<PAGE>   1



                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                    FORM 10-K

         [X]     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

         [   ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934
            FOR THE TRANSITION PERIOD FROM __________ TO ___________.

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
                          COMMISSION FILE NUMBER 1-9640

                              MERCHANTS GROUP, INC.
             (Exact name of registrant as specified in its charter)


               DELAWARE                               16-1280763
    (State or other jurisdiction            (I.R.S. Employer Identification No.)
    of incorporation or organization)

    250 MAIN STREET, BUFFALO, NEW YORK                   14202
  (Address of principal executive offices)             (Zip Code)


                                  716-849-3333
              (Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 Title of each class - COMMON STOCK, $.01 PAR VALUE PER SHARE 
 Name of each exchange on which registered - AMERICAN STOCK EXCHANGE, INC.

Securities registered pursuant to Section 12(g) of the Act:  NONE

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ x ]

As of March 1, 1999, 2,834,952 shares of common stock were outstanding. The
aggregate market value of the common shares held by non-affiliates of Merchants
Group, Inc. on March 1, 1999 was $55,791,000.

                       DOCUMENTS INCORPORATED BY REFERENCE

    Portions of the definitive Proxy Statement for the 1999 Annual Meeting of
            stockholders are incorporated by reference into Part III.


<PAGE>   2


                              MERCHANTS GROUP, INC.

                           ANNUAL REPORT ON FORM 10-K
                                DECEMBER 31, 1998

          PART  I
          -------

ITEM 1.   BUSINESS.

ITEM 2.   PROPERTIES.

ITEM 3.   LEGAL PROCEEDINGS.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

          PART  II
          --------

ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

ITEM 6.   SELECTED FINANCIAL DATA.

ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
          CONDITION AND RESULTS OF OPERATIONS.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES
          ABOUT MARKET RISK.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
          ACCOUNTING AND FINANCIAL DISCLOSURE.

          PART  III
          ---------

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

ITEM 11.  EXECUTIVE COMPENSATION.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
          AND MANAGEMENT.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

          PART  IV
          --------

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND
          REPORTS ON FORM 8-K.


<PAGE>   3



                                     PART I

Item 1.  BUSINESS.

General
-------

      Merchants Group, Inc. (the "Company") was incorporated in August 1986 as a
Delaware holding company which, through its wholly owned subsidiary Merchants
Insurance Company of New Hampshire, Inc. ("MNH"), offers property and casualty
insurance to preferred risk individuals and small to medium size businesses in
the northeastern United States.

Administration
--------------

      The Company and MNH operate and manage their business in conjunction with
Merchants Mutual Insurance Company ("Mutual"), a New York domiciled mutual
property and casualty insurance company, under a management agreement (the
"Management Agreement"). Mutual owns 9.0% of the Company's issued and
outstanding common stock. The Company and MNH do not have any significant
operating assets and have no employees. Under the Management Agreement, Mutual
provides the Company and MNH with the facilities, management and personnel
required to operate their day-to-day business. All costs incurred by Mutual with
respect to underwriting expenses are shared pro rata between Mutual and MNH
based upon their annual direct premiums written, and unallocated loss adjustment
expenses are allocated on the basis of the number of claims outstanding each
month that are attributable to each company. All of Mutual's and MNH's
investment expenses are shared pro rata based upon the average book value of the
invested assets of each company. MNH also pays Mutual an annual management fee
of $50,000. The Management Agreement requires that the Company and MNH pay
Mutual 110% of Mutual's costs of providing them with non-insurance related
services, and that the Company pay Mutual an annual fee of one half of one
percent (.5%) of the average book value of the Company's invested assets
exclusive of the Company's shares of MNH. Since the inception of the Management
Agreement, Mutual has not provided the Company or MNH with any non-insurance
related services.

      The Management Agreement has certain features that are intended to prevent
conflicts of interest or to deal with them on an equitable basis should they
occur. Generally, business opportunities which are presented to the common
officers or employees of the companies must be presented to each company's Board
of Directors and approved and determined to be fair to each company in the
transaction by a majority of the directors of each company who are not
affiliated with any other company in the transaction.

      Any amendment or modification of the Management Agreement must be approved
by the New York Insurance Department (the "Department"). The Management
Agreement provides that it may be terminated by any party to the agreement upon
five years written notice. On July 23, 1998, the Company gave notice to
terminate the Management Agreement to Mutual. Mutual and MNH have jointly
developed and paid for all accounting, computer and insurance marketing systems
used in their businesses. Upon termination of the Management Agreement, each
company will have the right, at no cost, to obtain copies of all these systems,
together with the right to use these systems in perpetuity.


<PAGE>   4


Marketing
---------

      The Company markets its products through approximately 625 independent
agents, which also represent Mutual. The Company's primary marketing efforts are
directed to those independent agents that are dedicated to providing superior
service to their customers. The Company believes the opportunity for growth
exists through further penetration of agencies that are strategically aligned
with the Company's commitment to growth in its targeted markets.

      The Company believes that as a regional insurance company, it has certain
advantages, including a closer relationship with its agents and a better
knowledge of its operating territories, that enable it to compete effectively
against larger regional and national carriers. The Company believes it
distinguishes itself from its competitors by providing its agents and
policyholders with superior service and ease of doing business, products that
target certain segments of the commercial and personal insurance markets, and an
agents' compensation program which, in addition to standard commission rates,
provides agents with a profit sharing plan.

      The Company services its agents from five Strategic Business Centers and
from its home office in Buffalo, New York. The Strategic Business Centers are
located in the Company's operating territories and focus primarily on policy
sales and underwriting. The manager of a Strategic Business Center appoints new
agents, agrees upon annual unit sales and premium objectives with the principal
of the agency, and ensures that the principal of the agency communicates these
objectives to the agency's sales staff. Strategic Business Center managers and
Agency Business Managers, or "ABM's," develop customized business plans for each
agent, which identify the opportunities to increase business and the actions
required to achieve the objectives agreed to by the agent and the Company.

      In each of its Strategic Business Centers, the Company uses ABM's who are
trained underwriters. ABM's meet with targeted agents' sales staff on a frequent
basis to underwrite the Company's renewal policies, as well as to solicit and
underwrite policies new to the agent and/or to the Company. ABM's are equipped
with electronic technology to provide prompt and efficient pricing and
communication and can provide quotes for all lines of business at the agents'
offices. The Company believes personal contact between ABM's, who have
underwriting authority, and an agent's sales staff provides the Company with a
competitive advantage compared to many other property and casualty insurers,
whose field representatives have limited or no underwriting authority. By
placing an underwriting decision maker in the agent's office, and thereby
simplifying the underwriting process, the Company believes it can maintain and
improve the retention rate on its renewal policies, as well as attract new
policies.

      Each Strategic Business Center has an Agents' Advisory Council that meets
at least twice a year. The Advisory Councils provide a forum for the Company and
its agents to discuss issues of mutual interest, and to assure that the agents'
business needs are being met. Additionally, the Chairpersons of the Advisory
Councils from each Strategic Business Center meet twice each year with senior
officers of the Company.

      In addition to standard commissions paid as a percentage of premiums
written, the Company's agents are eligible to participate in the Agents' Profit
Sharing Plan. This plan rewards agents based on premiums written and a two year
loss and allocated loss and loss adjustment expense ("LAE") ratio on business
placed by the agent with the Company. Payments under the Agents' Profit Sharing


<PAGE>   5



Plan for 1998 totaled $2,499,000, or 2.5% of total direct premiums written, and
increased participating agents' commissions received from the Company by
approximately 40%. The Company believes the terms of its Agents' Profit Sharing
Plan encourage its agents to increase the volume of profitable business they
place with the Company.

      Unlike many of its competitors, the Company pays the same commission rate
on policies billed directly to the insured by the Company and on policies billed
to the agent and, in turn, re-billed to the insured by the agent. By offering to
bill the insured directly for both personal and commercial policies, the Company
helps its agents minimize their administrative costs without a reduction in
commission income. Approximately 87% of the voluntary premiums written by the
Company in 1997 and 1998 were billed directly to policyholders.

      In order to assist its independent agents to compete more effectively with
insurance companies that have direct sales forces, and to strengthen its
relationship with those agents, the Company provides advanced automation
services. In 1998, the Company began development of Merchants MerLink(TM)
system. MerLink(TM) allows independent agents to submit policies to Merchants
over the Internet using their existing business computer and software, and to
have these submissions automatically update the Company's insurance policy
processing system. The benefits to agents are simplified client management, more
time available for sales activities, and fewer errors. Currently, the Company is
using MerLink(TM) for policy transactions with approximately 15 agents for
private passenger automobile and homeowners' policies. The Company plans to
offer MerLink(TM) capability for commercial insurance policies during the first
half of 1999. The Company believes that developing automation capabilities to
facilitate the sharing of information with its agents will improve its
competitive position compared to other property and casualty insurers that do
not yet have such capabilities.

Insurance Underwriting
----------------------

      The Company is licensed to issue insurance policies in 13 states,
primarily in the northeastern United States. In 1998, net premiums written
totaled $92,758,000, with 54% of the net premiums written derived from
commercial lines of insurance and 46% from personal lines of insurance.

      The following table sets forth the distribution of the Company's direct
premiums written by state for the years indicated:

<TABLE>
<CAPTION>
                  Years Ended December 31,
                  ------------------------
                  1996     1997     1998
                  ----     ----     ----
<S>               <C>      <C>      <C>
New York           64%      66%      65%
New Jersey         15       15       18
New Hampshire      11       10        9
Rhode Island        3        3        3
Pennsylvania        3        2        2
Massachusetts       3        2        2
Other               1        2        1
                  ---      ---      ---
      Total       100%     100%     100%
                  ===      ===      ===
</TABLE>

<PAGE>   6



      The Company is licensed to underwrite most major lines of property and
casualty insurance. It issues policies primarily to preferred risk individuals
and small to medium size commercial risks. In general, the Company does not
insure risks that involve a high potential of loss or have a long-tail reporting
period. The types of risks insured in the Company's lines of business include:

      o  Personal automobile - full coverage of family-owned standard
         performance automobiles, generally requiring drivers with good driving 
         records during the past three years.

      o  (degree) Homeowners' - properties generally with no losses in the last
         three years and that are less than 30 years old and valued between 
         $75,000 and $300,000.

      o  (degree) Commercial automobile - primarily light and medium use
         vehicles operating in a limited radius, with complete background 
         information required of all drivers.

      o  Commercial multi-peril - properties with medium to high construction
         quality and low to moderate fire exposure, and occupancies with low 
         to moderate exposure to hazardous materials and processes.

      o  General liability - low hazard service, mercantile and light
         processing businesses, generally with three years of business 
         experience and with no losses in the last three years.

      o  Workers' compensation - risks with low loss frequency and severity, 
         low to moderate exposure to hazardous materials and processes, and 
         favorable experience modification factors. Generally, workers' 
         compensation insurance is written in conjunction with other commercial 
         insurance.

      The Company's underwriting strategy is to offer its insurance at rates
which are designed to cover its costs, including the costs of any involuntary
business associated with a particular line of insurance or a particular
territory. This pricing strategy makes the Company's rates non-competitive with
respect to certain lines of insurance or certain geographic regions. For
example, the Company's published rates for personal automobile insurance in the
densely populated areas within its region of operations are significantly higher
than those of some of its competitors. The Company believes that its pricing
strategy allows the Company to write the types of insurance for which the price
charged reflects the cost of providing coverage.

      Agents of the Company are also agents of Mutual, which generally sells the
same lines of insurance as the Company to standard risk individuals and
businesses. Applicants that meet the Company's preferred risk criteria are
issued policies by the Company. Applicants that do not meet the Company's
underwriting criteria, but which meet the less restrictive criteria of Mutual,
are issued policies by Mutual, generally at higher premium rates. During the
years 1993 through 1995, under a quota share reinsurance agreement with Mutual,
MNH assumed 10% of the standard risks insured by Mutual, which would not
generally meet MNH's more stringent underwriting guidelines. The terms of the
agreement allow Mutual to reduce its cessions to MNH to 0% of Mutual's direct
voluntary premiums written for any calendar year prior to the beginning of that
calendar year. Mutual has not ceded any of its voluntary direct written premiums
to MNH under this agreement since 1995 and has informed the Company that it will
not cede any of its voluntary direct written premiums to MNH in 1999.


<PAGE>   7


      The Company establishes premium rates for most of its policies based on
its loss experience, in some cases after considering prospective loss costs
suggested by the Insurance Services Office, Inc., an industry advisory group,
for the preferred individual and commercial classes of business that it insures.
The Company establishes rates independently for its personal automobile and
homeowners insurance policies and its specialty products, such as its
Contractors Coverall Plus and businessowners' policies.

      The following table shows, for each of the years in the three year period
ended December 31, 1998 (i) the amount of the Company's net premiums written
attributable to various personal lines and commercial lines and (ii)
underwriting results attributable to each such line as measured by the calendar
year loss ratio for such line. The loss ratio is the ratio of incurred losses to
net premiums earned for a given period.


<TABLE>
<CAPTION>
                                                                     Year ended December 31,
                               --------------------------------------------------------------------------------------------------
                                              1996                              1997                             1998
                               --------------------------------------------------------------------------------------------------
                               Premiums                         Premiums                          Premiums
                               Written                          Written                           Written
                               --------------------------------------------------------------------------------------------------
                                                         Loss                              Loss                             Loss
                                Amount         %         Ratio    Amount         %         Ratio   Amount          %        Ratio
                               --------------------------------------------------------------------------------------------------
                                                                      (dollars in thousands)
<S>                            <C>            <C>        <C>     <C>            <C>        <C>     <C>            <C>       <C>
Personal
      Auto Liability           $23,964        24.8%      80.9%   $26,187        27.0%      69.7%   $21,394        23.1%     79.3%
      Auto Physical Damage      12,241        12.7       60.3     13,570        14.0       45.8     13,199        14.2      45.8
      Homeowners'
          Multi-Peril            7,269         7.5       68.1      7,789         8.0       35.7      8,066         8.7      36.5
                               -------       -----               -------       -----               -------       -----          

          Total                 43,474        45.0       73.1     47,546        49.0       57.5     42,659        46.0      61.8

Commercial
      Auto Liability            13,050        13.5       43.4     12,377        12.8      100.7     12,986        14.0      41.5
      Auto Physical Damage       3,225         3.3       51.7      2,948         3.1       45.8      3,025         3.3      49.8
      Commercial
          Multi-Peril           20,725        21.5       59.9     21,287        22.0       44.6     21,878        23.6      49.5
      Workers'
          Compensation          10,023        10.4      110.7      7,070         7.3      169.0      7,159         7.7      87.8
      Other Lines                6,125         6.3       57.4      5,583         5.8        6.0      5,051         5.4      39.1
                               -------       -----               -------       -----               -------       -----          

          Total                 53,148        55.0       63.5     49,265        51.0       73.6     50,099        54.0      50.6
                               -------       -----               -------       -----               -------       -----          

Total Personal &
      Commercial               $96,622       100.0%      67.7    $96,811       100.0%      65.7    $92,758       100.0%     56.5
                               =======       =====               =======       =====               =======       =====          
</TABLE>


      Calendar year loss ratios set forth in the table above include an estimate
of losses for that accident year, as well as increases or decreases in estimates
made in that year for prior accident year losses. Depending on the size of the
increase or decrease in prior accident year losses, calendar year loss ratios
may not be as indicative of the profitability of policies in force in a
particular year as accident year loss ratios, which do not take into account
increases or decreases in reserves for prior accident year losses.


<PAGE>   8

      The following table sets forth the composition of voluntary direct
premiums written for 1994 through 1998:

<TABLE>
<CAPTION>
                                          Year Ended December 31,
                                          -----------------------
                                  1994    1995     1996     1997     1998
                                  ----    ----     ----     ----     ----

<S>                              <C>     <C>      <C>      <C>      <C>
Commercial                         62%     62%      60%      57%      58%
Personal                           38      38       40       43       42 
                                  ---     ---      ---      ---      --- 
Total                             100%    100%     100%     100%     100%
                                  ===     ===      ===      ===      === 
</TABLE>


Commercial Lines
----------------

      The Company's commercial business is primarily retail and mercantile in
nature and generally consists of small to medium size, low hazard commercial
risks which as a group have relatively stable loss ratios. The Company's
underwriting criteria exclude lines of business and classes of risks that are
considered by the Company to be high hazard or volatile, or which involve latent
injury potential or other long-tail liability exposures. Although the commercial
underwriting objectives of the Company and Mutual are similar, the Company has
refined its selection criteria to include specific classes of businesses,
occupancies, and operations with lower hazard ratings, which present a
relatively lower exposure to loss and are charged a correspondingly lower
premium. The Company offers specialized products within the commercial
multi-peril line such as the Contractors Coverall Plus for artisan and trade
contractors, and BusinessElite for specified retail, service and office risks.

      Despite the lack of significant premium rate increases in recent years in
most of its commercial lines and the significant level of competition in the
lines of business that the Company targets, the Company believes it can insure
commercial business profitably by selecting those classes of risks that offer
better than average profit potential. The Company competes for commercial
business based upon the service it provides to agents and policyholders, the
compensation it pays to its agents, and in certain instances, the price of its
products. The Company establishes prices after considering its costs, the
exposures inherent in a particular class of risk, estimated investment income,
projected future trends in loss frequency and severity, and the degree of
competition within a specific territory. Accordingly, the relative prices of the
Company's commercial products may vary considerably in relation to competitors'
prices.

