##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 Form 10-K
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to.
 Commission File Number 1-9640
 MERCHANTS GROUP, INC.
 (Exact name of registrant as specified in its charter)
 Delaware
    
    16-1280763(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)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 Ac NONE
 o þ
 o þ
  þ o
 þ
  o o þ
 o þ




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##### Table of Contents



PART I
    
    
    3ITEM 1.
    
    BUSINESS
    
    
    3ITEM 1A.
    
    RISK FACTORS
    
    
    19ITEM 2.
    
    PROPERTIES
    
    
    21ITEM 3.
    
    LEGAL PROCEEDINGS
    
    
    22ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    22PART II
    
    
    22ITEM 5.
    
    MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
    
    
    23ITEM 6.
    
    SELECTED FINANCIAL DATA
    
    
    25ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
    
    
    26ITEM 7A.
    
    QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
    
    
    43ITEM 8.
    
    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
    
    
    43ITEM 9.
    
    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
    
    
    45ITEM 9A.
    
    CONTROLS AND PROCEDURES
    
    
    45ITEM 9B.
    
    OTHER INFORMATION
    
    
    45PART III
    
    
    46ITEM 10.
    
    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
    
    
    46ITEM 11.
    
    EXECUTIVE COMPENSATION
    
    
    49ITEM 12.
    
    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
    
    
    52ITEM 13.
    
    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
    
    
    55ITEM 14.
    
    PRINCIPAL ACCOUNTANT FEES AND SERVICES
    
    
    56PART IV
    
    
    58ITEM 15.
    
    EXHIBITS AND FINANCIAL STATEMENTS
    
    
    58EX-23EX-31EX-32
 2




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General
  Administration
     3




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Marketing
     4




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Insurance Underwriting
  Administration
 As of December 31,2004
    
    2005
    
    2006New York
    
    
    63
    %
    
    
    63
    %
    
    
    61
    %New Jersey
    
    
    14
    
    
    
    13
    
    
    
    14New Hampshire
    
    
    8
    
    
    
    8
    
    
    
    7Pennsylvania
    
    
    7
    
    
    
    7
    
    
    
    7Massachusetts
    
    
    3
    
    
    
    4
    
    
    
    4Rhode Island
    
    
    3
    
    
    
    3
    
    
    
    2Other
    
    
    2
    
    
    
    2
    
    
    
    5Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 5




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
    
    Personal automobile  full coverage of standard performance automobiles, generally
requiring drivers with good driving records during the past three years at the time of
first issuance by Merchants.
    
    Homeowners  properties generally with no losses in the last three years that are less than
30 years old and valued between $125,000 and $500,000.
    
    Commercial automobile  primarily light and medium duty vehicles operating in a limited
radius, with complete background information required of all drivers.
    
    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.
    
    General liability  low hazard service, mercantile and light processing businesses,
generally with at least three years of business experience and with no losses in the last three
years.
    
    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.
    6




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Year ended December 31,2004
    
    
    
    2005
    
    
    
    2006Premiums
    
    
    
    
    
    
    
    
    
    
    
    Premiums
    
    
    
    
    
    
    
    
    
    
    PremiumsWritten
    
    
    
    
    
    
    LALAE
    
    
    
    Written
    
    
    
    
    
    
    LALAE
    
    
    
    Written
    
    
    
    
    
    
    LALAEAmount
    
    
    %
    
    
    Ratio
    
    
    
    Amount
    
    
    %
    
    
    Ratio
    
    
    
    Amount
    
    
    %
    
    
    Ratio(dollars in thousands)PersonalAuto Liability
    
    
    $
    7,467
    
    
    
    14.1
    %
    
    
    59.5
    %
    
    
    $
    4,395
    
    
    
    9.7
    %
    
    
    21.0
    %
    
    
    $
    2,496
    
    
    
    6.6
    %
    
    
    24.7
    %Auto Physical Damage
    
    
    
    3,873
    
    
    
    7.3
    
    
    
    42.8
    
    
    
    
    2,254
    
    
    
    5.0
    
    
    
    36.0
    
    
    
    
    1,693
    
    
    
    4.5
    
    
    
    40.8Homeowners Multi-Peril
    
    
    
    5,080
    
    
    
    9.6
    
    
    
    59.4
    
    
    
    
    4,266
    
    
    
    9.5
    
    
    
    50.3
    
    
    
    
    3,405
    
    
    
    9.0
    
    
    
    69.1Total
    
    
    
    16,420
    
    
    
    31.0
    
    
    
    55.1
    
    
    
    
    10,915
    
    
    
    24.2
    
    
    
    34.5
    
    
    
    
    7,594
    
    
    
    20.1
    
    
    
    46.5CommercialAuto Liability
    
    
    
    12,542
    
    
    
