Company Executive Incentive  Compensation Plan—Adoption Agreement(1)(2)                                                                                                                                                                                                                                                                                                                                     |
| 10.21      |       | Safety Insurance Company Executive Incentive Compensation  Plan—Rabbi Trust Agreement(1)(2)                                                                                                                                                                                                                                                                                                                                  |

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| 10.22 |   | Form of Restricted Stock Notice and Agreement  (with vesting) under the 2002 Management Omnibus Incentive Plan(1)(2)                                                                                            |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23 |   | Form of Restricted Stock Notice and Agreement  (without vesting) under the 2002 Management Omnibus Incentive Plan(1)(2)                                                                                         |
| 10.24 |   | Form of Nonqualified Stock Option Notice and  Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)                                                                                                  |
| 10.25 |   | Form of Incentive Stock Option Notice and  Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)                                                                                                     |
| 10.26 |   | Form of Stock Appreciation Right Notice and  Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)                                                                                                   |
| 10.27 |   | Employment Agreement by and between Safety Insurance  Group, Inc. and James D. Berry, dated October 1, 2005.(1)(3)                                                                                         |
| 10.28 |   | Employment Agreement by and between Safety Insurance  Group, Inc. and George M. Murphy, dated October 1, 2005.(1)(3)                                                                                       |
| 10.29 |   | Excess Catastrophe Reinsurance Contract between  Safety Insurance Company, Safety Indemnity Insurance Company and Benfield  Blanch Inc., effective January 1, 2006.(4)                                          |
| 10.30 |   | Property Excess of Loss Reinsurance Contract between  Safety Insurance Company, Safety Indemnity Insurance Company and Benfield  Blanch Inc., effective January 1, 2006.(4)                                     |
| 10.31 |   | Casualty Excess of Loss Reinsurance Agreement  between Safety Insurance Company, Safety Indemnity Insurance Company and  Swiss Re America Corporation, effective January 1, 2006.(4)                            |
| 10.32 |   | Addendum No. 1 to Casualty Excess of Loss  Reinsurance Agreement between Safety Insurance Company, Safety Indemnity  Insurance Company and Swiss Re America Corporation, effective January 1,  2006.(4)    |
| 10.33 |   | Property Catastrophe Excess of Loss Reinsurance  Agreement between Safety Insurance Company, Safety Indemnity Insurance  Company and Swiss Re America Corporation, effective January 1, 2006.(4)                |
| 10.34 |   | Umbrella Liability Quota Share Reinsurance Agreement  between Safety Insurance Company, Safety Indemnity Insurance Company and  Swiss Re America Corporation, effective January 1, 2006.(4)                |
| 10.35 |   | Addendum No. 1 to Reinsurance Agreement between  Safety Insurance Company, Safety Indemnity Insurance Company and the Hartford  Steam Boiler Inspection and Insurance Company, effective April 1, 2006.(4) |
| 10.36 |   | Annual Performance Incentive Plan(4)                                                                                                                                                                                 |
| 21    |   | Subsidiaries of Safety Insurance Group, Inc.(4)                                                                                                                                                                 |
| 23    |   | Consent of PricewaterhouseCoopers LLP.(4)                                                                                                                                                                            |
| 24    |   | Power of Attorney**                                                                                                                                                                                                  |
| 31.1  |   | CEO Certification Pursuant to Rule 13a-14(a)/15d-14(a),  as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(4)                                                                          |
| 31.2  |   | CFO Certification Pursuant to Rule 13a-14(a)/15d-14(a),  as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(4)                                                                          |
| 32.1  |   | CEO Certification Pursuant to U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.(4)                                                                              |
| 32.2  |   | CFO Certification Pursuant to U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.(4)                                                                              |

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(1)          Denotes managementcontract or compensation plan or arrangement.

(2)          Incorporated herein byreference to the Registrant’s Form 10-K for the year ended December 31, 2004filed on March 16, 2005.

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(3)          Incorporated herein byreference to the Registrant’s Form 10-K for the year ended December 31, 2005filed on March 16, 2006.

(4)          Included herein.

*                    Incorporatedherein by reference to the Registrant’s Form 10-Q for the quarterly periodended September 30, 2004 filed on November 9, 2004.

**             Incorporated hereinby reference to the Registrant’s Registration Statement on Form S-1 (File No. 333-87056)filed April 26, 2002, and as amended on Form S-8 (Reg. No. 333-110676)filed on November 21, 2003 and as amended on Form S-8 (Reg. No. 333-140423)filed on February 2, 2007.

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