Personal Lines
--------------

      The Company offers personal automobile and homeowners' insurance to
preferred risk individuals, generally requiring experienced drivers with no
accidents or moving violations in the last three years for personal automobile
insurance, and medium to high value homes with systems that are less than thirty
years old in fire protected areas for homeowners' insurance. Personal automobile
premium rates attempt to cover costs associated with required participation in
involuntary personal automobile programs, in addition to the costs directly
associated with the policies written voluntarily.

      The Company and Mutual have developed automated underwriting procedures
for personal automobile and homeowners business, which perform an initial review
of policy applications based upon established underwriting guidelines.
Applications that do not meet the guidelines for automated acceptance are either
referred to personal lines underwriters who review the applications and assess

<PAGE>   9


exposure, or rejected if the risk characteristics are such that neither the
Company nor Mutual would accept the applicant.

      As a condition to writing voluntary business in most states in which it
operates, the Company must participate in state-mandated programs which provide
insurance for individuals and businesses unable to obtain insurance voluntarily,
primarily for personal automobile insurance. The legislation creating these
programs usually allocates a pro rata portion of the risks attributable to such
insureds to each company writing voluntary business in the state on the basis of
its voluntary premiums written or the number of automobiles which it insures
voluntarily.

      The Company's gross (direct and assumed) premiums written attributable to
involuntary policies were $11,325,000, $12,719,000 and $6,036,000 in 1996, 1997
and 1998, respectively, mostly in New York. The Company is unable to predict the
level of its annual involuntary business for 1999 or future years.

Claims
------

      Insurance claims on policies written by the Company are investigated and
settled by claims adjusters employed by Mutual pursuant to the Management
Agreement. The Company and Mutual maintain several claims offices within their
operating territories. In areas where there is insufficient claim volume to
justify the cost of internal claims staff, the Company and Mutual use
independent appraisers and adjusters to investigate claims. The Company's claims
policy emphasizes timely investigation of claims, settlement of meritorious
claims for equitable amounts, maintenance of adequate reserves for claims and
control of external claims adjustment expenses. In order to support its claims
policy, the Company has implemented a program designed to ensure that as soon as
practical, claims are assigned an accurate value based on available information.
The program includes the centralization of certain branch claims operations and
an emphasis on the training of claims adjusters and supervisors by senior claims
staff. This claims policy is designed to support the Company's marketing policy
and provide agents and policyholders with prompt service and support.

      Claims settlement authority levels are established for each adjuster,
supervisor and manager based on their expertise and experience. When the Company
receives notice of a claim, it is assigned to an adjuster based upon its type,
severity and line of business. The claims staff then reviews the claim, obtains
appropriate information and establishes a loss reserve. Claims that exceed
certain dollar amounts or that cannot be readily settled are assigned to more
senior claims staff.

Loss and LAE Reserves
---------------------

      The Company, like other insurance companies, establishes reserves for
losses and LAE. These reserves are estimates intended to cover the probable
ultimate cost of settling all losses incurred and unpaid, including those losses
not yet reported to the Company. An insurer's ultimate liability is likely to
differ from their estimates because during the life of a claim, which may be
many years, additional facts affecting an insurer's liability may become known.
The reserves of an insurer are frequently adjusted based on monitoring by the
insurer and periodic review by state insurance departments. The Company retains
an independent actuarial firm to satisfy state insurance departments'
requirements with respect to the certification of reserves for losses and LAE.


<PAGE>   10


      Loss reserves are established for known claims based on the type and
circumstance of the loss and the results of similar losses. For claims not yet
reported to the Company, loss reserves are based on statistical information from
previous experience periods adjusted for inflation, trends in court decisions
and economic conditions. LAE reserves are intended to cover the ultimate cost of
investigating all losses that have occurred and defending lawsuits, if any,
arising from these losses. LAE reserves are evaluated periodically using
statistical techniques which compare current costs with historical data.
Inflation is implicitly reflected in the reserving process through analysis of
cost trends, and review of historical reserve results. With the exception of an
amount relating to workers' compensation claims, loss reserves are not
discounted for financial statement purposes.

      The Company's reserving process is based on the assumption that past
experiences, adjusted for the effect of current developments and trends, are
relevant in predicting future events. In the absence of specific developments,
the process also assumes that the legal climate regarding the claims process and
underlying liabilities remains constant. Other assumptions employed by the
Company or its actuarial firm change from time to time as circumstances change.
In estimating loss and LAE reserves, the Company employs a number of actuarial
methods, depending on their applicability to each line of business, in order to
balance the advantages and disadvantages of each method. No single method is
used to estimate loss and LAE reserves. Although different actuarial methods may
give rise to different reserve estimates, which may be higher or lower than the
reserves actually established by the Company, the Company believes that those
differences are not material.

      The Company has recorded increases in reserves for prior accident year
losses in several years. These increases were necessary because of several
factors, including inaccurate estimation of the extent of liability associated
with a number of claims involving serious injuries and claims handling practices
that did not produce accurate and timely reserve levels for a broad range of
claims. In 1996 and 1997, the Company increased its reserves for prior years by
$6,832,000 and $4,508,000, respectively. These increases were primarily
attributable to higher than anticipated severity of claims on workers'
compensation policies. In 1998, the Company decreased its reserves for prior
years by $2,145,000, primarily due to favorable loss experience related to
automobile liability policies.




<PAGE>   11




       The following table sets forth the changes in the reserve for losses and
LAE for 1996, 1997 and 1998.

<TABLE>
<CAPTION>
                                                                 Year Ended December 31,
                                                                 -----------------------

                                                            1996           1997          1998
                                                            ----           ----          ----
                                                                     (in thousands)

<S>                                                       <C>           <C>          <C>      
Reserve for losses and LAE at beginning of year            $119,722      $133,479      $141,205
      Less reinsurance recoverables                           6,004         7,219        10,372
                                                           --------      --------      --------
      Net balance at beginning of year                      113,718       126,260       130,833
                                                           --------      --------      --------

Provision for losses and LAE for claims occurring in:
      Current year                                           72,771        67,119        67,379
      Prior years                                             6,832         4,508        (2,145)
                                                           --------      --------      --------
                                                             79,603        71,627        65,234
                                                           --------      --------      --------

Losses and LAE payments for claims occurring in:
      Current year                                           28,512        26,100        26,765
      Prior years                                            38,549        40,954        42,433
                                                           --------      --------      --------
                                                             67,061        67,054        69,198
                                                           --------      --------      --------

Reserve for losses and LAE at end of year, net              126,260       130,833       126,869
      Plus reinsurance recoverables                           7,219        10,372         9,816
                                                           --------      --------      --------
      Balance at end of year                               $133,479      $141,205      $136,685
                                                           ========      ========      ========
</TABLE>



      The first line of the following table presents, as of the end of the year
at the top of each column, the estimated amount of unpaid losses and LAE for
claims arising in that year and in all prior years, including claims that had
occurred but were not yet reported to the Company. For each column, the rows of
the table present, for the same group of claims, the amount of unpaid losses and
LAE as re-estimated as of the end of each succeeding year. The estimate is
modified as more information becomes known about the number and severity of
claims for each year. The "cumulative redundancy (deficiency)" represents the
change in the estimated amount of unpaid losses and LAE from the end of the year
at the top of each column through the end of 1998.

      For each column in the table, the change from the liability for losses and
LAE shown on the first line to the liability as re-estimated as of the end of
the following year was included in operating results for the following year.
That change includes the change in the previous year's column from the liability
as re-estimated one year later to the liability as re-estimated two years later
which, in turn, includes the change in the second preceding column from the
liability as re-estimated two years later to the liability as re-estimated three
years later, and so forth.

      The rows of the lower portion of the table present, as of the end of each
succeeding year, the amount of paid losses and LAE for claims unpaid at the end
of the year at the top of each column.


<PAGE>   12

<TABLE>
<CAPTION>
                                                                     Year Ended December 31,
                                                                     -----------------------
                                    1988      1989     1990     1991     1992     1993      1994      1995      1996     1997
                                    ----      ----     ----     ----     ----     ----      ----      ----      ----     ----
                                                                        (in thousands)
<S>                                <C>      <C>      <C>      <C>     <C>       <C>       <C>       <C>       <C>      <C>
Liability for losses and LAE:

                                   $55,412  $66,892  $71,222  $77,274 $ 86,159  $ 89,939  $ 97,614  $113,718  $126,260  $130,781
                                                                                                                              
Liability re-estimated as of:                                                                                      
One year later                      57,238   75,614   77,548   80,841   88,284    94,921   108,659   120,550   130,768   128,636 
Two years later                     61,534   76,310   75,987   81,743   91,224   100,607   113,091   128,192   133,029           
Three years later                   61,928   73,578   78,106   83,693   95,396   106,382   121,051   129,724                     
Four years later                    61,014   75,672   79,563   87,105   99,779   112,983   121,791                               
Five years later                    61,787   76,746   81,308   90,428  104,699   112,963                                        
Six years later                     62,201   77,026   84,530   92,370  104,808                                                 
Seven years later                   62,332   79,690   85,219   93,046                                                         
Eight years later                   64,388   79,890   84,765                                                                  
Nine years later                    64,194   79,415                                                                           
Ten years later                     64,014                                                                                    
                                   
Cumulative Redundancy (Deficiency):
                                  $ (8,602) (12,523) (13,543) (15,772) (18,649)  (23,024)  (24,177)  (16,006)   (6,769)    2,145
                                  %  (15.5)   (18.7)   (19.0)   (20.4)   (21.6)    (25.6)    (24.8)    (14.1)     (5.4)      1.6

Paid (Cumulative) as of:
One year later                      21,393   32,538   32,666   30,082   35,724    34,551    36,916    38,549    40,954    42,433
Two years later                     37,459   47,816   47,339   50,490   56,003    56,965    60,074    64,323    69,035
Three years later                   47,816   58,489   61,585   63,925   69,863    72,963    77,982    84,638
Four years later                    52,758   66,466   70,219   72,917   80,156    83,998    91,948
Five years later                    56,732   71,322   75,018   79,374   86,808    93,295
Six years later                     59,162   73,558   78,398   82,602   91,919
Seven years later                   59,994   75,822   79,884   84,707
Eight years later                   61,546   76,683   80,706
Nine years later                    62,183   76,996
Ten years later                     62,357
</TABLE>

      The loss and LAE reserves reported in the Company's consolidated financial
statements prepared in accordance with generally accepted accounting principles
("GAAP") differ from those reported in the statements filed by MNH with the New
Hampshire Insurance Department in accordance with statutory accounting
principles ("STAT") as follows:

<TABLE>
<CAPTION>
                                                                     As of December 31,
                                                                     ------------------
                                                                 1996        1997       1998
                                                                 ----        ----       ----
                                                                       (in thousands)

<S>                                                            <C>         <C>        <C>
Loss and LAE reserves on a STAT basis                          $125,821    $130,781   $126,820
Adjustments:
      Loss reserves ceded under a quota share
          agreement with an unrelated party                         379          --         --
      Ceded reinsurance balances recoverable                      7,219      10,372      9,816
      Write-down of reinsurance recoverable                          60          52         49
                                                               --------    --------   --------
Loss and LAE reserves on a GAAP basis                          $133,479    $141,205   $136,685
                                                               ========    ========   ========
</TABLE>



<PAGE>   13



Reinsurance
-----------

      The Company follows the customary industry practice of reinsuring a
portion of the exposure under its policies and as consideration pays to its
reinsurers a portion of the premium received on its policies. Insurance is ceded
principally to reduce an insurer's liability on individual risks and to protect
against catastrophic losses. Although reinsurance does not legally discharge an
insurer from its primary liability for the full amount of coverage provided by
its policies, it does make the assuming reinsurer liable to the insurer to the
extent of the reinsurance ceded.

      The Company is a party to reinsurance contracts under which certain types
of policies are automatically reinsured without the need for approval by the
reinsurer with respect to the individual risks that are covered ("treaty"
reinsurance). The Company also is a party to reinsurance contracts which are
handled on an individual policy or per risk basis and require the specific
agreement of the reinsurer as to each risk insured ("facultative" reinsurance).
Occasionally, the Company may secure facultative reinsurance to supplement its
coverage under treaty reinsurance.

      Effective January 1, 1998, the Company changed its primary reinsurer and
coverage. Prior to that time, the Company's excess of loss arrangements for
automobile liability, general liability and workers' compensation insurance
provided for recovery of losses over $500,000 up to a maximum of $5,000,000 per
occurrence. For claims occurring prior to 1993, the $500,000 threshold was
indexed for inflation for casualty lines other than workers' compensation and
New York State no-fault, and applied retroactively to all occurrences until they
are settled. There was no index provision for casualty claims occurring after
1992. This coverage was supplemented by additional treaty reinsurance covering
losses up to $5,000,000 in excess of the first $5,000,000.

      Prior to January 1, 1998, property reinsurance agreements provided for
recovery of property losses over $500,000 up to $2,000,000 per occurrence
without any index provision. Property catastrophe coverage placed with many
reinsurers worldwide provided for recovery of 95% of $40,000,000, subject to
aggregate retained losses of $5,000,000 for each natural disaster.
The reinsurance premium rate paid varied for each line of business.

      Effective January 1, 1998, the new property and casualty excess of loss
reinsurance agreements provide for recovery of casualty losses over $500,000 up
to $10,000,000 per occurrence and property losses over $500,000 up to
$10,000,000 per occurrence. This coverage is supplemented by a contingent
casualty layer of reinsurance for workers' compensation claims of $5,000,000 in
excess of the first $10,000,000 subject to a calendar year limit of $20,000,000.
Property catastrophe coverage provides for recovery of 95% of $50,000,000,
subject to aggregate retained losses of $5,000,000 per occurrence. The property
catastrophe reinsurance coverage is shared by the Company and Mutual on a pro
rata basis based upon the gross reported losses of the Company and Mutual for a
covered event.

      In 1987, the Company and its primary reinsurer agreed to limit the losses
which could be recovered by the Company under its excess of loss treaties for
the 1980 through 1986 accident years in exchange for a cap on retrospective
premiums due to the reinsurer. At December 31, 1998, recoverable losses exceeded
the cap and the excess losses have been retained by the Company.

      Effective January 1, 1993, Mutual and MNH entered into a quota share
reinsurance agreement under which MNH may assume up to 10% of Mutual's direct
voluntary written premiums and related

<PAGE>   14



losses and allocated LAE in exchange for a reinsurance commission of 35%. The
agreement also provides for MNH to pay a contingent commission to Mutual equal
to any underwriting profit on the premiums assumed. Mutual pays the ceded
premiums, net of commissions and paid losses, to MNH on a monthly basis and MNH
invests these funds and earns investment income. To the extent commissions and
paid losses exceed premiums, MNH is required to pay the net monthly balance to
Mutual. The agreement may be terminated by either party effective as of any
January 1 with the prior approval of the New York Superintendent of Insurance
and upon six months' notice to the other party. In addition, the agreement may
be terminated by MNH at any time if any amount payable to MNH by Mutual becomes
more than 90 days overdue or if there is a change in control of Mutual approved
by the New York Superintendent of Insurance. Further, the agreement allows
Mutual to reduce its cessions to MNH from a maximum of 10% to a minimum of 0% of
Mutual's direct voluntary premiums written for any calendar year prior to the
beginning of that calendar year. Mutual has not ceded any portion of its direct
voluntary written premiums to MNH since 1995 and has informed the Company that
it will not cede any voluntary direct written premiums to MNH in 1999.

Investments
-----------

      The primary source of funds for investment by the Company is premiums
collected. Although premiums, net of commissions and other underwriting costs,
are taken into income ratably over the terms of the policies, they provide funds
for investment from the date they are received. Similarly, although
establishment of and changes in reserves for losses and LAE are included in
results of operations immediately, the amounts so set aside are available to be
invested until the Company pays those claims.

      The investments of the Company are regulated by New Hampshire insurance
law and are reviewed by the Board of Directors of the Company. Other than
certain short-term investments held to maintain liquidity, the Company primarily
invests in medium-term bonds, mortgage-backed and other asset-backed securities
including collateralized mortgage obligations, and tax-exempt securities. The
mortgage-backed securities held by the Company are typically purchased at
expected yields which are greater than comparable maturity Treasury securities
and are AAA or AA rated.

      The Company had $27,066,000 of tax-exempt bonds in its investment
portfolio at December 31, 1998. The Company believes these tax-exempt bonds are
of high quality (rated A or better) and offer an after-tax total return greater
than comparable taxable securities.

      At December 31, 1998, the Company had $6,280,000 of short-term investments
with maturities less than 30 days, and $6,706,000 of non-investment grade
securities. These non-investment grade securities represented 3% of its
investment portfolio.

      The table below gives information regarding the Company's investments as
of the dates indicated.