    23.6
    
    
    
    51.2
    
    
    
    
    11,074
    
    
    
    24.5
    
    
    
    32.0
    
    
    
    
    9,697
    
    
    
    25.7
    
    
    
    40.9Auto Physical Damage
    
    
    
    2,734
    
    
    
    5.1
    
    
    
    38.1
    
    
    
    
    2,235
    
    
    
    5.0
    
    
    
    37.9
    
    
    
    
    2,094
    
    
    
    5.5
    
    
    
    42.9Commercial Multi-Peril
    
    
    
    15,701
    
    
    
    29.6
    
    
    
    76.6
    
    
    
    
    14,926
    
    
    
    33.1
    
    
    
    63.9
    
    
    
    
    13,084
    
    
    
    34.7
    
    
    
    35.8Workers Compensation
    
    
    
    4,536
    
    
    
    8.5
    
    
    
    72.8
    
    
    
    
    4,461
    
    
    
    9.9
    
    
    
    9.1
    
    
    
    
    4,235
    
    
    
    11.3
    
    
    
    117.1Other
    
    
    
    1,169
    
    
    
    2.2
    
    
    
    75.5
    
    
    
    
    1,524
    
    
    
    3.3
    
    
    
    189.1
    
    
    
    
    1,036
    
    
    
    2.7
    
    
    
    18.1Total
    
    
    
    36,682
    
    
    
    69.0
    
    
    
    64.6
    
    
    
    
    34,220
    
    
    
    75.8
    
    
    
    50.2
    
    
    
    
    30,146
    
    
    
    79.9
    
    
    
    48.3Total Personal & Commercial
    
    
    $
    53,102
    
    
    
    100.0
    %
    
    
    61.2
    
    
    
    $
    45,135
    
    
    
    100.0
    %
    
    
    45.9
    
    
    
    $
    37,740
    
    
    
    100.0
    %
    
    
    47.9
   For the Year Ended December 31,2002
    
    2003
    
    2004(1)
    
    2005(1)
    
    2006 (1)Commercial
    
    
    40
    %
    
    
    63
    %
    
    
    73
    %
    
    
    79
    %
    
    
    82
    %Personal
    
    
    60
    
    
    
    37
    
    
    
    27
    
    
    
    21
    
    
    
    18Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 
 (1)
    
    Shown on a group-wide basis for the Pooled Business. See the Administration
section of this Item for further discussion. 7




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Commercial Business
   Personal Business
  Involuntary Business
   8




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Pooling Agreement
  Claims
   Loss and Loss Adjustment Expense Reserves
   9




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10




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##### Table of Contents



Year Ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Reserve for losses and LAE at beginning of year
    
    $
    115,191
    
    
    $
    128,415
    
    
    $
    146,474Less reinsurance recoverables
    
    
    (13,807
    )
    
    
    (15,630
    )
    
    
    (22,715
    )Net balance at beginning of year
    
    
    101,384
    
    
    
    112,785
    
    
    
    123,759Provision for losses and LAE for claims occurring in:Current year
    
    
    26,317
    
    
    
    29,711
    
    
    
    38,524Prior years
    
    
    (4,170
    )
    
    
    (3,303
    )
    
    
    (843
    )22,147
    
    
    
    26,408
    
    
    
    37,681Losses and LAE payments for claims occurring in:Current year
    
    
    (9,382
    )
    
    
    (10,359
    )
    
    
    (13,647
    )Prior years
    
    
    (20,810
    )
    
    
    (27,450
    )
    
    
    (35,008
    )(30,192
    )
    
    
    (37,809
    )
    
    
    (48,655
    )Reserve for losses and LAE at end of year, net
    
    
    93,339
    
    
    
    101,384
    
    
    
    112,785Plus reinsurance recoverables
    
    
    11,575
    
    
    
    13,807
    
    
    
    15,630Balance at end of year
    
    $
    104,914
    
    
    $
    115,191
    
    
    $
    128,415
    11




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As of December 31,1996
    
    
    1997
    
    
    1998
    
    
    1999
    
    
    2000
    
    
    2001
    
    
    2002
    
    
    2003
    
    
    2004
    
    
    2005(in thousands)Net liability for losses and LAE:
    
    $
    126,260
    
    
    $
    130,781
    
    
    $
    126,820
    
    
    $
    127,458
    
    
    $
    131,178
    
    
    $
    132,113
    
    
    $
    127,756
    
    
    $
    123,759
    
    
    $
    112,785
    
    
    $
    101,384Liability re-estimated as of:One year later
    
    
    130,768
    
    
    
    128,636
    
    
    
    123,071
    
    
    
    128,886
    
    
    
    129,704
    
    
    
    128,328
    
    
    
    127,666
    
    
    
    122,916
    
    
    