<PAGE>   15



<TABLE>
<CAPTION>
                                                           As of December 31,
                                       ---------------------------------------------------------
                                              1996                1997                1998
                                       ---------------------------------------------------------
                                         Amount      %      Amount       %      Amount       %
                                         ------    ----     ------     ----     ------     ----
                                                        (dollars in thousands)

<S>                                    <C>         <C>     <C>        <C>      <C>        <C>  
Fixed Maturities (1):
      U.S. Government and Agencies     $ 49,990    24.8%   $ 48,734    23.2%   $ 30,392    14.1%
      Corporate Bonds                    86,308    42.8     117,060    55.7     140,326    65.2
      Tax-Exempt Bonds                   46,818    23.2      28,764    13.7      27,066    12.6
                                       --------   -----    --------   -----    --------   ----- 
          Total Bonds                   183,116    90.8     194,558    92.6     197,784    91.9
Preferred stocks (2)                      7,928     3.9      10,582     5.0      10,373     4.9
Short-Term Investments (3)                8,248     4.1       4,470     2.1       6,280     2.9
Other (4)                                 2,305     1.2         634      .3         735      .3
                                       --------   -----    --------   -----    --------   ----- 

Total Invested Assets                  $201,597   100.0%   $210,244   100.0%   $215,172   100.0%
                                       ========   =====    ========   =====    ========   ===== 
</TABLE>


(1)   Fixed Maturities are shown at their carrying amounts in the respective
      balance sheet. Held to Maturity fixed maturities are included at amortized
      cost. Available for Sale fixed maturities are included at fair value.

(2)   Shown at fair value.

(3)   Shown at cost, which approximates fair value.

(4)   Shown at estimated fair value or unpaid principal balance, which
      approximates estimated fair value.

      The table below sets forth the Company's net investment income and net
realized gains and losses, excluding the effect of income taxes, for the periods
shown:

<TABLE>
<CAPTION>
                                                      Year Ended December 31,
                                                      -----------------------
                                                   1996          1997            1998
                                                   ----          ----            ----
                                                       (dollars in thousands)

<S>                                             <C>            <C>            <C>      
Average investments (1)                          $194,677       $202,041       $211,272
Net investment income                              11,724         12,770         13,277
Net investment income as a percentage
    of average investments (2)                        6.0%           6.3%           6.3%

Net realized gains (losses) on investments       $    996       $    112       $     (2)
</TABLE>

(1)   At amortized cost.

(2)   The taxable equivalent yield for the years ended December 31, 1996, 1997
      and 1998 was 6.6%, 6.9%, and 6.8%, respectively, assuming an effective
      tax rate of 34%.

      The table below sets forth the carrying value of bonds and percentage
distribution of various maturities at the dates indicated. Fixed Maturities are
shown at their carrying amounts in the respective balance sheet. Held to
Maturity fixed maturities are included at amortized cost. Available for Sale
fixed maturities are included at fair value. The estimated repayment date is
used instead of the ultimate repayment date for mortgage backed and other asset
backed securities.


<PAGE>   16



<TABLE>
<CAPTION>
                                                    As of December 31, 
                             ------------------------------------------------------------ 
                                       1996                1997                 1998
                             ------------------------------------------------------------ 
                              Amount      %         Amount      %        Amount      %   
                             --------   -----      --------   -----      --------  ----- 
                                                  (dollars in thousands)
  
<S>                         <C>         <C>       <C>         <C>       <C>        <C>
1 year or less               $ 15,518     8.5%     $ 47,499    24.4%     $ 51,892   26.2%   
1 year through 5 years        123,856    67.6       116,508    59.9       126,631   64.0
5 years through 10 years       32,452    17.7        27,877    14.3        17,721    9.0
More than 10 years             11,290     6.2         2,674     1.4         1,540     .8
                             --------   -----      --------   -----      --------  ----- 
      Total                  $183,116   100.0%     $194,558   100.0%     $197,784  100.0%
                             ========   =====      ========   =====      ========  ===== 
</TABLE>


Competition
-----------

      The property and casualty insurance business is highly competitive. The
Company is in direct competition with many national and regional multiple-line
insurers, many of which are substantially larger than the Company and have
considerably greater financial resources. Competition is further intensified by
the independent agency system because each of the independent agents who sells
the Company's policies also represents one or more other insurers. Also, the
Company's agents compete with direct writing insurers and this indirectly
affects the Company.

      Historically, the property and casualty industry has tended to be cyclical
in nature. During the "up" cycle, or "hard market," the industry is
characterized by price increases, strengthening of loss and LAE reserves,
surplus growth and improved underwriting results. Near the end of the "up"
cycle, an increase in capacity causes insurance companies to begin to compete
for market share on the basis of price. This price competition causes the
emergence of the "down" cycle, or "soft market," characterized by a reduction in
the premium growth rate and a general decline in profitability. Generally, the
down cycle is eventually accompanied by a decline in the adequacy of loss and
LAE reserves and a decrease in premium writing capacity. The property and
casualty insurance industry has experienced a cyclical downturn for the past
several years due primarily to intense premium rate competition and an excess
capacity to write premiums. Many of the circumstances which led to the current
cyclical downturn in the property and casualty insurance industry continue to
exist, and the Company cannot predict when or if market conditions for the
industry will improve.

Regulation
----------

General
-------

      MNH is subject to regulation under applicable insurance statutes,
including insurance holding company statutes, of the various states in which it
writes insurance. Insurance regulation is intended to provide safeguards for
policyholders rather than to protect stockholders of insurance companies or
their holding companies. Insurance laws of the various states establish
regulatory agencies with broad administrative powers including, but not limited
to, the power to grant or revoke licenses to transact insurance business and to
regulate trade practices, investments, premium rates, the deposit of securities,
the form and content of financial statements and insurance policies, accounting
practices and the maintenance of specified reserves and capital. The regulatory
agencies of each state have statutory authority to enforce their laws and
regulations through various administrative orders, civil and criminal
enforcement proceedings, and the suspension or revocation of certificates of
authority. 


<PAGE>   17


In extreme cases, including insolvency, impending insolvency and other matters,
a regulatory authority may take over the management and operation of an
insurer's business and assets.

      Under insolvency or guaranty laws in the states in which MNH operates,
insurers doing business in those states can be assessed up to prescribed limits
for policyholder losses caused by other insurance companies that become
insolvent. The extent of any requirement for MNH to make any further payment
under these laws is not determinable. Most laws do provide, however, that an
assessment may be excused or deferred if it would threaten a solvent insurer's
financial strength. In addition, MNH is required to participate in various
mandatory pools or underwriting associations in certain states in which it
operates.

      The property and casualty insurance industry has been the subject of new
regulations and legislative activity in various states attempting to address the
affordability and availability of different lines of insurance. The regulations
and legislation generally restrict the discretion an insurance company has in
operating its business. It is not possible to predict the effect, if any, that
new regulations and legislation would have on the Company and MNH.

      The Company depends on cash dividends from MNH to pay cash dividends to
its stockholders and to meet its expenses. MNH is subject to New Hampshire state
insurance laws which restrict its ability to pay dividends without the prior
approval of state regulatory authorities. These restrictions limit dividends to
those that, when added to all other dividends paid within the preceding twelve
months, would not exceed 10% of the insurer's policyholders' surplus as of the
preceding December 31st. The maximum amount of dividends that MNH could pay
during any twelve month period ending in 1999 without the prior approval of the
New Hampshire Insurance Commissioner is $5,058,000.

      In certain states in which it operates, MNH is required to maintain
deposits with the appropriate regulatory authority to secure its obligations
under certain insurance policies written in the jurisdiction. At December 31,
1998, investments of MNH having a par value of $1,800,000 were on deposit with
regulatory authorities.

      MNH and Mutual are required to file detailed annual reports with the
appropriate regulatory agency in each of the states in which they do business.
Their business and accounts are subject to examination by such agencies at any
time, and the laws of many states require periodic examination.

      In 1993 the National Association of Insurance Commissioners ("NAIC")
adopted a risk-based capital measurement formula to be applied to all property
and casualty insurance companies. The formula calculates a minimum required
statutory net worth, based on the underwriting, investment, credit, loss reserve
and other business risks inherent in an individual company's operations. Any
insurance company that does not meet threshold risk-based capital measurement
standards could be forced to reduce the scope of its operations and ultimately
could become subject to statutory receivership proceedings. MNH's capital
substantially exceeds the statutory minimum as determined by the risk-based
capital measurement formula as of December 31, 1998.

      The NAIC has established eleven financial ratios (the Insurance Regulatory
Information System, or "IRIS") to assist state insurance departments in their
oversight of the financial condition of insurance companies operating in their
respective states. The NAIC calculates these ratios based on information
submitted by insurers on an annual basis and shares the information with the
applicable


<PAGE>   18


state insurance departments. The ratios relate to leverage, profitability,
liquidity and loss reserve development. One of the Company's ratios as of
December 31, 1998 relating to loss reserve development fell outside of the
acceptable range of ratios. The ratio was outside of the acceptable range due to
the $4,508,000 increase in the provision for losses and LAE recorded in 1997 for
claims occurring in prior years, as discussed in this Item under the heading
"Loss and LAE Reserves". The Company's inability to operate within an acceptable
range of the aforementioned IRIS ratio is not expected to have a material effect
on the Company's business or its operations.

Rates
-----

      Premium rate regulations vary greatly among states and lines of insurance,
and frequently require approval of the regulatory authority or limited review by
the authority prior to changes in rates. However, in New York and certain other
states, insurers writing private passenger automobile policies and in designated
commercial risk, professional liability and public entity insurance markets may
periodically revise rates within the limits of applicable flexibility bands
("flex-bands") on a file and use basis, but must obtain the Department's prior
approval in order to implement rate increases or decreases beyond these
flex-bands.

Insurance Holding Companies
---------------------------

      The Company is subject to statutes governing insurance holding company
systems. Typically, such statutes require the Company to file information
periodically concerning its capital structure, ownership, financial condition
and general business operations and material inter-company transactions not in
the ordinary course of business. Under the terms of applicable New Hampshire
statutes, any person or entity desiring to purchase shares which would result in
such person beneficially owning 10% or more of the Company's outstanding voting
securities would be required to obtain regulatory approval prior to the
purchase.

Involuntary Insurance
---------------------

      As a condition to writing voluntary insurance in most of the states in
which it operates, the Company must participate in programs that provide
insurance for persons or businesses unable to obtain insurance voluntarily.
Uncertainties as to the size of the involuntary market population make it
difficult to predict the amount of involuntary business in a given year.

Employees
---------

      The Company has no employees. At December 31, 1998, Mutual had 350
full-time equivalent employees. The Company believes that Mutual's relationship
with its employees is satisfactory.

Item 2. PROPERTIES.

      Although the Company has no facilities, it benefits from the facilities of
Mutual pursuant to the Management Agreement, under which the Company is charged
a proportionate share of the costs of such facilities.

      The Company's corporate headquarters are located in Buffalo, New York in a
building owned by Mutual that contains approximately 113,000 square feet of
office space. Mutual also has regional 


<PAGE>   19


underwriting and/or claims office facilities in Buffalo, Albany and Central
Islip, New York; Bedford, New Hampshire; and Moorestown, New Jersey. All of the
offices except the Buffalo office are leased.

Item 3. LEGAL PROCEEDINGS.

      MNH, like many other property and casualty insurance companies, is subject
to environmental damage claims asserted by or against its insureds. Management
of the Company is of the opinion that based on various court decisions
throughout the country such claims should not be recoverable under the terms of
MNH's insurance policies because of either specific or general coverage
exclusions contained in the policies. However, there is no assurance that the
courts will agree with MNH's position in every case, nor can there be assurance
that material claims will not be asserted under policies which a court will find
do not explicitly or implicitly exclude claims for environmental damages.
Management, however, is not aware of any pending claim or group of claims which
would result in a liability that would have a material adverse effect on the
financial condition of the Company or MNH.

      In addition to the foregoing matters, MNH is a defendant in a number of
other legal proceedings in the ordinary course of its business. Management of
the Company is of the opinion that the ultimate aggregate liability, if any,
resulting from such proceedings will not materially affect the financial
condition of the Company or MNH.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None

<PAGE>   20


                                     PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

       The Company's common stock is traded on the American Stock Exchange (AMEX
symbol: MGP). The following table sets forth the high and low closing prices of
the common stock for the periods indicated as reported on the American Stock
Exchange.

<TABLE>
<CAPTION>
1998:                  High       Low
-----                  ----       ---

<S>                   <C>        <C>   
Fourth Quarter        $21.75     $18.50
Third Quarter          24.38      19.25
Second Quarter         26.25      23.63  
First Quarter          22.75      19.75

1997:                  High       Low
-----                  ----       ---

Fourth Quarter        $21.25     $18.63
Third Quarter          20.38      17.38
Second Quarter         20.50      18.75
First Quarter          19.13      17.50
</TABLE>

       The number of stockholders of record of the Company's Common Stock as of
February 26, 1999 was 122. Securities held by nominees are counted as one
stockholder of record.

       The Company has paid a quarterly cash dividend of $.05 per share to its
common stockholders since the third quarter of 1993. Continued payment of this
dividend and its amount will depend upon the Company's operating results,
financial condition, capital requirements and other relevant factors, including
legal restrictions applicable to the payment of dividends by its insurance
subsidiary, MNH.

       As a holding company, the Company depends on dividends from its
subsidiary, MNH, to pay cash dividends to its stockholders. MNH is subject to
New Hampshire state insurance laws which restrict its ability to pay dividends
without the prior approval of state regulatory authorities. These restrictions
limit dividends to those that, when added to all other dividends paid within the
preceding twelve months, would not exceed 10% of the insurer's policyholders'
surplus as of the preceding December 31. The maximum amount of dividends that
MNH could pay during any twelve month period ending in 1999 without prior
approval of the New Hampshire Insurance Commissioner is $5,058,000.


<PAGE>   21



Item 6. SELECTED FINANCIAL DATA.

       The selected financial data set forth in the following table for each of
the five years in the period ended December 31, 1998 have been derived from the
audited consolidated financial statements of the Company.

<TABLE>
<CAPTION>
                                                                           Year Ended December 31,
                                                      ---------------------------------------------------------------------
                                                        1994           1995           1996           1997           1998
                                                        ----           ----           ----           ----           ----
                                                                          (in thousands, except per share amounts)

<S>                                                   <C>            <C>            <C>            <C>           <C>
Net premiums written                                   $ 90,187       $ 97,577       $ 96,622       $ 96,811      $ 92,758
                                                       ========       ========       ========       ========      ========

Net premiums earned                                    $ 90,845       $ 94,749       $ 95,752       $ 96,054      $ 93,540
Net investment income                                     9,849         10,368         11,724         12,770        13,277
Net realized investment gains (losses)                       20           (832)           996            112            (2)
Other revenues                                              638            259            172            214           153
                                                       --------       --------       --------       --------      --------
     Total revenues                                     101,352        104,544        108,644        109,150       106,968
                                                       --------       --------       --------       --------      --------
Net losses and loss adjustment expenses                  70,800         78,195         79,603         71,627        65,234
Amortization of deferred policy acquisition costs        24,424         25,458         25,374         25,454        24,788
Other underwriting expenses                               5,892          7,709          6,700          6,647         8,689
                                                       --------       --------       --------       --------      --------
Total expenses                                          101,116        111,362        111,677        103,728        98,711
                                                       --------       --------       --------       --------      --------
Income (loss) before income taxes                           236         (6,818)        (3,033)         5,422         8,257
Provision (benefit) for income taxes                       (895)        (2,999)        (1,885)         1,224         2,334
                                                       --------       --------       --------       --------      --------
Net income (loss)                                      $  1,131       $ (3,819)      $ (1,148)      $  4,198      $  5,923
                                                       ========       ========       ========       ========      ========
Earnings (loss) per share:
Basic                                                  $    .36       $  (1.19)      $   (.36)      $   1.41      $   2.05
                                                       ========       ========       ========       ========      ========
Diluted                                                $    .36       $  (1.19)      $   (.36)      $   1.41      $   2.04
                                                       ========       ========       ========       ========      ========
Weighted average number of shares
     outstanding:
Basic                                                     3,158          3,214          3,174          2,973         2,895
Diluted                                                   3,177          3,219          3,182          2,980         2,904

Balance Sheet Data: (at year end)
---------------------------------
Total investments                                      $170,747       $192,218       $201,597       $210,244      $215,172
Total assets                                            227,750        252,808        262,123        273,974       274,523
Reserve for losses and loss
       adjustment expenses                              104,015        119,722        133,479        141,205       136,685
Unearned premiums                                        45,449         48,773         49,710         50,406        49,382
Stockholders' equity                                     67,279         69,970         65,029         67,462        71,783

Dividend Data:
--------------
Cash dividend per common share                         $    .20       $    .20       $    .20       $    .20      $    .20
</TABLE>

<PAGE>   22

"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995:

Certain statements made in this Annual Report on Form 10-K constitute
forward-looking statements and are made pursuant to the safe harbor provisions
of the Private Securities Litigation Reform Act of 1995. Such forward-looking
statements involve certain assumptions, risks and uncertainties that could cause
actual results to differ materially from those included in or contemplated by
those statements. These assumptions, risks and uncertainties include, but are
not limited to, those associated with factors affecting the property and
casualty insurance industry generally, including price competition, size and
frequency of claims, increasing crime rates, escalating damage awards, natural
disasters, fluctuations in interest rates and general business conditions; the
Company's dependence on investment income; the geographic concentration of the
Company's business in the northeastern United States and in particular in New
York, New Hampshire, New Jersey, Rhode Island, Pennsylvania and Massachusetts;
the adequacy of the Company's loss reserves; government regulation of the
insurance industry; exposure to environmental claims; dependence of the Company
on its relationship with Mutual; and the other risks and uncertainties discussed
or indicated in all documents filed by the Company with the Commission. The
Company expressly disclaims any obligation to update any forward-looking
statements as a result of developments occurring after the filing of this
report.


<PAGE>   23

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

1998 Compared to 1997.
----------------------

       Total revenues for 1998 were $106,968,000, a decrease of $2,182,000, or
2%, from $109,150,000 in 1997.