    109,482
    
    
    
    97,214Two years later
    
    
    133,029
    
    
    
    130,498
    
    
    
    120,345
    
    
    
    123,299
    
    
    
    129,621
    
    
    
    132,674
    
    
    
    129,722
    
    
    
    122,071
    
    
    
    106,843Three years later
    
    
    132,948
    
    
    
    127,893
    
    
    
    113,661
    
    
    
    124,944
    
    
    
    133,769
    
    
    
    135,865
    
    
    
    129,254
    
    
    
    120,827Four years later
    
    
    129,210
    
    
    
    122,508
    
    
    
    114,068
    
    
    
    128,121
    
    
    
    138,538
    
    
    
    137,813
    
    
    
    128,492Five years later
    
    
    124,238
    
    
    
    122,347
    
    
    
    117,678
    
    
    
    131,977
    
    
    
    140,804
    
    
    
    137,990Six years later
    
    
    124,319
    
    
    
    125,741
    
    
    
    120,958
    
    
    
    133,913
    
    
    
    142,403Seven years later
    
    
    127,659
    
    
    
    128,998
    
    
    
    123,359
    
    
    
    134,697Eight years later
    
    
    130,280
    
    
    
    130,907
    
    
    
    123,310Nine years later
    
    
    131,887
    
    
    
    130,995Ten years later
    
    
    131,334Net cumulative redundancy (deficiency):
    
    $
    (5,074
    )
    
    
    (214
    )
    
    
    3,510
    
    
    
    (7,239
    )
    
    
    (11,225
    )
    
    
    (5,877
    )
    
    
    (736
    )
    
    
    2,932
    
    
    
    5,942
    
    
    
    4,170%(4.0
    )
    
    
    (.2
    )
    
    
    2.8
    
    
    
    (5.7
    )
    
    
    (8.6
    )
    
    
    (4.4
    )
    
    
    (.6
    )
    
    
    2.4
    
    
    
    5.3
    
    
    
    4.1Net paid (cumulative) as of:One year later
    
    
    40,954
    
    
    
    42,433
    
    
    
    37,125
    
    
    
    40,970
    
    
    
    45,461
    
    
    
    40,843
    
    
    
    35,168
    
    
    
    35,008
    
    
    
    27,450
    
    
    
    20,810Two years later
    
    
    69,035
    
    
    
    66,477
    
    
    
    63,325
    
    
    
    69,393
    
    
    
    70,075
    
    
    
    64,959
    
    
    
    61,031
    
    
    
    56,290
    
    
    
    43,250Three years later
    
    
    86,364
    
    
    
    86,313
    
    
    
    80,142
    
    
    
    86,670
    
    
    
    85,772
    
    
    
    83,552
    
    
    
    78,109
    
    
    
    68,677Four years later
    
    
    98,300
    
    
    
    97,770
    
    
    
    89,383
    
    
    
    96,222
    
    
    
    98,053
    
    
    
    96,986
    
    
    
    86,588Five years later
    
    
    105,787
    
    
    
    104,282
    
    
    
    94,809
    
    
    
    102,892
    
    
    
    107,913
    
    
    
    103,268Six years later
    
    
    109,639
    
    
    
    107,431
    
    
    
    99,131
    
    
    
    108,438
    
    
    
    112,706Seven years later
    
    
    111,822
    
    
    
    110,193
    
    
    
    103,180
    
    
    
    111,091Eight years later
    
    
    114,246
    
    
    
    113,200
    
    
    
    105,167Nine years later
    
    
    116,279
    
    
    
    115,174Ten years later
    
    
    117,446Gross/net liability for losses and LAE:Initial gross liability for
losses and LAE:
    
    $
    133,859
    
    
    $
    141,154
    
    
    $
    136,636
    
    
    $
    133,483
    
    
    $
    145,004
    
    
    $
    151,355
    
    
    $
    147,136
    
    
    $
    146,474
    
    
    $
    132,112
    
    
    $
    122,401Initial ceded liability for
losses and LAE:
    
    
    7,599
    
    
    
    10,373
    
    
    
    9,816
    
    
    
    6,025
    
    
    
    13,826
    
    
    
    19,242
    
    
    
    19,380
    
    
    
    22,715
    
    
    
    19,327
    
    
    
    21,017Initial net liability
    
    $
    126,260
    
    
    $
    130,781
    
    
    $
    126,820
    
    
    $
    127,458
    
    
    $
    131,178
    
    
    $
    132,113
    
    
    $
    127,756
    
    
    $
    123,759
    
    
    $
    112,785
    
    
    $
    101,384Gross liability as
currently re-estimated
    
    
    139,584
    
    
    
    139,691
    
    
    
    132,125
    
    
    
    148,358
    
    
    