       Direct premiums written for 1998 were $98,956,000, a decrease of
$2,108,000, or 2%, from $101,064,000 in 1997. Net written premiums for 1998 were
$92,758,000, a decrease of $4,053,000, or 4%, from $96,811,000 in 1997.

       Voluntary personal lines direct premiums written for 1998 were
$39,518,000, substantially unchanged from $39,415,000 in 1997. Private passenger
automobile direct premiums written, which comprised 78% and 79% of total
voluntary personal lines direct premiums written in 1998 and 1997, respectively,
decreased 1% in 1998 compared to 1997 primarily due to intensified price-based
market competition. Homeowners direct premiums written increased 5% in 1998
compared to 1997 due to a 5% increase in average premium per policy.

       Voluntary commercial lines direct premiums written for 1998 were
$54,246,000, an increase of 5% from $51,572,000 in 1997. This increase resulted
primarily from a $1,260,000, or 9%, increase in commercial auto direct premiums
written, a $1,014,000, or 17%, increase in workers' compensation direct premiums
written and a $530,000, or 6%, increase in commercial package policies direct
premiums written.

       The increase in commercial auto direct premiums written was primarily due
to an 8% increase in average premium per policy at December 31, 1998 compared to
December 31, 1997. The increase in workers' compensation direct premiums written
was due to a 36% increase in new business units (policies written by the Company
for the first time) in 1998 as compared to 1997. The increase in commercial
package policy direct premiums written was due to an 11% increase in policies in
force at December 31, 1998 compared to 1997, partially offset by a 3% decrease
in average premium size.

       Involuntary direct premiums written, primarily involuntary private
passenger automobile insurance, which comprised 5% and 10% of total direct
premiums written during 1998 and 1997, respectively, were $5,192,000 for 1998
compared to $10,077,000 in 1997. This 48% decrease resulted primarily from
decreased mandatory assignments from the New York Automobile Insurance Plan
("NYAIP"), which provides coverage for individuals who are unable to obtain auto
insurance in the voluntary market. During 1998 the Plan adjusted its assignments
as a result of having over assigned policies to the Company in 1997 and an
overall decrease in the NYAIP's pool of business. Assignments from the NYAIP
vary depending upon a company's private passenger automobile market share and
the size of the NYAIP.

       Net premiums earned for 1998 were $93,540,000, a decrease of $2,514,000,
or 3%, from $96,054,000 in 1997. Net premiums earned decreased primarily due to
a $2,503,000 (22%) decrease in involuntary earned premiums.


<PAGE>   24




       Net investment income was $13,277,000 in 1998, an increase of 4% from
$12,770,000 in 1997, due to a 5% increase in average invested assets. Realized
investment losses were $2,000 in 1998 compared to $112,000 of realized gains in
1997.

       Net losses and LAE were $65,234,000 for 1998, a decrease of 9% from
$71,627,000 in 1997. The loss and LAE ratio decreased to 69.7% in 1998 from
74.6% in 1997. The decrease in net losses and LAE resulted from the fact that
there was a net decrease of $2,145,000 recorded during 1998 for losses occurring
in prior accident years. The Company recorded an increase to its reserves for
losses related to prior accident years of $4,508,000 in 1997.

       Involuntary automobile insurance business increased the Company's
calendar year loss and LAE ratio by approximately 3.5 and 3.4 percentage points
for the years ended December 31, 1998 and 1997, respectively. The combined ratio
on involuntary automobile business was greater than the combined ratio on
voluntary automobile business.

       The ratio of policy acquisition costs and other underwriting expenses to
net premiums earned increased to 35.8% in 1998 from 33.4% in 1997 primarily due
to increased agency incentive commissions related to the Company's improved
underwriting results.

       Commissions, premium taxes and other state assessments that vary directly
with the Company's premium volume represented 21.7% and 20.8% of net premiums
earned in 1998 and 1997, respectively. The increase was due primarily to the
increase in agency incentive commissions. Certain other underwriting expenses,
such as salaries, employee benefits, and other operating expenses vary
indirectly with volume and comprise the remainder of the Company's underwriting
expenses.

       The amounts recorded by the Company for income taxes in 1998 and 1997
differed from those calculated using the statutory federal income tax rate
primarily due to tax exempt bond income.

1997 Compared to 1996.
----------------------

       Total revenues, net premiums earned, net premiums written and direct
premiums written were all substantially unchanged when compared to 1996. Total
revenues for 1997 were $109,150,000, compared to $108,644,000 in 1996. Net
premiums earned for 1997 were $96,054,000, compared to $95,752,000 in 1996. Net
premiums written for 1997 were $96,811,000, compared to $96,622,000 in 1996.
Direct premiums written for 1997 were $101,064,000, compared to $101,007,000 in
1996.

       Voluntary personal lines direct premiums written for 1997 were
$39,415,000, an increase of 5% from $37,616,000 in 1996. Private passenger
automobile direct premiums written, which comprised 79% of total voluntary
personal lines direct premiums written in 1997 and 1996, increased 5% in 1997
compared to 1996. This increase resulted primarily from a 6% increase in average
premium per policy at December 31, 1997 compared to December 31, 1996.
Homeowners direct premiums written increased 4% in 1997 compared to 1996 due to
a 6% increase in average premium per policy.

       Voluntary commercial lines direct premiums written for 1997 were
$51,572,000, a decrease of 7% from $55,467,000 in 1996. This decrease resulted
primarily from a $2,416,000, or 28%, decrease in workers' compensation direct
premiums written and an $804,000, or 5%, decrease in commercial

<PAGE>   25



auto direct premiums written. The decrease in workers' compensation direct
premiums written resulted from the Company's decision in late 1996 to exit
certain unprofitable classes of that business starting in late 1996 and
continuing throughout 1997. The decrease in commercial auto direct premiums
written was due to a 4% decrease in policies in force at December 31, 1997
compared to December 31, 1996, which resulted in part from the Company's
decision not to write certain related workers' compensation policies.

       Involuntary direct premiums written, primarily involuntary private
passenger automobile insurance, which comprised 10% and 8% of total direct
premiums written during 1997 and 1996, respectively, were $10,077,000 for 1997
compared to $7,923,000 in 1996. This 27% increase resulted from increased
assignments from the NYAIP.

       Net investment income was $12,770,000 in 1997, an increase of 9% from
$11,724,000 in 1996, primarily due to a 4% increase in average invested assets
and a 5% increase in the investment portfolio yield. Realized investment gains
were $112,000 in 1997 compared to $996,000 in 1996.

       Losses and LAE were $71,627,000 for 1997, a decrease of 10% from
$79,603,000 in 1996. The loss and LAE ratio decreased to 74.6% in 1997 from
83.1% in 1996. In 1997, the Company recorded increases to its reserve for losses
that occurred prior to 1997, primarily for its workers' compensation line of
business. The net increase in the reserve for prior year losses and LAE was
$4,508,000 and added 4.7 percentage points to the loss and LAE ratio in 1997.
Losses and LAE in 1996 included a $6,896,000 increase in reserves for accidents
that occurred prior to 1996, which added 7.2 percentage points to the loss and
LAE ratio in 1996.

       Losses and LAE in 1996 included $2,200,000 of higher than normal losses
related to unusually severe winter weather that affected the northeastern United
States during the first quarter of 1996. These higher than normal weather
related losses increased the 1996 loss and LAE ratio by 2.3 percentage points.
There were no such higher than normal weather related losses in 1997.

       Involuntary automobile insurance business increased the Company's
calendar year loss and LAE ratio by approximately 3.4 and .7 percentage points
for the years ended December 31, 1997 and 1996, respectively.

       The ratio of policy acquisition costs and other underwriting expenses to
net premiums earned decreased to 33.4% in 1997 from 33.5% in 1996.

       Commissions, premium taxes and other state assessments that vary directly
with the Company's premium volume represented 20.8% and 22.0% of net premiums
earned in 1997 and 1996, respectively. Certain other underwriting expenses, such
as salaries, employee benefits, and other operating expenses vary indirectly
with volume and comprise the remainder of the Company's underwriting expenses.

       The Company recorded an income tax provision in 1997 and an income tax
benefit in 1996. The amounts recorded for income taxes differed from those
calculated using the statutory federal income tax rate primarily due to tax
exempt bond income.


<PAGE>   26




Liquidity and Capital Resources
-------------------------------

       In developing its investment strategy, the Company determines a level of
cash and short-term investments which, when combined with expected cash flow, is
estimated to be adequate to meet expected cash obligations. Historically, the
excess of premiums collected over payments on claims, combined with cash income
from investments, has provided the Company with short-term funds in excess of
normal operating demands for cash.

       Net cash provided by operations decreased by $5,234,000, or 55%, from
$9,533,000 in 1997 to $4,299,000 in 1998 primarily due to a $1,981,000 decrease
in the collection of premiums, a $2,144,000 increase in the payment of losses
and LAE and a $1,337,000 increase in income taxes paid.

       Net cash used in investing activities decreased $1,478,000, or 25%, from
$5,905,000 in 1997 to $4,427,000 in 1998. This decrease resulted primarily from
a $6,625,000 net decrease in cash used to purchase fixed maturities, and a
$2,067,000 decrease in cash used to acquire preferred stock, partly offset by a
net increase in cash used to purchase short-term investments ($5,588,000).

       Net cash provided by financing activities increased $3,763,000 from a
$3,629,000 use of cash in 1997 to a $134,000 source of cash in 1998, primarily
due to a $2,048,000 increase in receipts from the Company's affiliate to settle
monthly transactions under the Management Agreement.

       The Company's objectives with respect to its investment portfolio include
maximizing total return while protecting policyholders' surplus, maintaining
flexibility and liquidity, and maintaining a reasonable duration match between
assets and liabilities. Like other property and casualty insurers, the Company
relies on premiums as a major source of cash, and therefore liquidity. Cash
flows from the Company's investment portfolio, either in the form of interest or
principal payments, are an additional source of liquidity. Because the duration
of the Company's investment portfolio relative to the duration of its
liabilities is carefully managed, increases or decreases in market interest
rates are not expected to have a material effect on the Company's liquidity, or
its results of operations.

       The Company generally designates newly acquired fixed maturity
investments as available for sale and carries these investments at fair value.
Unrealized gains and losses related to these investments are recorded as
accumulated other comprehensive income within stockholders' equity. At December
31, 1998, the Company had recorded $1,173,000 of unrealized gains, net of tax,
associated with its fixed maturity investments as accumulated other
comprehensive income. During 1998 the Company recorded $112,000 of unrealized
gains, net of tax, related to its investment portfolio as a component of other
comprehensive income.

       At December 31, 1998, the Company's portfolio of fixed maturity
investments represented 91.9% of invested assets. Management believes that this
level of bond holdings is consistent with the Company's liquidity needs because
it anticipates that cash receipts from net premiums written and investment
income will enable the Company to satisfy its cash obligations. Furthermore, a
portion of the Company's bond portfolio is invested in mortgage-backed and other
asset-backed securities which, in addition to interest income, provide monthly
paydowns of bond principal.

       At December 31, 1998, $126,250,000, or 63.8%, of the Company's fixed
maturity portfolio was invested in mortgage-backed and other asset- backed
securities. The Company invests in a


<PAGE>   27



variety of collateralized mortgage obligation ("CMO") products but has not
invested in the derivative type of CMO products such as interest only, principal
only or inverse floating rate securities. All of the Company's CMO investments
have an active secondary market and their effect on the Company's liquidity does
not differ from that of other fixed maturity investments. The Company does not
own any other derivative financial instruments.

       At December 31, 1998, $6,706,000, or 3%, of the Company's investment
portfolio was invested in non-investment grade securities, compared to $861,000,
or .4%, at December 31, 1997.

       During 1998 the Company repurchased 58,800 shares of its common stock at
an average price of $20.26 and was holding 378,400 shares in treasury as of
December 31, 1998.

       As a holding company, the Company is dependent upon cash dividends from
MNH to meet its obligations and to pay any cash dividends. MNH is subject to New
Hampshire insurance laws which place certain restrictions on its ability to pay
dividends without the prior approval of state regulatory authorities. These
restrictions limit dividends to those that, when added to all other dividends
paid within the preceding twelve months, would not exceed 10% of the insurer's
policyholders' surplus as of the preceding December 31. The maximum amount of
dividends that MNH could pay during any twelve month period ending in 1999
without the prior approval of the New Hampshire Insurance Commissioner is
$5,058,000. The Company paid a $.05 per share quarterly cash dividend to its
common stockholders totaling $579,000 in 1998.

       Industry and regulatory guidelines suggest that the ratio of a property
and casualty insurer's annual net premiums written to its statutory surplus
should not exceed 3 to 1. The Company has consistently followed a business
strategy that would allow MNH to meet this 3 to 1 regulatory guideline. MNH's
ratio of net premiums written to statutory surplus for 1998 was 1.8 to 1.

Year 2000
---------

The Year 2000 issue relates to the way in which information systems distinguish
date data between the twentieth and twenty-first centuries. Also, many systems
and equipment that are not typically thought of as relating to computers contain
embedded hardware or software ("non-IT") that may have a time element.

Under the Management Agreement, Mutual is responsible for the Company's being
Year 2000 compliant. The Company is relying upon the expertise of Mutual's
employees for assuring that the necessary precautions for Year 2000 compliance
are taken. Mutual has advised the Company that the process of preparing all of
its computer systems to be Year 2000 compliant is substantially completed.
Mutual began work on becoming Year 2000 compliant in 1996. The scope of the
project includes: ensuring the compliance of all computer software applications
and operating systems, mainframe, mid-range and personal computers, local and
wide-area networks, and telecommunications equipment; addressing issues related
to non-IT embedded software and equipment; remediation of affected systems and
equipment; and addressing the compliance of key suppliers.

The project has three phases: assessment of systems, equipment and business
relationships affected by the Year 2000 issue; definition of strategies
necessary to address affected systems and relationships; and remediation or
replacement and testing of affected systems, equipment and relationships.


<PAGE>   28




Mutual's target for completing all phases of the project is the fourth quarter
of 1999. Mutual has completed the assessment and strategy phases for all
systems. Mutual began converting to a mid-range computer based policy and claims
system known as "MOST" (Merchants Optimum Services & Technology) in 1994. The
final phase of the conversion to MOST was completed in October 1998. All new
business and policy renewals for all products are now processed on the MOST
system. Mutual has advised the Company that it believes the MOST system, its
mainframe, mid-range and personal computers, and its local area networks are
substantially Year 2000 compliant.

Mutual and the Company depend upon a number of key business partners and
suppliers. As part of its Year 2000 project, Mutual has identified key business
partners, vendors, suppliers, and service providers with whom it and the Company
conduct business, and has made substantial progress in contacting these
organizations to determine their Year 2000 readiness. Based upon the responses
to Mutual's inquiries to these organizations, Mutual has taken and will continue
to take appropriate actions. In certain instances where it may not be possible
to verify with certainty a supplier's Year 2000 compliance (for example, it may
not be possible for Mutual to test the operational ability of its
telecommunications, electricity or gas service suppliers in a Year 2000
environment) and where alternate sources of supply are not feasible, Mutual and
the Company may have to rely on the assurances of the supplier.

The Company estimates that its share of the total expenses associated with
becoming Year 2000 compliant will total approximately $290,000. Approximately
$150,000 of the expenses have been for external costs, which include
approximately $112,000 in outside consultant expenses and $38,000 for specific
upgrades of software to address Year 2000 compliance, and $140,000 of the
expenses have been for internal resources dedicated to achieving Year 2000
compliance. It is estimated that any remaining external or internal costs will
not be material. The Company estimates its share of costs incurred in 1998 to be
$210,000, which has been expensed. There has not been a material impact on the
Company's results of operations or financial condition as a result of
information technology projects being deferred due to resource constraints
caused by the Year 2000 project.

Although based on the successful implementation of the MOST system Mutual has
notified the Company that it believes that critical systems are substantially
Year 2000 compliant and that to the best of Mutual's knowledge, the likelihood
that critical systems will have a failure that materially affects operating
results is remote. Mutual also informed the Company that testing will continue
as needed to assure that systems are Year 2000 compliant and that any situation
that develops which needs to be addressed will be corrected by January 1, 2000.
Mutual is continuing to work with third party vendors to assess their ability to
operate in the Year 2000, to assess third-party remediation plans, and to take
steps to identify and transfer support to third party vendors who are Year 2000
compliant. The Company will continue to monitor and assess the reasonably likely
worst case Year 2000 scenario and plans to have contingency plans, as required,
in place by mid-1999. If the Company does not complete its Year 2000 program
prior to the commencement of the Year 2000, if it fails to identify and
remediate all critical Year 2000 problems, or if major suppliers or customers
experience material Year 2000 problems, the Company's results of operations or
financial condition could be materially affected.

MNH continues to evaluate the complex issues related to insurance coverage for
losses arising from the various possible situations involving Year 2000 problems
and its potential liability to its insureds. The Company believes that the
coverages MNH provides do not extend to the types of losses which are most
likely to occur as a result of Year 2000 problems. MNH plans to use coverage
exclusion endorsements based on its evaluation of the potential exposure to Year
2000 problems for certain classes of commercial risks, and has adopted
endorsements to its policies based on forms provided and filed for approval with


<PAGE>   29


various regulatory authorities by the Insurance Services Office, Inc. Use of
these special endorsements is governed by the law and regulatory policies of
states in which MNH is authorized to do business.