    172,782
    
    
    
    168,823
    
    
    
    157,855
    
    
    
    145,203
    
    
    
    128,619
    
    
    
    116,223Ceded liability as
currently re-estimated
    
    
    8,250
    
    
    
    8,696
    
    
    
    8,815
    
    
    
    13,661
    
    
    
    30,379
    
    
    
    30,833
    
    
    
    29,363
    
    
    
    24,376
    
    
    
    21,776
    
    
    
    19,009Net liability as
currently re-estimated
    
    $
    131,334
    
    
    $
    130,995
    
    
    $
    123,310
    
    
    $
    134,697
    
    
    $
    142,403
    
    
    $
    137,990
    
    
    $
    128,492
    
    
    $
    120,827
    
    
    $
    106,843
    
    
    $
    97,214Gross cumulative
redundancy
(deficiency):
    
    $
    (5,725
    )
    
    
    1,463
    
    
    
    4,511
    
    
    
    (14,875
    )
    
    
    (27,778
    )
    
    
    (17,468
    )
    
    
    (10,719
    )
    
    
    1,271
    
    
    
    3,493
    
    
    
    6,178%(4.3
    )
    
    
    1.0
    
    
    
    3.3
    
    
    
    (11.1
    )
    
    
    (19.2
    )
    
    
    (11.5
    )
    
    
    (7.3
    )
    
    
    .9
    
    
    
    2.6
    
    
    
    5.0
  12




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##### Table of Contents



As of December 31,2006
    
    
    2005
    
    
    2004(in thousands)Loss and LAE reserves on a SAP basis
    
    $
    93,339
    
    
    $
    101,384
    
    
    $
    112,785Adjustments:Ceded reinsurance balances recoverable
    
    
    11,575
    
    
    
    13,807
    
    
    
    15,630Loss and LAE reserves on a GAAP basis
    
    $
    104,914
    
    
    $
    115,191
    
    
    $
    128,415
 Reinsurance
     13




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Administration
 Administration
  Investments
    14




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##### Table of Contents



As of December 31,2006
    
    
    2005
    
    
    2004Amount
    
    
    %
    
    
    Amount
    
    
    %
    
    
    Amount
    
    
    %(dollars in thousands)Fixed Maturities (1):U.S. Government and Agencies
    
    $
    10,139
    
    
    
    5.7
    %
    
    $
    7,145
    
    
    
    3.9
    %
    
    $
    5,028
    
    
    
    2.5
    %Corporate Securities
    
    
    26,448
    
    
    
    14.9
    
    
    
    17,147
    
    
    
    9.4
    
    
    
    28,003
    
    
    
    14.2Mortgage and Asset Backed Securities
    
    
    80,518
    
    
    
    45.4
    
    
    
    97,044
    
    
    
    53.2
    
    
    
    110,082
    
    
    
    55.7Tax-Exempt Bonds
    
    
    39,759
    
    
    
    22.4
    
    
    
    45,257
    
    
    
    24.8
    
    
    
    40,979
    
    
    
    20.7Total Bonds
    
    
    156,864
    
    
    
    88.4
    
    
    
    166,593
    
    
    
    91.3
    
    
    
    184,092
    
    
    
    93.1Preferred Stocks (1)
    
    
    3,563
    
    
    
    2.0
    
    
    
    4,312
    
    
    
    2.4
    
    
    
    3,509
    
    
    
    1.8Short-Term Investments (2)
    
    
    17,017
    
    
    
    9.6
    
    
    
    10,650
    
    
    
    5.9
    
    
    
    7,412
    
    
    
    3.7Other (3)
    
    
    84
    
    
    
    
    
    
    
    734
    
    
    
    .4
    
    
    
    2,696
    
    
    
    1.4Total Invested Assets
    
    $
    177,528
    
    
    
    100.0
    %
    
    $
    182,289
    
    
    
    100.0
    %
    
    $
    197,709
    
    
    
    100.0
    %
 
 (1)
    
    Shown at fair value.(2)
    
    Shown at cost, which approximates fair value.(3)
    
    Shown at estimated fair value or unpaid principal balance, which approximates estimated fair value.  Year Ended December 31,2006
    
    2005
    
    2004(dollars in thousands)Average investments
    
    $
    180,589
    
    
    $
    185,925
    
    
    $
    196,148Net investment income
    
    
    7,938
    
    
    
    7,733
    
    
    
    7,881Net investment income as a percentage
of average investments (1)
    
    
    4.4
    %
    
    
    4.2
    %
    
    
    4.0
    %Net gains (losses) on investments
    
    $
    (60
    )
    
    $
    
    
    
    $
    (221
    )
 
 (1)
    