It is possible, however, that future court interpretations of policy language
based on specific facts, or legislation mandating coverage, could result in
coverage for losses attributable to Year 2000 problems. Such decisions or
legislation could have a material adverse impact MNH's results of operations and
financial condition. It is also possible that MNH may incur expenses defending
claims for which it is ultimately determined there is no insurance coverage. MNH
has made no provision for reserves for losses or LAE on claims based on
potential Year 2000 problems.

Environmental Claims
--------------------

       MNH, like many other property and casualty insurance companies, is
subject to environmental damage claims asserted by or against its insureds.
Management of the Company is of the opinion that based on various court
decisions throughout the country, such claims should not be recoverable under
the terms of MNH's insurance policies because of either specific or general
coverage exclusions contained in the policies. However, there is no assurance
that the courts will agree with MNH's position in every case, nor can there be
assurance that material claims will not be asserted under policies which a court
will find do not explicitly or implicitly exclude claims for environmental
damages. Management, however, is not aware of any pending claim or group of
claims which would result in a liability that would have a material adverse
effect on the financial condition of the Company or MNH.

Inflation
---------

       Inflation affects the Company, like other companies in the property and
casualty insurance industry, by contributing to higher losses, LAE and operating
costs, as well as greater investment income resulting from the higher interest
rates which can prevail in an inflationary period. Premium rates, however, may
not keep pace with inflation since competitive forces generally limit the
Company's ability to increase premium rates. The Company considers inflationary
trends in estimating its reserves for claims reported and for incurred but not
reported claims.

Relationship with Mutual
------------------------

       The Company's and MNH's business and day-to-day operations are closely
aligned with those of Mutual. This is the result of a combination of factors.
Mutual has had a historical ownership interest in the Company and MNH. Prior to
November 1986 MNH was a wholly-owned subsidiary of Mutual. Following the
Company's initial public offering in November 1986 and until a secondary stock
offering in July 1993 the Company was a majority-owned subsidiary of Mutual.
Mutual currently owns 9.0% of the Company's common stock. Under the Management
Agreement, Mutual provides the Company and MNH with all facilities and personnel
to operate their business. The only officers of the Company or MNH who are paid
full time employees are employees of Mutual whose services are purchased under
the Management Agreement. Also, the operation of the Company's insurance
business, which offers substantially the same lines of insurance as Mutual
through the same independent insurance agents, creates a very close relationship
among the companies.

       During 1998, Mutual initiated discussions with the Company concerning
proposals for the acquisition of the Company by Mutual. The Company's Directors
who are not affiliated with Mutual


<PAGE>   30



(the "Independent Directors") determined that the terms proposed by Mutual were
inadequate. The Independent Directors also determined that the Management
Agreement prevents the Company's shareholders from realizing the Company's fair
value in a sale or merger, and on July 23, 1998 the Company gave notice to
Mutual of its intention to terminate the Management Agreement.

       The provisions of the Management Agreement require five year's prior
written notice for its termination. The Company does not expect the notice of
termination to have any material, short-term effect on the Company's operations.
However, the Independent Directors believe that the Management Agreement, as
currently written, creates conflicts of interest between the Company and Mutual
in their joint operations and prevents the Company's shareholders from realizing
the fair value of their shares.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk
-----------

Market risk represents the potential for loss due to changes in the fair value
of financial instruments. The market risk related to the Company's financial
instruments primarily relates to its investment portfolio. The value of the
Company's investment portfolio of $215,172,000 at December 31, 1998 is subject
to changes in interest rates and to a lesser extent on credit quality. Further,
certain mortgage-backed and asset-backed securities are exposed to accelerated
prepayment risk generally caused by interest rate movements. If interest rates
were to decline, mortgage holders would be more likely to refinance existing
mortgages at lower rates. Acceleration of future repayments could adversely
affect future investment income, if reinvestment of the accelerated receipts was
made in lower yielding securities.

The table below provides information related to the Company's fixed maturity
investments at December 31, 1998. The table presents cash flows of principal
amounts and related weighted average interest rates by expected maturity dates.
The cash flows are based upon the maturity date or, in the case of
mortgage-backed and asset-backed securities, expected payment patterns. Actual
cash flows could differ from those shown in the table.

<PAGE>   31


Fixed Maturities
----------------

Expected Cash Flows of Principal Amounts ($ in 000's):

<TABLE>
<CAPTION>
                                                                                                                           TOTAL
                                                                                                                           -----
                                                                                                                           Esti-
                                                                                                               Amor-       mated
                                                                                                 There-        tized       Market
                                     1999       2000         2001        2002         2003        after        Cost        Value
                                     ----       ----         ----        ----         ----        -----        ----        -----
Held to Maturity
----------------
<S>                                <C>        <C>         <C>        <C>          <C>          <C>          <C>          <C>     
U.S. Treasury securities and
       obligations of U.S. 
       Government corporations
       and agencies                $     0    $ 1,647     $     0    $     0      $     0      $     0      $  1,647     $  1,635
    Average interest rate              0.0%       5.4%        0.0%       0.0%         0.0%         0.0%           --           --

Mortgage & asset backed
       securities                    4,799      2,514       2,972      1,071        1,933        2,064        15,353       16,121
    Average interest rate              8.0%       7.8%        7.7%       7.7%         7.5%         7.3%           --           --
                                   -------    -------     -------    -------      -------      -------      --------     --------

Total                              $ 4,799    $ 4,161     $ 2,972    $ 1,071      $ 1,933      $ 2,064      $ 17,000     $ 17,756
                                   =======    =======     =======    =======      =======      =======      ========     ========

Available for Sale
------------------

U.S. Treasury securities and
       obligations of U.S. 
       Government corporations
       and agencies                $ 5,005    $ 7,400     $     0    $   350      $     0      $     0      $ 12,755     $ 12,776
    Average interest rate              4.7%       5.3%        0.0%       6.3%         0.0%         0.0%           --           --

Obligations of states and
       political subdivisions          701     11,858      10,812      1,708            0        1,455        26,534       27,066
    Average interest rate              4.9%       4.8%        4.9%       5.6%         0.0%         5.4%           --           --

Corporate securities                 6,711      3,601       1,104     10,233        6,912          825        29,386       30,045
    Average interest rate              6.0%       5.5%        6.9%       7.1%         8.5%         8.6%           --           --

Mortgage & asset
       backed securities            34,375     19,561      21,136     17,338        2,779       14,777       109,966      110,897
    Average interest rate              6.8%       6.9%        6.9%       7.0%         7.1%         7.2%           --           -- 
                                   -------    -------     -------    -------      -------      -------      --------     --------

Total                              $46,792    $42,420     $33,052    $29,629      $ 9,691      $17,057      $178,641     $180,784
                                   =======    =======     =======    =======      =======      =======      ========     ========
</TABLE>


<PAGE>   32

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

       The consolidated financial statements required in response to this Item
are submitted as part of Item 14 (a) of this report, and are incorporated in
this item by reference.

       Quarterly data for the two most recent fiscal years is set forth below:


<TABLE>
<CAPTION>
                                                             Three months ended
                                                             ------------------
                                                3/31         6/30          9/30         12/31
                                                ----         ----          ----         -----
                                                  (in thousands, except per share amounts)

<S>                                           <C>          <C>           <C>           <C>     
1998
----
   Net premiums earned                         $23,740      $23,875       $23,448       $22,477
   Net investment income                         3,290        3,331         3,317         3,339
   Net realized investment gains (losses)           --           --            (2)           --  
   Other revenues                                   42           42            51            18
                                               -------      -------       -------       -------
   Total revenues                              $27,072      $27,248       $26,814       $25,834
                                               =======      =======       =======       =======
   Income before income taxes                  $ 1,846      $ 2,098       $ 2,041       $ 2,272
   Net income                                  $ 1,346      $ 1,520       $ 1,483       $ 1,574
   Net income per diluted share                $   .46      $   .52       $   .51       $   .55
                                                                                               
1997                                                                                         
----                                                                                         
   Net premiums earned                         $23,000      $24,158       $23,764       $25,132
   Net investment income                         3,029        3,190         3,223         3,328
   Net realized investment gains (losses)          107           (4)            9            --
   Other revenues                                   61           25            77            51
                                               -------      -------       -------       -------
   Total revenues                              $26,197      $27,369       $$7,073       $28,511
                                               =======      =======       =======       =======
   Income before income taxes                  $   617      $ 1,395       $ 1,689       $ 1,721
   Net income                                  $   481      $ 1,059       $ 1,289       $ 1,369
   Net income per diluted share                $   .16      $   .35       $   .43       $   .47
</TABLE>


Item 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE.

None.


<PAGE>   33


                                    PART III


Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

       The information in response to this item is incorporated by reference
herein to the information under the caption "Election of Directors" presented in
the Company's definitive proxy statement filed or to be filed pursuant to
Regulation 14A and used in connection with the Company's 1999 Annual Meeting of
Shareholders to be held on or about May 5, 1999.

Item 11. EXECUTIVE COMPENSATION.

       The information in response to this item is incorporated by reference
herein to the information under the caption "Executive Compensation" and
"Compensation of Directors" presented in the Company's definitive proxy
statement filed or to be filed pursuant to Regulation 14A and used in connection
with the Company's 1999 Annual Meeting of Shareholders to be held on or about
May 5, 1999, provided, however that information appearing under the captions
"Compensation Committee Report on Executive Compensation" and "Performance
Comparison" is not incorporated herein and should not be deemed to be included
in this document for any purpose.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND 
         MANAGEMENT.

       The information in response to this item is incorporated by reference
herein to the information under the caption "Security Ownership of Certain
Beneficial Owners" and "Security Ownership of Management" presented in the
Company's definitive proxy statement filed or to be filed pursuant to Regulation
14A and used in connection with the Company's 1999 Annual Meeting of
Stockholders to be held on or about May 5, 1999.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

       The information in response to this item is incorporated herein by
reference to the information under the caption "Management Agreement" and
"Certain Transactions" presented in the Company's definitive proxy statement
filed or to be filed pursuant to Regulation 14A and used in connection with the
Company's 1999 Annual Meeting of Shareholders to be held on or about May 5,
1999.


<PAGE>   34



                                     PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

    (a) (1)  The following financial statements of Merchants Group, Inc. are
             included on pages F-1 to F-22:

             Report of Independent Accountants

             Consolidated Balance Sheet - December 31, 1997 and 1998.
             
             Consolidated Statement of Operations - Years ended December 31,
             1996, 1997 and 1998.

             Consolidated Statement of Changes in Stockholders' Equity - Years
             ended December 31, 1996, 1997 and 1998.

             Consolidated Statement of Cash Flows - Years ended December 31,
             1996, 1997 and 1998. 

             Notes to Consolidated Financial Statements.

       (2)   The following financial statement schedules of Merchants Group, 
             Inc. are filed herewith pursuant to Item 8:

              Schedule I -
                  Summary of Investments - Other Than Investments in Related 
                  Parties.

              Schedule II -
                  Amounts Receivable From/Payable to Related Parties, and
                  Underwriters, Promoters and Employees Other Than Related
                  Parties.

              Schedule III -
                  Condensed Financial Information of Registrant.

              Schedule V -
                  Supplemental Insurance Information (see Schedule X).

              Schedule VI - Reinsurance

              Schedule X  -
                  Supplemental Insurance Information Concerning Property - 
                  Casualty Subsidiaries

    (b)      Reports on Form 8-K.
             There were no reports on Form 8-K filed for the quarter ended
             December 31, 1998.

    (c)      Exhibits required by Item 601 of Regulation S-K:

             (3)  (a)   Restated Certificate of Incorporation (incorporated by
                        reference to Exhibit No. 3C to Amendment No. 1 to the
                        Company's Registration Statement (No. 33-9188) on 
                        Form S-1 filed on November 7, 1986).

                  (b)   Restated By-laws (incorporated by reference to Exhibit
                        No. 3D to Amendment No. 1 to the Company's Registration
                        Statement (No. 33-9188) on Form S-1 filed on 
                        November 7, 1986).


<PAGE>   35

             (10) (a)   Management Agreement dated as of September 29, 1986 by
                        and among Merchants Mutual Insurance Company, Registrant
                        and Merchants Insurance Company of New Hampshire, Inc.
                        (incorporated by reference to Exhibit No. 10A to the
                        Company's Registration Statement (No. 33-9188) on Form
                        S-1 filed on September 30, 1986).

                  (b)   Agreement of Reinsurance No. 6922 between Merchants
                        Mutual Insurance Company, Merchants Insurance Company of
                        New Hampshire, Inc. and General Reinsurance Corporation
                        (incorporated by reference to Exhibit No. 10E to the
                        Company's Registration Statement (No. 33-9188) on Form
                        S-1 filed on September 30, 1986).

                  (c)   Agreement of Reinsurance No. 7299 between Merchants
                        Mutual Insurance Company, Merchants Insurance Company of
                        New Hampshire, Inc. and General Reinsurance Corporation,
                        (incorporated by reference to Exhibit No. 10o to the
                        Company's 1987 Annual Report on Form 10-K (File No.
                        1-9640) filed on March 19, 1988).

                  (d)   Agreement of Reinsurance dated January 27, 1993, between
                        Merchants Mutual Insurance Company and Merchants
                        Insurance Company of New Hampshire, Inc. (incorporated
                        by reference to Exhibit (3) in the Company's Current
                        Report on Form 8-K (File No. 1-9640) filed on January
                        29, 1993).

                  (e)   Agreement of Reinsurance No. 8009 between Merchants
                        Mutual Insurance Company, Merchants Insurance Company of
                        New Hampshire, Inc. and General Reinsurance Corporation,
                        (incorporated by reference to Exhibit 10e to the
                        Company's 1995 Annual Report on Form 10-K filed on March
                        28, 1996).

                  (f)   Property Catastrophe Reinsurance Agreement (HCI
                        Agreement No. 439) between Merchants Mutual Insurance
                        Company, Merchants Insurance Company of New Hampshire,
                        Inc. and General Reinsurance Corporation, et. al., dated
                        January 1, 1997, (incorporated by reference to Exhibit
                        No. 10f to the Company's 1996 Annual Report on Form 10-K
                        filed on March 28, 1997).

                   (g)  Property and Casualty Excess of Loss Reinsurance
                        Agreement between Merchants Mutual Insurance Company,
                        Merchants Insurance Company of New Hampshire, Inc. and
                        American Reinsurance Company, including endorsement,
                        (filed herewith).

                   (h)  Property Catastrophe Excess of Loss Reinsurance
                        Agreement between Merchants Mutual Insurance Company,
                        Merchants Insurance Company of New Hampshire, Inc. and
                        the Subscribing Reinsurers Executing the Interest and
                        Liabilities Contracts attached to this agreement,
                        effective January 1, 1998 (filed herewith).

               *   (i)  Merchants Mutual Capital Accumulation Plan (incorporated
                        by reference to Exhibit No. 10G to the Company's
                        Registration Statement (No. 33-9188) on Form S-1 filed
                        on September 30, 1986).


<PAGE>   36


               * (j)    Merchants Mutual Capital Accumulation Plan, fourth
                        amendment, effective January 1, 1996 (incorporated by
                        referenced to Exhibit 10(h) to the Company's 1996 Annual
                        Report on Form 10-K (File No. 1-9640) filed on March 28,
                        1997).

               * (k)    Merchants Mutual Capital Accumulation Plan Trust
                        Agreement (restated as of January 1, 1996 (incorporated
                        by reference to Exhibit 10(i) to the Company's 1996
                        Annual Report on Form 10-K (File No. 1-9640) filed on
                        March 28, 1997).

               * (l)    Merchants Mutual Supplemental Executive Retirement Plan
                        dated as of December 29, 1989 and Agreement of Trust
                        dated as of December 29, 1989 (incorporated by reference
                        to Exhibit No. 10K to the Company's 1989 Annual Report
                        on Form 10-K (File No. 1-9640) filed on March 21, 1990).

               * (m)    Amendment dated June 10, 1992 to Agreement of Trust
                        under Merchants Mutual Supplemental Executive Retirement
                        Plan dated as of December 29, 1989 (incorporated by
                        reference to Exhibit No. 10R to the Company's 1992
                        Annual Report on Form 10-K (File No. 1-9640) filed on
                        March 31, 1993).

               * (n)    Merchants Group, Inc. 1986 Stock Option Plan As Amended
                        Through February 16, 1993 (incorporated by reference to
                        Exhibit No. 10E to the Company's 1992 Annual Report on
                        Form 10-K (File No. 1-9640) filed on March 31, 1993).

               * (o)    Form of Amended Indemnification Agreement entered into
                        by Registrant with each director and executive office of
                        Registrant (incorporated by reference to Exhibit No. 10N
                        to Amendment No. 1 to the Company's Registration
                        Statement on (No. 33-9188) Form S-1 filed on November 7,
                        1986).

               * (p)    Merchants Mutual Insurance Company Incentive
                        Compensation Plan, as amended January 24, 1996
                        (incorporated by reference to Exhibit No. 10(n) to the
                        Company's 1996 Annual Report on Form 10-K (File No.
                        1-9640) filed on March 28, 1997).

               * (q)    Employment Agreement between Robert M. Zak and Merchants
                        Mutual Insurance Company dated as of June 1, 1994
                        (incorporated by reference to Exhibit No. 10O to the
                        Company's 1994 Annual Report on Form 10-K (File No.
                        1-9640) filed on March 31, 1995).