    The taxable equivalent yield for the years ended December 31, 2006, 2005 and 2004 was 4.7%,
4.5% and 4.3%, respectively, assuming an effective tax rate of 34%.  15




---



##### Table of Contents



As of December 31,2006
    
    
    2005
    
    
    2004Amount
    
    
    %
    
    
    Amount
    
    
    %
    
    
    Amount
    
    
    %(dollars in thousands)1 year or less
    
    $
    27,027
    
    
    
    17.2
    %
    
    $
    35,259
    
    
    
    21.2
    %
    
    $
    49,275
    
    
    
    26.8
    %1 year through 5 years
    
    
    103,081
    
    
    
    65.7
    
    
    
    104,957
    
    
    
    63.0
    
    
    
    112,476
    
    
    
    61.15 years through 10 years
    
    
    16,590
    
    
    
    10.6
    
    
    
    18,978
    
    
    
    11.4
    
    
    
    18,870
    
    
    
    10.2More than 10 years
    
    
    10,166
    
    
    
    6.5
    
    
    
    7,399
    
    
    
    4.4
    
    
    
    3,471
    
    
    
    1.9Total
    
    $
    156,864
    
    
    
    100.0
    %
    
    $
    166,593
    
    
    
    100.0
    %
    
    $
    184,092
    
    
    
    100.0
    %
 Competition
   Regulation
 General
  16




---



##### Table of Contents



17




---



##### Table of Contents



Rates
  Renewal of Policies
  Insurance Holding Companies
  Involuntary Business
  Employees
  18




---



##### Table of Contents



If our estimates of loss and LAE reserves prove inaccurate and if we have to make even a relatively
small adjustment to our reserves, the adjustment may have a significant impact on our income.
 BUSINESS
 The demand for property and casualty insurance is cyclical, which may adversely affect our
operating results for extended periods.
  If catastrophic events affect many of our policyholders at the same time, we may experience
significant extraordinary losses.
   Adequate reinsurance may not be available at acceptable prices so that we may not be able to
adequately protect the Company against extraordinary losses.
 BUSINESS
 19




---



##### Table of Contents



Our investment income is very sensitive to prevailing interest rates, and general decreases in
interest rates will adversely affect both our investment income and our net income.
  Government regulation affecting property and casualty insurance companies could restrict our
operations in ways that would adversely affect our business.
    The Companys and MNHs current operations are heavily dependent on their relationships with
Mutual, and any disruption of those relationships could adversely affect our business.
 BUSINESS
 20




---



##### Table of Contents



We compete with other regional and national property and casualty insurance companies, many of
which have greater resources than we do.
  Our operations are relatively concentrated in one geographic region, and a large disaster in the
states that we serve could adversely affect our business.
  New Hampshire state regulations limit our ability to pay dividends even when we have sufficient
cash to pay them.
 st
  
    21




---



##### Table of Contents



(1)
    
    To adopt the Agreement and Plan of Merger, dated as of October 31, 2006, by and among
Merchants Group, Inc., a Delaware corporation, American European Group, Inc., a Delaware
corporation, and, American European Financial, Inc., a Delaware corporation (the Merger
Agreement), and to approve the merger and related transactions contemplated by the Merger
Agreement.
 For
    
    
    1,651,644Against
    
    
    7,802Abstain
    
    
    
 (2)
    
    To adjourn or postpone the special meeting, if necessary, in order to solicit additional
proxies in favor if there are not sufficient favorable votes at the time of the meeting to
adopt the Merger Agreement and approve the merger and related transactions.
 For
    
    
    1,631,749Against
    
    
    26,697Abstain
    
    
    
 
  22




---



##### Table of Contents



Item 5.
    
    MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
OF EQUITY SECURITIES.
  2006:
    
    High
    
    Low
    
    DividendFourth Quarter
    
    $
    32.44
    
    
    $
    29.51
    
    
    $
    .25Third Quarter
    
    
    31.30
    
    
    
    29.69
    
    
    
    .25Second Quarter
    
    
    31.50
    
    
    
    28.98
    
    
    
    .25First Quarter
    
    
    30.65
    
    
    
    27.85
    
    
    
    .25
 2005:
    
    High
    
    Low
    
    DividendFourth Quarter
    
    $
    31.60
    
    
    $
    26.65
    
    
    $
    .25Third Quarter
    
    
    27.10
    
    
    
    24.10
    
    
    
    .10Second Quarter
    
    
    26.60
    
    
    
    24.00
    
    
    
    .10First Quarter
    
    
    26.15
    
    
    
    23.60
    
    
    
    .10
     Equity Compensation Plan Information
 23




---



##### Table of Contents



Number of SecuritiesRemaining Available forNumber of Securities to
    
    Weighted-Average
    
    Future Issuance Underbe Issued Upon Exercise
    
    Exercise Price of
    
    Equity Compensation PlansOf Outstanding Options,
    
    Outstanding Options,
    
    (Excluding Securities)Plan Category
    
    Warrants and Rights
    
    Warrants and Rights
    
    Reflected in Column (a))(a)
    