                 (r)    Employee Retention Agreement between Edward M. Murphy 
                        and Merchant Mutual Insurance Company dated as of 
                        March 1, 1999 (filed herewith).

                 (s)    Employee Retention Agreement between Kenneth J. Wilson
                        and Merchants Mutual Insurance Company dated as of 
                        March 1, 1999 (filed herewith).


            (11) (a)    Statement re computation of per share earnings
                        (incorporated herein by reference to Note 1 to the
                        Consolidated Financial Statements included in Item 8).

            (21)        List of Subsidiaries of Registrant (incorporated by
                        reference to Exhibit No. 22 to the Company's
                        Registration Statement ( No. 33-9188) on Form S-1 filed
                        on September 30, 1986).


<PAGE>   37


            (23)        Consent of Independent Accountants (filed herewith).

            (27)        Financial Data Schedule (filed herewith).

*  Indicates a management contract or compensation plan or arrangement.




<PAGE>   38



                              MERCHANTS GROUP, INC.
                      SCHEDULE I - SUMMARY OF INVESTMENTS -
                    OTHER THAN INVESTMENTS IN RELATED PARTIES
                                December 31, 1998
                                 (in thousands)


<TABLE>
<CAPTION>
                                                                         Amount at   
                                                                        which shown  
                                          Amortized Cost/    Market   in the balance 
Type of Investment                             Cost           value        sheet    
------------------                             ----           -----        -----    

<S>                                         <C>             <C>          <C>         
Fixed maturities:                                                                    
                                                                                     
United States Government and                                                         
    government agencies and authorities     $ 14,402        $ 14,411     $ 14,423    
Corporate bonds                               29,386          30,045       30,045    
Mortgage and asset backed securities         125,319         127,018      126,250    
Tax exempt bonds                              26,534          27,066       27,066    
                                            --------        --------     --------    
                                                                                     
       Total fixed maturities                195,641         198,540      197,784    
                                                                                     
Preferred stocks                              10,099          10,373       10,373    
                                                                                     
Short-term investments                         6,280           6,280        6,280    
                                                                                     
Other                                            735             735          735    
                                            --------        --------     --------    
                                            $212,755        $215,928     $215,172    
                                            ========        ========     ========    
</TABLE>



<PAGE>   39



                              MERCHANTS GROUP, INC.
        SCHEDULE II - AMOUNTS RECEIVABLE FROM/PAYABLE TO RELATED PARTIES,
                 AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER
                              THAN RELATED PARTIES
                  Years ended December 31, 1996, 1997 and 1998
                                 (in thousands)


<TABLE>
<CAPTION>
                                                   1996         1997        1998
                                                   ----         ----        ----

<S>                                               <C>          <C>         <C>
Receivable from (payable to) Merchants Mutual
  Insurance Company(1):

Balance at beginning of period                    $ 1,091      $   327     $   527
Increase (decrease)                                  (764)         200      (1,848)
                                                  -------      -------     -------

Balance at end of period                          $   327      $   527     $(1,321)
                                                  =======      =======     ======= 
</TABLE>


(1)   Under a Management Agreement, Merchants Mutual Insurance Company
      ("Mutual") provides employees, services and facilities for Merchants
      Insurance Company of New Hampshire, Inc. ("MNH") to carry on its insurance
      business on a cost reimbursed basis. The balance in the intercompany
      receivable (payable) account indicates the amount due from (to) Mutual for
      the excess (deficiency) of premiums collected over (from) payments for
      losses, employees, services and facilities provided to MNH.


<PAGE>   40


                              MERCHANTS GROUP, INC.
          SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                (in thousands except per share and share amounts)


<TABLE>
<CAPTION>
BALANCE SHEET                                                                      December 31,
-------------                                                                      ------------
                                                                                 1997          1998
                                                                                 ----          ----

<S>                                                                             <C>           <C>
       Assets
       ------
Investment in subsidiary                                                        $67,116       $70,788
Other assets                                                                        407         1,043
                                                                                -------       -------
       Total Assets                                                             $67,523       $71,831
                                                                                =======       =======

       Liabilities and Stockholders' Equity
       ------------------------------------

Other liabilities                                                               $    61       $    48
                                                                                -------       -------
Total liabilities                                                                    61            48
                                                                                -------       -------

Stockholders' equity:
    Preferred stock, $.01 par value, authorized and
         unissued 3,000,000 shares                                                   --            --
    Preferred stock, no par value, $424.30 stated value,
         no shares issued or outstanding at December 31,
         1997 or 1998                                                                --            --
    Common stock, $.01 par value, authorized 10,000,000 shares; 
         issued and outstanding of 2,906,502 shares at December 31,
         1997 and 2,851,452 shares at December 31, 1998                              32            32
    Additional paid in capital                                                   35,455        35,511
    Treasury stock, 319,600 shares at December 31, 1997
         and 378,400 shares at December 31, 1998                                 (5,906)       (7,097)
    Accumulated other comprehensive income                                        1,061         1,173
    Accumulated earnings                                                         36,820        42,164
                                                                                -------       -------


       Total stockholders' equity                                                67,462        71,783
                                                                                -------       -------
       Total liabilities and stockholders' equity                               $67,523       $71,831
                                                                                =======       =======
</TABLE>


<PAGE>   41



                              MERCHANTS GROUP, INC.
          SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                    Continued
                                 (in thousands)



INCOME STATEMENT
----------------
 
<TABLE>
<CAPTION>
                                                         Year ended December 31,
                                                     --------------------------------

                                                       1996        1997         1998
                                                       ----        ----         ----

<S>                                                  <C>          <C>         <C>
Revenues:
       Equity in net income (loss) of subsidiary     $(1,570)     $ 4,485     $ 6,161
       Investment income                                 133           21          61
       Net realized investment gains                     902            2          --   
                                                     -------      -------     -------
              Total revenues                            (535)       4,508       6,222

Expenses:
       General and administrative expenses               281          230         337
                                                     -------      -------     -------
Operating income before income taxes                    (816)       4,278       5,885
Income tax expense (benefit)                             332           80         (38)
                                                     -------      -------     -------
              Net income (loss)                      $(1,148)     $ 4,198     $ 5,923
                                                     =======      =======     =======
</TABLE>


<PAGE>   42


                              MERCHANTS GROUP, INC.
          SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                 (in thousands)



STATEMENT OF CASH FLOWS
-----------------------

Increase (Decrease) in Cash and Cash Equivalents:

<TABLE>
<CAPTION>
                                                                                  Year ended December 31,
                                                                                  -----------------------
                                                                              1996         1997         1998
                                                                              ----         ----         ----
                                                                                     (in thousands)

<S>                                                                         <C>          <C>          <C>
Cash flows from operating activities:                                       $   560      $  (227)     $  (251)
                                                                            -------      -------      ------- 
Cash flows from investing activities:
       Receipt of subsidiary common stock dividend                               --        2,800        2,600
       Sale (purchase) of other investments, net                              2,992          853         (630)
                                                                            -------      -------      ------- 
       Cash flows from investing activities                                   2,992        3,653        1,970
                                                                            -------      -------      ------- 

Cash flows from financing activities:
       Purchase of treasury stock                                            (2,983)      (2,923)      (1,191)
       Cash dividend on common stock                                           (634)        (589)        (579)
       Exercise of common stock options                                          70           83           56
                                                                            -------      -------      ------- 
       Cash flows from financing activities                                  (3,547)      (3,429)      (1,714)
                                                                            -------      -------      ------- 

Net increase (decrease) in cash and cash equivalents                              5           (3)           5
Cash and cash equivalents, beginning of year                                      3            8            5
                                                                            -------      -------      ------- 
Cash and cash equivalents, end of year                                      $     8      $     5      $    10
                                                                            =======      =======      ======= 

Reconciliation of net income to net 
       cash provided by operations:

Net income (loss)                                                           $(1,148)     $ 4,198      $ 5,923

Adjustments to reconcile net income
       to net cash provided by operations:

              Equity in (income) loss of subsidiary                           1,570       (4,485)      (6,161)
              Net realized investment gains                                    (902)          (2)          --
              Decrease in liabilities                                          (219)         (20)         (13)
              (Increase) decrease in other
                 (non-investment) assets                                        514           93           (6)
              Other, net                                                        745          (11)           6
                                                                            -------      -------      ------- 
Net cash provided by (used in) operating activities                         $   560      $  (227)     $  (251)
                                                                            =======      =======      ======= 
</TABLE>



<PAGE>   43





                              MERCHANTS GROUP, INC.
                 SCHEDULE III - CONDENSED FINANCIAL INFORMATION



NOTES TO CONDENSED FINANCIAL STATEMENTS

       Cash dividends of $2,800,000 and $2,600,000 were paid to the Registrant
by its consolidated subsidiary in the years ended December 31, 1997 and 1998,
respectively. No cash dividends were paid to the Registrant by its consolidated
subsidiary in 1996.


<PAGE>   44


                              MERCHANTS GROUP, INC.
                            SCHEDULE VI - REINSURANCE
                    YEARS ENDED DECEMBER 31, 1996, 1997, 1998
                            (in thousands) Percentage



<TABLE>
<CAPTION>
                                                                                 Percentage
                                                Ceded      Assumed               of amount
                                    Gross     to other   from other    Net        assumed
                                    amount    companies   companies   amount       to net
                                    ------    ---------   ---------   ------       ------

<S>                                <C>          <C>        <C>        <C>           <C> 
Year ended December 31, 1996
Property and Casualty Premiums     $101,007     $7,786     $3,401     $96,622       3.5%

Year Ended December 31, 1997
Property and Casualty Premiums     $101,064     $6,895     $2,642     $96,811       2.7%

Year ended December 31, 1998
Property and Casualty Premiums     $ 98,956     $7,042     $  844     $92,758        .9%
</TABLE>

<PAGE>   45




                              MERCHANTS GROUP, INC.
           SCHEDULE X - SUPPLEMENTAL INSURANCE INFORMATION CONCERNING
                        PROPERTY - CASUALTY SUBSIDIARIES
                  Years ended December 31, 1996, 1997 and 1998
                                 (in thousands)


<TABLE>
<CAPTION>
                             Reserves                                        Losses & loss
                    Deferred for       Discount                            adjustment expenses   Amoritiza-
                    policy   losses &  if any,                     Net      incurred related to  tion of    Paid losses
                    acquis-  loss ad-  deducted           Net      invest-    (1)       (2)      deferred    & loss ad-   Direct
                    ition    justment  from     Unearned  earned   ment     Current    Prior    acquisition  justment     premium
                    costs    expenses  reserves premiums  premiums income    years     years       costs      expenses    written
                    -----    --------  -------- --------  -------- ------    -----     -----       -----      --------    -------
Yar ended:
<S>                 <C>      <C>       <C>      <C>       <C>      <C>       <C>      <C>       <C>         <C>          <C>
December 31, 1996   $12,396  $133,479  $1,113   $49,710   $95,752  $11,724   $72,771  $ 6,832     $25,374     $67,061    $101,007

December 31, 1997   $12,597  $141,205  $6,394   $50,406   $96,054  $12,770   $67,119  $ 4,508     $25,454     $67,054    $101,064

December 31, 1998   $12,390  $136,685  $9,256   $49,382   $93,540  $13,277   $67,379  $(2,145)    $24,788     $69,198    $ 98,956
</TABLE>

<PAGE>   46


                                   SIGNATURES

       Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.


                              Merchants Group, Inc.

Date: March 29, 1999       BY: /s/Robert M. Zak, Senior Vice President
                               ----------------------------------------
                                  Robert M. Zak, Senior Vice President and 
                                     Chief Operating Officer

      Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.


     SIGNATURE                   TITLE                      DATE
     ---------                   -----                      ----


/s/Richard E. Garman       Director, Chairman            March 29, 1999
-----------------------    of the Board
Richard E. Garman          


/s/Brent D. Baird          Director, President           March 29, 1999
-----------------------
Brent D. Baird


/s/Robert M. Zak           Director, Sr. VP &            March 29, 1999
-----------------------    Chief Operating
Robert M. Zak              Officer        
                           

/s/Kenneth J. Wilson       Vice President & CFO          March 29, 1999
-----------------------    (principal financial   
Kenneth J. Wilson          and accounting officer)
                           

/s/Andrew A. Alberti       Director                      March 29, 1999
-----------------------
Andrew A. Alberti


/s/Frank J. Colantuono     Director                      March 29, 1999
-----------------------
Frank J. Colantuono


/s/Henry P. Semmelhack     Director                      March 29, 1999
-----------------------
Henry P. Semmelhack
<PAGE>   47


                        Report of Independent Accountants
                        ---------------------------------




To the Board of Directors
and Stockholders of
Merchants Group, Inc.



In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) and (2) present fairly, in all material respects,
the financial position of Merchants Group, Inc. and its subsidiaries at December
31, 1998 and 1997, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles. These financial statements are
the responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.




/s/ PricewaterhouseCoopers
Buffalo, New York
February 15, 1999





                                      F-1
<PAGE>   48




                              MERCHANTS GROUP, INC.

                           CONSOLIDATED BALANCE SHEET

                                 (in thousands)


<TABLE>
<CAPTION>
                                                                      December 31,
                                                                      ------------
                                                                   1997        1998
                                                                   ----        ----
                 Assets
                 ------
<S>                                                             <C>          <C>     
Investments:
   Fixed maturities:
     Held to maturity at amortized cost                         $ 19,631     $ 17,000
     Available for sale at fair value                            174,927      180,784
Preferred stock at fair value                                     10,582       10,373
Other long-term investments at fair value                            634          735
Short-term investments                                             4,470        6,280
                                                                --------     --------
               Total investments                                 210,244      215,172
Cash
Interest due and accrued                                              10           16
Premiums receivable, net of allowance for doubtful accounts        1,858        1,923
   of $543 in 1997 and $454 in 1998
Deferred policy acquisition costs                                 21,084       20,629
Ceded reinsurance balances receivable                             12,597       12,390
Prepaid reinsurance premiums                                      11,132        9,741
Receivable from affiliate                                          2,871        2,629
Deferred federal income taxes                                        527           --
Other assets                                                       6,319        5,055
                                                                   7,332        6,968
                                                                --------     --------
               Total assets                                     $273,974     $274,523
                                                                ========     ========
</TABLE>





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



                                      F-2
<PAGE>   49



                              MERCHANTS GROUP, INC.

                           CONSOLIDATED BALANCE SHEET

                       (in thousands except share amounts)

<TABLE>
<CAPTION>
                                                                        December 31,
                                                                        ------------
                                                                    1997           1998
                                                                    ----           ----

          Liabilities and Stockholders' Equity
          ------------------------------------
<S>                                                              <C>            <C>      
Liabilities:
   Reserve for losses and loss adjustment expenses               $ 141,205      $ 136,685
   Unearned premiums                                                50,406         49,382
   Payable to affiliate                                                 --          1,321
   Other liabilities                                                14,901         15,352
                                                                 ---------      ---------

                  Total liabilities                                206,512        202,740
                                                                 ---------      ---------

Stockholders' equity:
   Common stock, issued and outstanding 2,906,502
       shares at December 31, 1997 and 2,851,452
       shares at December 31, 1998                                      32             32
   Additional paid in capital                                       35,455         35,511
   Treasury stock, 319,600 shares at December 31, 1997
        and 378,400 shares at December 31, 1998                     (5,906)        (7,097)
   Accumulated other comprehensive income                            1,061          1,173
   Accumulated earnings                                             36,820         42,164
                                                                 ---------      ---------

                  Total stockholders' equity                        67,462         71,783
                                                                 ---------      ---------

Commitments and contingent liabilities (Note 10)                        --             --

                  Total liabilities and stockholders' equity     $ 273,974      $ 274,523
                                                                 =========      =========
</TABLE>






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



                                      F-3
<PAGE>   50




                              MERCHANTS GROUP, INC.

                      CONSOLIDATED STATEMENT OF OPERATIONS

                     (in thousands except per share amounts)

<TABLE>
<CAPTION>
                                                                  Year ended December 31,
                                                                  -----------------------
                                                            1996           1997          1998
                                                            ----           ----          ----
<S>                                                      <C>            <C>           <C>      
Revenues:
   Net premiums earned                                   $  95,752      $  96,054     $  93,540
   Net investment income                                    11,724         12,770        13,277
   Net realized investment gains (losses)                      996            112            (2)
   Other revenues                                              172            214           153
                                                         ---------      ---------     ---------
       Total revenues                                      108,644        109,150       106,968
                                                         ---------      ---------     ---------

Expenses:
   Net losses and loss adjustment expenses                  79,603         71,627        65,234
   Amortization of deferred policy acquisition costs        25,374         25,454        24,788
   Other underwriting expenses                               6,700          6,647         8,689
                                                         ---------      ---------     ---------
       Total expenses                                      111,677        103,728        98,711
                                                         ---------      ---------     ---------

Income (loss) before income taxes                           (3,033)         5,422         8,257
Income tax provision (benefit)                              (1,885)         1,224         2,334
                                                         ---------      ---------     ---------
       Net income (loss)                                 $  (1,148)     $   4,198     $   5,923
                                                         =========      =========     =========

Earnings (loss) per share:
    Basic                                                $    (.36)     $    1.41     $    2.05
                                                         =========      =========     =========
    Diluted                                              $    (.36)     $    1.41     $    2.04
                                                         =========      =========     =========

Weighted average number of shares outstanding:               
   Basic                                                     3,174          2,973         2,895
   Diluted                                                   3,182          2,980         2,904
</TABLE>




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




                                      F-4
<PAGE>   51




                              MERCHANTS GROUP, INC.

                 CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

                                 (in thousands)

<TABLE>
<CAPTION>
                                                        Year ended December 31,
                                                        -----------------------
                                                    1996         1997         1998
                                                    ----         ----         ----
<S>                                               <C>          <C>          <C>    
Net income (loss)                                 $(1,148)     $ 4,198      $ 5,923
                                                  -------      -------      -------
Other comprehensive income (loss) before tax:
    Unrealized gains (losses)
          on securities                            (1,187)       2,595          185
    Reclassification adjustment
           for gains and losses included
           in net income                              814          (74)         (15)
                                                  -------      -------      -------
Other comprehensive income (loss)
    before tax                                       (373)       2,521          170
Income tax provision (benefit) related to
    items of other comprehensive income              (127)         857           58
                                                  -------      -------      -------
Other comprehensive income (loss)                    (246)       1,664          112
                                                  -------      -------      -------

Comprehensive income (loss)                       $(1,394)     $ 5,862      $ 6,035
                                                  =======      =======      =======
</TABLE>







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




                                      F-5
<PAGE>   52



                              MERCHANTS GROUP, INC.

            CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY

                                 (in thousands)

<TABLE>
<CAPTION>
                                                         Year ended December 31,
                                                         -----------------------
                                                     1996         1997          1998
                                                     ----         ----          ----
<S>                                               <C>           <C>           <C>     
Common stock:
    Beginning and end of year                     $     32      $     32      $     32
                                                  --------      --------      --------

Additional paid in capital:
    Beginning of year                               35,302        35,372        35,455
    Exercise of common stock options                    70            83            56
                                                  --------      --------      --------
    End of year                                     35,372        35,455        35,511
                                                  --------      --------      --------

Treasury stock:
    Beginning of year                                   --        (2,983)       (5,906)
    Purchase of treasury shares                     (2,983)       (2,923)       (1,191)
                                                  --------      --------      --------
    End of year                                     (2,983)       (5,906)       (7,097)
                                                  --------      --------      --------

Accumulated other comprehensive income (loss)
    Beginning of year                                 (357)         (603)        1,061
    Other comprehensive income (loss)                 (246)        1,664           112
                                                  --------      --------      --------
    End of year                                       (603)        1,061         1,173
                                                  --------      --------      --------

Accumulated earnings:
    Beginning of year                               34,993        33,211        36,820
    Net income (loss)                               (1,148)        4,198         5,923
    Cash dividends                                    (634)         (589)         (579)
                                                  --------      --------      --------
    End of year                                     33,211        36,820        42,164
                                                  --------      --------      --------

                 Total stockholders' equity       $ 65,029      $ 67,462      $ 71,783
                                                  ========      ========      ========
</TABLE>




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




                                      F-6
<PAGE>   53



                              MERCHANTS GROUP, INC.
                      CONSOLIDATED STATEMENT OF CASH FLOWS

                                 (in thousands)

<TABLE>
<CAPTION>
                                                                        Year ended December 31,
                                                                        -----------------------
                                                                    1996          1997          1998
                                                                    ----          ----          ----
<S>                                                              <C>           <C>           <C>     
Cash flows from operations:
     Collection of premiums                                      $ 96,684      $ 96,102      $ 94,121
     Payment of losses and loss adjustment expenses               (67,061)      (67,054)      (69,198)
     Payment of underwriting expenses                             (32,311)      (32,019)      (32,159)
     Investment income received                                    11,917        12,763        13,220
     Investment expenses paid                                        (287)         (309)         (341)
     Income taxes (paid) recovered                                  2,734          (164)       (1,501)
     Other cash receipts                                              188           214           157
                                                                 --------      --------      --------
         Net cash provided by operations                           11,864         9,533         4,299
                                                                 --------      --------      --------

Cash flows from investing activities:
     Proceeds from fixed maturities sold or matured                55,899        81,035        95,217
     Purchase of fixed maturities                                 (55,910)      (90,176)      (97,733)
     Net increase in preferred stock                               (6,928)       (2,067)           --
     Net (increase) decrease in other long-term investments         2,148         1,671          (101)
     Net (increase) decrease in short-term investments             (3,778)        3,778        (1,810)
     Purchase of equipment, net                                      (540)         (146)           --
                                                                 --------      --------      --------
         Net cash used in investing activities                     (9,109)       (5,905)       (4,427)
                                                                 --------      --------      --------

Cash flows from financing activities:
     Settlement of affiliate balances                                 764          (200)        1,848
     Purchase of treasury stock                                    (2,983)       (2,923)       (1,191)
     Proceeds from exercise of common stock options                    70            83            56
     Cash dividends                                                  (634)         (589)         (579)
                                                                 --------      --------      --------
         Net cash provided by (used in) financing
         activities                                                (2,783)       (3,629)          134
                                                                 --------      --------      --------
     Increase (decrease) in cash                                      (28)           (1)            6
Cash, beginning of year                                                39            11      $     10
                                                                 --------      --------      --------
Cash, end of year                                                $     11      $     10      $     16
                                                                 ========      ========      ========

                                                                                    
</TABLE>







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




                                      F-7
<PAGE>   54




                              MERCHANTS GROUP, INC.
                      CONSOLIDATED STATEMENT OF CASH FLOWS
         RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATIONS

                                 (in thousands)

<TABLE>
<CAPTION>
                                                                 Year ended December 31,
                                                                 -----------------------
                                                            1996          1997         1998
                                                            ----          ----         ----
<S>                                                      <C>           <C>           <C>     
Net income (loss)                                        $ (1,148)     $  4,198      $  5,923

Adjustments:
     Depreciation and amortization                             33           (19)         (123)
     Net realized investment (gains) losses                  (996)         (112)            2

(Increase) decrease in assets:
     Interest due and accrued                                  93           (65)          (65)
     Premiums receivable                                     (141)         (583)          455
     Deferred policy acquisition costs                       (231)         (201)          207
     Ceded reinsurance balances receivable                   (821)       (3,297)        1,391
     Prepaid reinsurance premiums                             (66)           61           242
     Federal income taxes receivable                        1,877         1,266            --
     Deferred federal income taxes                         (1,027)         (532)        1,206
     Other assets                                              35             8           154

Increase (decrease) in liabilities:
     Reserve for losses and loss adjustment expenses       13,757         7,726        (4,520)
     Unearned premiums                                        937           696        (1,024)
     Other liabilities                                       (438)          387           451
                                                         --------      --------      --------
          Net cash provided by operations                $ 11,864      $  9,533      $  4,299
                                                         ========      ========      ========
</TABLE>





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



                                      F-8
<PAGE>   55



                              MERCHANTS GROUP, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   Significant Accounting Policies

     Principles of consolidation and basis of presentation

     The consolidated financial statements of Merchants Group, Inc. (the
     "Company") include the accounts of the Company, its wholly owned
     subsidiary, Merchants Insurance Company of New Hampshire, Inc. ("MNH"), and
     M.F.C. of New York, Inc., an inactive premium finance company which is a
     wholly owned subsidiary of MNH. MNH is a stock property and casualty
     insurance company domiciled in the state of New Hampshire. MNH offers
     property and casualty insurance to preferred risk individuals and small to
     medium sized businesses in the northeast United States, primarily in New
     York, New Hampshire and New Jersey where a majority of its policies are
     written. As a holding company, the Company has had no operations.

     The consolidated financial statements have been prepared in conformity with
     generally accepted accounting principles ("GAAP") which differ in some
     respects from those followed in reports to insurance regulatory
     authorities. In its Annual Statement filed with regulatory authorities, MNH
     reported policyholders' surplus of $46,006,000 and $50,576,000 at December
     31, 1997 and 1998, respectively. MNH's net income (loss) as reported in its
     Annual Statement was ($2,788,000) in 1996, $3,481,000 in 1997 and
     $7,367,000 in 1998. All significant intercompany balances and transactions
     have been eliminated.

     The preparation of consolidated financial statements in conformity with
     GAAP requires management to make estimates and assumptions that affect the
     reported amounts of assets and liabilities and disclosure of contingent
     assets and liabilities at the date of the financial statements and the
     reported amounts of revenues and expenses during the reporting period.
     Actual results may differ from those estimates.

     Investments

     The Company has classified its investments in fixed maturities as either
     held to maturity or available for sale. Fixed maturities classified as held
     to maturity are presented at amortized cost and consist of debt securities
     that management intends and has the ability to hold until maturity. Fixed
     maturities classified as available for sale are presented at fair value and
     consist of debt securities that management may not hold until maturity. The
     net aggregate unrealized gain or loss, net of applicable income taxes,
     related to fixed maturities available for sale is included as a component
     of accumulated other comprehensive income in stockholders' equity.

     Fixed maturities include mortgage backed and asset backed securities which
     are valued using the interest method. The Company estimates prepayments
     utilizing published data when 



                                      F-9
<PAGE>   56


     applying the interest method. Periodic adjustments to prepayment
     assumptions are credited or charged to investment income.

     Preferred stocks are carried at fair value. Other long-term investments
     include collateralized mortgage obligation residuals, carried at unpaid
     principal balances which do not vary significantly from fair value.
     Short-term investments, consisting primarily of money market mutual funds,
     have original maturities of three months or less and are carried at cost,
     which approximates fair value. Realized gains and losses on the sale of
     investments are based on the cost of the specific investment sold.

     Net premiums earned

     Premiums are recorded as revenue ratably over the terms of the policies
     written (principally one year). Unearned premiums are calculated using a
     monthly pro rata method.

     Deferred policy acquisition costs

     Policy acquisition costs, such as commissions (net of reinsurance
     commissions), premium taxes and certain other underwriting expenses which
     vary directly with premium volume, are deferred and amortized over the
     terms of the related insurance policies. Deferred policy acquisition costs
     do not exceed estimated recoverable amounts after allowing for anticipated
     investment income.

     Reinsurance

     Reinsurance assumed from business written through state reinsurance
     facilities has been reflected in unearned premiums, loss reserves, premiums
     earned and losses incurred based on reports received from such facilities.
     Ceded reinsurance premiums, losses and ceding commissions are netted
     against earned premiums, losses and commission expense, respectively.

     Reserve for losses and loss adjustment expenses

     Liabilities for unpaid losses and loss adjustment expenses ("LAE") are
     estimates of future payments to be made to settle all insurance claims for
     reported losses and estimates of incurred but not reported losses based
     upon past experience modified for current trends. With the exception of
     workers' compensation losses, loss reserves are not discounted. Estimated
     amounts of salvage and subrogation on paid and unpaid losses are deducted
     from the liability for unpaid claims. The estimated liabilities may be more
     or less than the amount ultimately paid when the claims are settled.
     Management and the Company's independent consulting actuary regularly
     review the estimates of reserves needed and any changes are reflected in
     current operating results.

     The Company discounts its liability for workers' compensation case reserves
     on a tabular basis, using the National Council on Compensation Insurance
     Workers' Compensation 



                                      F-10
<PAGE>   57


     Statistical Plan Table III A at a rate of 3.5%. The amount of discount at
     December 31, 1997 and 1998 is $6,394,000 and $9,256,000, respectively.
     Reserves for losses incurred but not reported and for LAE are not
     discounted.

     Structured settlements have been negotiated for claims on certain insurance
     policies. Structured settlements are agreements to provide periodic
     payments to claimants, and are funded by annuities purchased from various
     life insurance companies. The Company remains primarily liable for payment
     of these claims. Accordingly, a liability and a corresponding deposit in
     the amount $5,942,000 and $5,764,000 at December 31, 1997 and 1998,
     respectively, are recorded in the Company's consolidated balance sheet.

     Income taxes

     The Company and its wholly owned subsidiary file a consolidated federal
     income tax return. The Company follows the asset and liability approach to
     account for income taxes, which requires the recognition of deferred tax
     liabilities and assets for the expected future tax consequences of
     temporary differences between the financial statement carrying amounts and
     the tax basis of assets and liabilities.

     Other financial instruments

     The fair values of the Company's other financial instruments, principally
     premiums receivable and certain non-insurance related liabilities, do not
     vary significantly from the amounts assigned in these financial statements.

     Earnings per share

     During 1997, the Company adopted Statement of Financial Accounting
     Standards ("SFAS") No. 128, "Earnings Per Share". This statement prescribes
     new standards for computing and presenting earnings per share ("EPS") and
     makes those standards consistent with international standards. The Company
     has calculated EPS in conformity with the requirements of SFAS No. 128 for
     all periods presented in these financial statements.

     Other comprehensive income

     In 1997, the Financial Accounting Standards Board issued SFAS No. 130,
     "Reporting Comprehensive Income". SFAS No. 130 establishes standards for
     the reporting of comprehensive income in a full set of general-purpose
     financial statements. Comprehensive income as described in SFAS No. 130
     includes net income as well as items under existing accounting standards
     that are reported as adjustments to stockholders' equity. Such adjustments
     to stockholders' equity include unrealized gains and losses on certain
     investments in debt and equity securities. The Company adopted SFAS No. 130
     in the first quarter of 1998.



                                      F-11
<PAGE>   58



     Insurance-Related assessments

     In December 1997, the American Institute of Certified Public Accountants
     ("AICPA") Accounting Standards Executive Committee issued Statement of
     Position ("SOP") 97-3, "Accounting by Insurance and Other Enterprises for
     Insurance-Related Assessments". The accounting guidance of this SOP focuses
     on the timing of recognition and measurement of liabilities for
     insurance-related assessments. The SOP is effective for fiscal years
     beginning after December 15, 1998. The Company estimates that
     implementation of this SOP will not have a material impact on the Company's
     financial condition or results of operations.

2.   Related Party Transactions

     The Company and MNH have no paid employees. Under a management agreement
     Merchants Mutual Insurance Company ("Mutual"), which owns 8.9% of the
     Company's outstanding common stock at December 31, 1998, provides the
     Company and MNH with the facilities, management and personnel required to
     manage their day-to-day business. All underwriting, administrative, claims
     and investment expenses incurred on behalf of Mutual and MNH are shared on
     an allocated cost basis, determined as follows: for underwriting and
     administrative expenses, the respective share of total direct premiums
     written for Mutual and MNH serves as the basis of allocation; for claims
     expenses, the average number of outstanding claims is used; investment
     expenses are shared based on each company's share of total invested assets.
     MNH also pays an annual management fee of $50,000 to Mutual. On July 23,
     1998, the Company gave notice to Mutual of its intent to terminate the
     management agreement under its terms, which termination is effective five
     years after the date of notice.

     MNH's agents are also licensed to sell Mutual's products. The agents are
     informed of the underwriting criteria of each company as well as the
     classes of business that are acceptable to each company. Underwriters
     review each application submitted by an agent to determine which company's
     underwriting criteria the risk meets and then issue a policy in the
     appropriate company. The payable to or receivable from Mutual is
     non-interest bearing and represents the net of premiums collected and loss
     and operating expense payments made by Mutual on behalf of MNH. This
     balance is settled in cash on a monthly basis.





                                      F-12
<PAGE>   59









3.   Investments

     Investments in fixed maturities and preferred stocks

     The amortized cost and estimated fair values of investments in fixed
     maturities held to maturity and available for sale and the cost and
     estimated fair value of preferred stocks are as follows:

<TABLE>
<CAPTION>
                                      Amortized      Gross        Gross
                                        Cost/     Unrealized    Unrealized   Estimated
                                        Cost         Gains        Losses     Fair Value    
                                      ---------   ----------    ----------   ----------    
                                                         (in thousands)
<S>                                   <C>          <C>          <C>          <C>     
     December 31, 1997
     -----------------
     Fixed maturities:
     
     Held to maturity
     ----------------
     U.S. Treasury securities and
        obligations of U.S. 
        government corporations
        and agencies                  $  2,147     $      1     $     30     $  2,118
     Mortgage and asset backed
        securities                      17,484          725           --       18,209
                                      --------     --------     --------     --------
             Total                    $ 19,631     $    726     $     30     $ 20,327
                                      ========     ========     ========     ========

     Available for sale
     ------------------
     U.S. Treasury securities and
        obligations of U.S. 
        government corporations
        and agencies                  $ 21,755     $      7     $    113     $ 21,649
     Obligations of states and
        political subdivisions          28,217          547           --       28,764
     Corporate securities               20,035          513           --       20,548
     Mortgage and asset backed
        securities                     102,989        1,016           39      103,966
                                      --------     --------     --------     --------
             Total                    $172,996     $  2,083     $    152     $174,927
                                      ========     ========     ========     ========

     Preferred stocks                 $ 10,038     $    544     $     --     $ 10,582
                                      ========     ========     ========     ========
</TABLE>




                                      F-13
<PAGE>   60




<TABLE>
<CAPTION>
                                      Amortized      Gross        Gross
                                        Cost/     Unrealized    Unrealized   Estimated
                                        Cost         Gains        Losses     Fair Value    
                                      ---------   ----------    ----------   ----------    
                                                         (in thousands)
<S>                                   <C>          <C>          <C>          <C>     
     December 31, 1998
     -----------------
     Fixed maturities:

     Held to maturity
     ----------------
     U.S. Treasury securities and
        obligations of U.S. 
        government corporations
        and agencies                  $  1,647     $     --     $     12     $  1,635
     Mortgage and asset backed
        securities                      15,353          768           --       16,121
                                      --------     --------     --------     --------
             Total                    $ 17,000     $    768     $     12     $ 17,756
                                      ========     ========     ========     ========

     Available for sale
     ------------------
     U.S. Treasury securities and
        obligations of U.S. 
        government corporations
        and agencies                  $ 12,755     $     21     $     --     $ 12,776
     Obligations of states and              --
        political subdivisions          26,534          532           34       27,066
     Corporate securities               29,386          693                    30,045
     Mortgage and asset backed
        securities                     109,966          976           45      110,897
                                      --------     --------     --------     --------
             Total                    $178,641     $  2,222     $     79     $180,784
                                      ========     ========     ========     ========
     Preferred stocks                 $ 10,099     $    408     $    134     $ 10,373
                                      ========     ========     ========     ========
</TABLE>



    The amortized cost and fair value of fixed maturities by expected maturity
    at December 31, 1998 are shown below. Mortgage and asset backed securities
    are distributed in the table based upon management's estimate of repayment
    periods. Expected maturities will differ from contractual maturities because
    borrowers may have the right to call or prepay obligations with or without
    call or prepayment penalties.