    (b)
    
    (c)Equity Compensation Plans
Approved by Security
Holders
    
    
    0
    
    
    
    N/A
    
    
    
    0Equity Compensation Plans
Not Approved by
Security Holders
    
    
    0
    
    
    
    N/A
    
    
    
    0Total
    
    
    0
    
    
    
    N/A
    
    
    
    0
  24




---



##### Table of Contents



As of December 31,2002
    
    
    2003
    
    
    2004
    
    
    2005
    
    
    2006(in thousands, except per share amounts)Net premiums written
    
    $
    70,528
    
    
    $
    64,179
    
    
    $
    53,102
    
    
    $
    45,135
    
    
    $
    37,740Net premiums earned
    
    $
    83,120
    
    
    $
    65,097
    
    
    $
    57,123
    
    
    $
    49,121
    
    
    $
    41,173Net investment income
    
    
    10,403
    
    
    
    8,815
    
    
    
    7,881
    
    
    
    7,733
    
    
    
    7,938Net investment gains (losses)
    
    
    953
    
    
    
    2,500
    
    
    
    (221
    )
    
    
    
    
    
    
    (60
    )Other revenues
    
    
    635
    
    
    
    560
    
    
    
    722
    
    
    
    571
    
    
    
    489Total revenues
    
    
    95,111
    
    
    
    76,972
    
    
    
    65,505
    
    
    
    57,425
    
    
    
    49,540Net losses and loss adjustment expenses
    
    
    62,873
    
    
    
    49,612
    
    
    
    37,681
    
    
    
    26,408
    
    
    
    22,147Amortization of deferred policy acquisition costs
    
    
    22,227
    
    
    
    16,925
    
    
    
    14,852
    
    
    
    12,771
    
    
    
    10,705Other underwriting expenses
    
    
    5,744
    
    
    
    5,031
    
    
    
    8,291
    
    
    
    8,811
    
    
    
    8,324Total expenses
    
    
    90,844
    
    
    
    71,568
    
    
    
    60,824
    
    
    
    47,990
    
    
    
    41,176Income before income taxes
    
    
    4,267
    
    
    
    5,404
    
    
    
    4,681
    
    
    
    9,435
    
    
    
    8,364Provision for income taxes
    
    
    1,729
    
    
    
    1,039
    
    
    
    919
    
    
    
    2,736
    
    
    
    2,427Net income
    
    $
    2,538
    
    
    $
    4,365
    
    
    $
    3,762
    
    
    $
    6,699
    
    
    $
    5,937Earnings per shareBasic
    
    $
    1.19
    
    
    $
    2.07
    
    
    $
    1.78
    
    
    $
    3.17
    
    
    $
    2.77Diluted
    
    $
    1.19
    
    
    $
    2.07
    
    
    $
    1.78
    
    
    $
    3.16
    
    
    $
    2.77Weighted average number of shares outstanding:Basic
    
    
    2,125
    
    
    
    2,110
    
    
    
    2,114
    
    
    
    2,115
    
    
    
    2,145Diluted
    
    
    2,129
    
    
    
    2,111
    
    
    
    2,118
    
    
    
    2,118
    
    
    
    2,145Balance Sheet Data: (at year end)Total investments
    
    $
    209,397
    
    
    $
    202,887
    
    
    $
    197,709
    
    
    $
    182,289
    
    
    $
    177,528Total assets
    
    
    265,900
    
    
    
    268,678
    
    
    
    255,704
    
    
    
    233,978
    
    
    
    222,795Reserve for losses and loss adjustment expenses
    
    
    147,136
    
    
    
    146,474
    
    
    
    128,415
    
    
    
    115,191
    
    
    
    104,914Unearned premiums
    
    
    35,119
    
    
    
    36,176
    
    
    
    33,685
    
    
    
    29,662
    
    
    
    25,371Stockholders equity
    
    
    67,924
    
    
    
    70,259
    
    
    
    71,974
    
    
    
    75,894
    
    
    
    80,221Dividend Data:Cash dividend per common share
    
    $
    .40
    
    
    $
    .40
    
    
    $
    .40
    
    
    $
    .55
    
    
    $
    1.00
 25




---



##### Table of Contents



2006 Compared to 2005
   MNHGroup-wide DWP
    
    
    
    
    
    
    Pro Forma ShareYear ended
    
    
    
    
    
    
    Year endedDecember 31,
    
    
    
    
    
    
    December 31,2006
    
    
    2005
    
    
    Variance
    
    
    2006
    
    
    2005
    
    
    Variance(000s omitted)
    