                                      F-14
<PAGE>   61


<TABLE>
<CAPTION>
                                                                    Estimated Fair
                                                  Amortized Cost         Value      
                                                  --------------    --------------  
                                                          (in thousands)
<S>                                                 <C>               <C>     
         Held to maturity
         ----------------
         Due in one year or less                    $  4,799          $  5,039
         Due after one year through five years        10,138            10,550
         Due after five years through ten years        1,876             1,970
         Due after ten years                             187               197
                                                    --------          --------
                 Total                              $ 17,000          $ 17,756
                                                    ========          ========

         Available for sale
         ------------------
         Due in one year or less                    $ 46,792          $ 47,093
         Due after one year through five years       114,792           116,493
         Due after five years through ten years       15,715            15,845
         Due after ten years                           1,342             1,353
                                                    --------          --------
                 Total                              $178,641          $180,784
                                                    ========          ========
</TABLE>



     Discount and premium pertaining to collateralized mortgage obligations are
     amortized over the securities' estimated redemption periods using the
     effective interest method. Yields used to calculate premium or discount are
     adjusted for prepayments quarterly.

     Fixed maturities with a par value of $1,800,000 were on deposit at December
     31, 1998 with various state insurance departments in compliance with
     applicable insurance laws.

     Proceeds from sales of available for sale fixed maturity securities and
     preferred stocks and gross realized gains and losses related to such sales
     are as follows:

<TABLE>
<CAPTION>
                                      Year ended December 31,      
                                --------------------------------
                                  1996         1997       1998
                                  ----         ----       ----
                                         (in thousands)
<S>                             <C>         <C>         <C>    
      Proceeds from sales       $38,499     $26,652     $ 9,955
      Gross realized gains        1,012         138           1
      Gross realized losses          16          26           3
</TABLE>



                                      F-15
<PAGE>   62






     Net investment income

     Net investment income consists of:

<TABLE>
<CAPTION>
                                        Year ended December 31,
                                        -----------------------
                                      1996        1997        1998
                                      ----        ----        ----
                                            (in thousands)
<S>                                 <C>         <C>         <C>    
     Fixed maturities               $10,956     $11,472     $12,236
     Short-term investments             443         686         513
     Other                              612         921         869
                                    -------     -------     -------
        Total investment income      12,011      13,079      13,618
     Investment expenses                287         309         341
                                    -------     -------     -------
        Net investment income       $11,724     $12,770     $13,277
                                    =======     =======     =======
</TABLE>

4.   Reinsurance

     MNH follows the customary practice of reinsuring a portion of the exposure
     under its policies. Insurance is ceded principally to reduce net liability
     on individual risks and to protect against catastrophic losses. Although
     reinsurance does not legally discharge an insurer from its primary
     liability for the full amount of coverage provided by its policies, it does
     make the assuming reinsurer liable to the insurer to the extent of the
     reinsurance ceded.

     The effect of reinsurance on premiums written and earned for the years
     ended December 31, 1997 and 1998 is as follows:

<TABLE>
<CAPTION>
                                     1997                          1998      
                          -------------------------     -------------------------
                            Premiums      Premiums       Premiums       Premiums
                            Written        Earned        Written         Earned
                            -------        ------        -------         ------

                                              (in thousands)
<S>                       <C>            <C>            <C>            <C>      
     Direct               $ 101,064      $ 100,146      $  98,956      $  99,556
     Assumed                  2,642          2,864            844          1,267
     Ceded                   (6,895)        (6,956)        (7,042)        (7,283)
                          ---------      ---------      ---------      ---------
         Net premiums     $  96,811      $  96,054      $  92,758      $  93,540
                          =========      =========      =========      =========
</TABLE>


     Reinsurance ceded transactions decreased losses and LAE by $5,528,000 and
     $483,000 for the years ended December 31, 1997 and 1998, respectively.

     As a result of the reinsurance agreements maintained by MNH, MNH is exposed
     to certain credit risk if its primary reinsurers were to become financially
     unstable. As of December 31, 1998, MNH has recognized amounts to be
     recovered from its primary reinsurers related to ceded losses and ceded
     unearned premiums totaling $11,259,000. MNH generally does not require
     collateral for reinsurance recoverable.



                                      F-16
<PAGE>   63



5.   Reserve for Losses and Loss Adjustment Expenses

     Activity in the reserve for losses and LAE is summarized as follows:

<TABLE>
<CAPTION>
                                                                  1997          1998
                                                                  ----          ----
                                                                    (in thousands)
<S>                                                            <C>           <C>      
     Reserve for losses and LAE at beginning of year           $ 133,479     $ 141,205
         Less reinsurance recoverables                             7,219        10,372
                                                               ---------     ---------
         Net balance at beginning of year                        126,260       130,833
                                                               ---------     ---------

     Provision for losses and LAE for claims occurring in:
         Current year                                             67,119        67,379
         Prior years                                               4,508        (2,145)
                                                               ---------     ---------
                                                                  71,627        65,234
                                                               ---------     ---------

     Loss and LAE payments for claims occurring in:
         Current year                                             26,100        26,765
         Prior years                                              40,954        42,433
                                                               ---------     ---------
                                                                  67,054        69,198
                                                               ---------     ---------

     Reserve for losses and LAE at end of year, net              130,833       126,869
         Plus reinsurance recoverables                            10,372         9,816
                                                               ---------     ---------
         Balance at end of year                                $ 141,205     $ 136,685
                                                               =========     =========
</TABLE>


     In 1997, the Company increased its reserves for prior years by $4,508,000.
     The increase in reserves for prior years recorded in 1997 was primarily
     attributable to higher than anticipated severity of claims on workers'
     compensation policies. In 1998, the Company decreased its reserves for
     prior years by $2,145,000, primarily due to favorable loss experience
     related to automobile liability policies.

6.   Income Taxes

     The provision (benefit) for federal income taxes consists of:

<TABLE>
<CAPTION>
                                                  Year ended December 31,               
                                            ---------------------------------
                                              1996         1997         1998
                                              ----         ----         ----
                                                     (in thousands)

<S>                                         <C>          <C>          <C>    
     Current                                $(1,208)     $ 1,756      $ 1,127
     Deferred                                  (677)        (532)       1,207
                                            -------      -------      -------
     Total federal income tax provision
      (benefit)                             $(1,885)     $ 1,224      $ 2,334
                                            =======      =======      =======
</TABLE>



                                      F-17
<PAGE>   64







     A reconciliation of the difference between the Company's total federal
     income tax provision and that calculated using the federal statutory income
     tax rate is as follows:

<TABLE>
<CAPTION>
                                                  Year ended December 31,               
                                            ----------------------------------
                                              1996         1997         1998
                                              ----         ----         ----
                                                     (in thousands)
<S>                                         <C>          <C>          <C>    
     Computed provision (benefit) at
           statutory rate                   $(1,031)     $ 1,843      $ 2,807
     Adjustments:
           Tax-exempt investment income        (726)        (491)        (393)
           Dividend exclusion                   (47)        (147)        (128)
           Other items                          (81)          19           48
                                            -------      -------      -------
     Total federal income tax provision
          (benefit)                         $(1,885)     $ 1,224      $ 2,334
                                            =======      =======      =======
</TABLE>

                                                             

     Deferred federal tax liabilities (assets) are comprised of the following:

<TABLE>
<CAPTION>
                                                      December 31,                 
                                                -----------------------
                                                   1997          1998
                                                   ----          ----
                                                    (in thousands)
<S>                                             <C>           <C>     
     Deferred policy acquisition costs          $  4,283      $  4,213
     Unrealized investment gains                     547           604
     Accretion of bond discount                      100           349
     Other                                           187           204
                                                --------      --------
     Total deferred federal tax liabilities        5,117         5,370
                                                --------      --------

     Discounting of reserve for losses and
          loss adjustment expenses                (7,450)       (6,826)
     Unearned premiums                            (3,232)       (3,179)
     Other                                          (311)         (279)
     Minimum tax credit carryforward                (443)         (141)
                                                --------      --------
     Total deferred federal tax assets           (11,436)      (10,425)
                                                --------      --------
          Net deferred federal income taxes     $ (6,319)     $ (5,055)
                                                ========      ========
</TABLE>


     Although realization is not assured, based upon the available evidence the
     Company believes that it is more likely than not that the net deferred
     federal income tax asset will be realized. The amount of the deferred tax
     asset considered realizable, however, could be reduced in the near term if
     estimates of future taxable income are not achieved.


                                      F-18
<PAGE>   65



7.   Stockholders' Equity

     Preferred and common stock

     Stockholders' equity is comprised of the following:

     Preferred stock, no par value, $424.30 stated value, 10,000 shares
     authorized; no shares issued or outstanding at December 31, 1997 or
     December 31, 1998. The Company also has 3,000,000 shares of $.01 par value
     preferred stock which is authorized and unissued.

     Common stock, $.01 par value, authorized 10,000,000 shares; issued and
     outstanding 2,906,502 shares at December 31, 1997 and 2,851,452 shares at
     December 31, 1998.

     Dividends

     The Company depends on dividends from its subsidiary, MNH, to pay cash
     dividends to its stockholders and to meet its expenses. MNH is subject to
     New Hampshire state insurance laws which restrict its ability to pay
     dividends without the prior approval of state regulatory authorities. These
     restrictions limit dividends to those that, when added to all other
     dividends paid within the preceding twelve months, would not exceed 10% of
     an insurer's policyholders' surplus as of the preceding December 31. The
     maximum amount of dividends that MNH could pay during any twelve month
     period ending in 1999, without the prior approval of the New Hampshire
     Insurance Commissioner, is $5,058,000. The Company paid a quarterly cash
     dividend to its common stockholders in 1996, 1997 and 1998.

     Stock option plans

     The Company's stock option plan (the "Plan"), which reserved 200,000 shares
     of common stock for issuance to the Company's and MNH's officers and key
     employees of the Company's affiliate, Mutual, expired in 1996. Under the
     Plan, qualified and non-qualified stock options were granted at amounts not
     less than the fair market value of the Company's stock on the date of
     grant. Options granted under the Plan have a 10 year life and may be
     exercised in cumulative annual increments of 25% commencing one year from
     the date of grant.

     During 1996, 53,000 options were granted under the Plan at an exercise
     price of $21.00 per share. The weighted average fair value of options
     granted in 1996 was $6.48 per option.

     In March 1994, the Company's Board of Directors approved a stock option
     program providing for the issuance of options to purchase a total of 25,000
     shares of the Company's common stock to certain of MNH's independent
     insurance agents. In June 1994, the Company issued options to purchase
     22,500 shares of common stock under the program at $16.38 per share. These
     options became exercisable on June 1, 1996.

     In 1996, the Company adopted the disclosure provisions of SFAS No. 123
     "Accounting for Stock Based Compensation", but opted to remain under the
     expense recognition provisions of 


                                      F-19
<PAGE>   66


     Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to
     Employees" in accounting for its stock option plans. No compensation
     expense was recognized in 1996, 1997 or 1998 for options granted under
     these plans.

     Had compensation expense for stock options granted under the Company's
     stock option plans been determined based on the fair value at the grant
     date consistent with the method required by SFAS No. 123, the Company's net
     income and earnings per share for the years ended December 31, 1997 and
     1998 would have been as follows:

<TABLE>
<CAPTION>
                                        1997          1998
                                        ----          ----
<S>                                  <C>            <C>       
     Net income:
         As reported                 $4,198,000     $5,923,000
         Pro forma                   $4,123,000     $5,884,000
     Diluted earnings per share:
         As reported                      $1.41          $2.04
         Pro forma                        $1.38          $2.03
</TABLE>

     The fair value of each option granted in 1996 was estimated using a
     binomial option pricing model which is a modification of the Black-Scholes
     option pricing model, with the following assumptions for 1996: risk free
     interest rate of 6.25%, volatility of 18.0%, expected dividend yield of
     1.1% and expected life of 10 years.

     A summary of the status of the Company's outstanding options as of December
     31, 1996, 1997 and 1998, and changes during the years ending on those dates
     is presented below:

<TABLE>
<CAPTION>
                                    1996                          1997                       1998             
                         --------------------------   ---------------------------   ---------------------
                                           Weighted                     Weighted 
                                           Average                      Average
                          Options          Exercise     Options         Exercise     Options      Exercise
                        Outstanding         Price     Outstanding         Price     Outstanding    Price    
                        -----------        --------   -----------       --------    -----------   --------
<S>                        <C>            <C>            <C>            <C>           <C>            <C>   
     Beginning
       of year             49,083         $   14.51      90,750         $   18.28     79,250         $18.39
     Granted               53,000             21.00          --                --         --             --
     Exercised             (6,458)            12.01      (5,750)            14.64     (3,750)         15.04
     Forfeited             (4,875)            18.50      (5,750)            20.40     (4,000)         21.00
                           ------                        ------                       ------               
     End of year           90,750             18.28      79,250             18.39     71,500          18.38
                           ======                        ======                       ======          
     Options exer-
       cisable at
       year-end            40,750             14.93      45,500             16.45     51,000          17.37
                           ======                        ======                       ======          
</TABLE>



                                      F-20
<PAGE>   67


     The following table summarizes information about the Company's outstanding
     stock options at December 31, 1998:

<TABLE>
<CAPTION>
      Number            Remaining         Average             Number
   Outstanding         Contractual        Exercise          Exercisable
   at 12/31/98        Life in Years        Price           at 12/31/98
   -----------        -------------        -----           -----------
<S>                    <C>                <C>              <C>  
      4,000                .2             $ 9.38              4,000
      8,000               3.1              14.38              8,000
     18,500                .4              16.38             18,500
     41,000               7.1              21.00             20,500
     ------                                                  ------
     71,500                                                  51,000
     ======                                                  ======
</TABLE>
     
     Common stock repurchases

     During 1996, 1997 and 1998, the Company repurchased 160,700, 158,900 and
     58,800 shares of its common stock, respectively. The Company was holding
     378,400 of these shares in treasury as of December 31, 1998.

8.   Earnings Per Share

     The computations for basic and diluted earnings per share are as follows:

<TABLE>
<CAPTION>
                                                         Year Ended December 31,        
                                                 -------------------------------------
                                                   1996            1997           1998
                                                 -------         -------        -------
<S>                                              <C>             <C>            <C>    
     Basic:
     Net income (loss)                           $(1,148)        $ 4,198        $ 5,923
     Weighted average shares outstanding           3,174           2,973          2,895
     Basic earnings (loss) per share             $  (.36)        $  1.41        $  2.05

     Diluted:
     Net income (loss)                           $(1,148)        $ 4,198        $ 5,923
     Weighted average shares outstanding           3,174           2,973          2,895
     Plus incremental shares from assumed
        conversion of stock options                    8               7              9
                                                 -------         -------        -------
     Weighted average shares
        outstanding-adjusted                       3,182           2,980          2,904
                                                 =======         =======        =======
     Diluted earnings (loss) per share           $  (.36)        $  1.41        $  2.04
</TABLE>




                                      F-21
<PAGE>   68




9.   Benefit Programs

     Mutual maintains a capital accumulation plan which is a profit sharing plan
     under Section 401(a) of the Internal Revenue Code that covers all employees
     who have completed one year of service. Mutual matches at least 15% and up
     to 100% of employee contributions, based on the combined net operating
     profits of Mutual and MNH. Additional contributions may be made at the
     discretion of the Board of Directors of Mutual. Under the terms of the
     management agreement, the Company's portion of the total contribution was
     $238,000, $457,000 and $554,000 for the years ended December 31, 1996, 1997
     and 1998, respectively.

10.  Commitments and Contingencies

     MNH, like many other property and casualty insurance companies, is subject
     to environmental damage claims asserted by or against its insureds.
     Management is of the opinion that based on various court decisions
     throughout the country, such claims should not be recoverable under the
     terms of MNH's insurance policies because of either specific or general
     coverage exclusions contained in the policies. However, there is no
     assurance that the courts will agree with MNH's position in every case, nor
     can there be assurance that material claims will not be asserted under
     policies which a court will find do not explicitly or implicitly exclude
     claims for environmental damages. Management, however, is not aware of any
     pending claim or group of claims which would result in a liability that
     would have a material adverse effect on the financial condition of MNH.

     In addition to the foregoing, MNH is a defendant in a number of other legal
     proceedings in the ordinary course of its business. Management of the
     Company is of the opinion that the ultimate aggregate liability, if any,
     resulting from such proceedings will not materially affect the financial
     condition of MNH or the Company.





                                      F-22