    
    
    
    
    
    (000s omitted)(25
    %)
    
    
    (30
    %)Voluntary Personal
    
    $
    36,154
    
    
    $
    40,842
    
    
    
    (11
    %)
    
    $
    9,038
    
    
    $
    12,253
    
    
    
    (26
    %)Voluntary Commercial
    
    
    145,838
    
    
    
    131,789
    
    
    
    11
    %
    
    
    36,460
    
    
    
    39,537
    
    
    
    (8
    %)Umbrella Program
    
    
    15,060
    
    
    
    19,688
    
    
    
    (24
    %)
    
    
    3,765
    
    
    
    5,906
    
    
    
    (36
    %)Involuntary
    
    
    1,206
    
    
    
    2,909
    
    
    
    (59
    %)
    
    
    302
    
    
    
    873
    
    
    
    (65
    %)Total Direct Written Premiums
    
    $
    198,258
    
    
    $
    195,228
    
    
    
    2
    %
    
    $
    49,565
    
    
    $
    58,569
    
    
    
    (15
    %)
 26




---



##### Table of Contents



27




---



##### Table of Contents



CommercialHome-
    
    
    PPA
    
    
    Auto
    
    
    Workers
    
    
    Commercial
    
    
    General
    
    
    AllAccident Year
    
    owners
    
    
    Liability
    
    
    Liability
    
    
    Compensation
    
    
    Package
    
    
    Liability
    
    
    Other
    
    
    TotalIncreases (decreases) (in thousands)Prior to2003
    
    $
    266
    
    
    $
    (408
    )
    
    $
    (135
    )
    
    $
    2,240
    
    
    $
    (2,045
    )
    
    $
    (632
    )
    
    $
    (50
    )
    
    $
    (764
    )2003
    
    
    15
    
    
    
    (322
    )
    
    
    181
    
    
    
    385
    
    
    
    (758
    )
    
    
    (11
    )
    
    
    32
    
    
    
    (478
    )2004
    
    
    (84
    )
    
    
    (245
    )
    
    
    (149
    )
    
    
    (532
    )
    
    
    (586
    )
    
    
    194
    
    
    
    8
    
    
    
    (1,394
    )2005
    
    
    120
    
    
    
    (361
    )
    
    
    (412
    )
    
    
    (335
    )
    
    
    (312
    )
    
    
    (266
    )
    
    
    32
    
    
    
    (1,534
    )Total
    
    $
    317
    
    
    $
    (1,336
    )
    
    $
    (515
    )
    
    $
    1,758
    
    
    $
    (3,701
    )
    
    $
    (715
    )
    
    $
    22
    
    
    $
    (4,170
    )
  28




---



##### Table of Contents



2005 Compared to 2004
   29




---



##### Table of Contents



MNHGroup-wide DWP
    
    
    
    
    
    
    Pro Forma ShareYear ended
    
    
    
    
    
    
    Year endedDecember 31,
    
    
    
    
    
    
    December 31,2005
    
    
    2004
    
    
    Variance
    
    
    2005
    
    
    2004
    
    
    Variance(000s omitted)
    
    
    
    
    
    
    (000s omitted)(30
    %)
    
    
    (35
    %)Voluntary Personal
    
    $
    40,842
    
    
    $
    50,879
    
    
    
    (20
    %)
    
    $
    12,253
    
    
    $
    17,808
    
    
    
    (31
    %)Voluntary Commercial
    
    
    131,789
    
    
    
    119,113
    
    
    
    11
    %
    
    
    39,537
    
    
    
    41,690
    
    
    
    (5
    %)Umbrella Program
    
    
    19,688
    
    
    
    17,536
    
    
    
    12
    %
    
    
    5,906
    
    
    
    6,138
    
    
    
    (4
    %)Involuntary
    
    
    2,909
    
    
    
    3,610
    
    
    
    (19
    %)
    
    
    873
    
    
    
    1,264
    
    
    
    (31
    %)Total Direct Written Premiums
    
    $
    195,228
    
    
    $
    191,138
    
    
    
    2
    %
    
    $
    58,569
    
    
    $
    66,900
    
    
    
    (12
    %)
       30




---



##### Table of Contents




    
    An improvement in the accident year direct loss and LAE ratio for each of the Companys
primary products, the most significant of which was an improvement from 64.4% to 54.1% in the
accident year direct loss and LAE ratio in the Companys PPA product. This improvement was due to
increased fraud prevention, detection and prosecution efforts resulting from certain legislative
changes in New York State. PPA is one of the Companys larger products and represents
approximately 23% of the Companys net earned premiums. The decrease in the PPA loss and LAE ratio
decreased the Companys overall loss and LAE ratio by approximately 1.6 percentage points.
    
    Mild weather in the Companys operating territory during 2005 contributed to
significant decreases in claim frequency (reported claims per earned policy) in the
Companys homeowners and commercial property products.
  31




---



##### Table of Contents



CommercialHome-
    
    
    PPA
    
    
    Auto
    
    
    Workers
    
    
    Commercial
    
    
    General
    
    
    AllAccident Year
    
    owners
    
    
    Liability
    
    
    Liability
    
    
    Compensation
    
    
    Package
    
    
    Liability
    
    
    Other
    
    
    TotalIncreases (decreases) (in thousands)Prior to2002
    
    $
    126
    
    
    $
    (172
    )
    
    $
    (43
    )
    
    $
    (1,856
    )
    
    $
    2,054
    
    
    $
    1,540
    
    
    $
    300
    
    
    $
    1,9492002
    
    
    79
    
    
    
    (568
    )
    
    
    (132
    )
    
    
    (501
    )
    
    
    (1,216
    )
    
    
    (99
    )
    
    
    21
    
    
    
    (2,416
    )2003
    
    
    211
    
    
    
    (333
    )
    
    
    (323
    )
    
    
    (36
    )
    
    
    91
    
    
    
    117
    
    
    
    (104
    )
    
    
    (377
    )2004
    
    
    (361
    )
    
    
    (926
    )
    
    
    (731
    )
    
    
    (166
    )
    
    
    4
    
    
    
    223
    
    
    
    (502
    )
    
    
    (2,459
    )Total
    
    $
    55
    
    
    $
    (1,999
    )
    
    $
    (1,229
    )
    
    $
    (2,559
    )
    
    $
    933
    
    
    $
    1,781
    
    
    $
    (285
    )
    
    $
    (3,303
    )
       32




---



##### Table of Contents



33




---



##### Table of Contents



Critical Accounting Policies
 Reserve for Losses and LAE
    Paid Loss Development
  Incurred Loss Development
  34




---



##### Table of Contents



Bornhuetter-Ferguson with Premium and Paid Loss
  Bornhuetter-Ferguson with Premium and Incurred Loss
  Ultimate Claims and Average Loss
   Paid ALAE Development
  Bornhuetter-Ferguson with Ultimate Loss and Paid ALAE
  35




---



##### Table of Contents




    
    How results of methods based on paid losses compare to methods based on
incurred losses.
 
    
    How results of paid and incurred development methods compare to results of paid
and incurred BF methods.
 
    
    Whether diagnostic tests cause management to favor the results of one or more
methods over the results of other methods. Such tests include:
 
    
    closed claim to reported claim ratios
    
    average case reserves per open claim
    
    paid loss per closed claim
    
    paid loss to incurred loss ratios
    
    the reasonableness of ultimate loss & ALAE ratios and ultimate severities
    
    managements consideration of other factors such as premium and
loss trends, large loss experience, legislative and judicial changes and changes in
underwriting guidelines and practices.
   Range of Net Loss & LAE Reserves ($000s)Products*
    
    Low
    
    Recorded
    
    HighPersonal Auto
    
    $
    7,357
    
    
    $
    8,673
    
    
    $
    10,147Homeowners
    
    $
    1,669
    
    
    $
    2,256
    
    
    $
    2,943Commercial Auto
    
    $
    8,896
    
    
    $
    12,377
    
    
    $
    16,036Workers Compensation
    
    $
    21,227
    
    
    $
    26,029
    
    
    $
    31,093Commercial General Liability
    
    $
    30,621
    
    
    $
    39,923
    
    
    $
    51,578Commercial Property
    
    $
    3,262
    
    
    $
    4,078
    
    
    $
    4,893Other
    
    $
    3
    
    
    $
    3
    
    
    $
    4All Products
    
    $
    79,596
    
    
    $
    93,339
    
    
    $
    108,565
 
 *
    
    The product categories shown in this table are those used by the
Company in its loss reserving process. The Companys reserve for unpaid losses and LAE in the
table that follows are segregated by product type as defined in the Companys Annual Statement
filed with insurance department regulators.  36




---



##### Table of Contents



December 31,2006
    
    
    2005(000s)Case reserves:PPA liability
    
    $
    5,203
    
    
    $
    6,072Homeowners
    
    
    1,353
    
    
    
    1,899Commercial auto liability
    
    
    4,336
    
    
    
    5,384Workers compensation
    
    
    13,136
    
    
    
    14,531Commercial package
    
    
    10,302
    
    
    
    12,739General liability
    
    
    618
    
    
    
    505Other
    
    
    147
    
    
    
    308Total case reserves
    
    
    35,095
    
    
    
    41,438IBNR:PPA liability
    
    
    2,092
    
    
    
    4,372Homeowners
    
    
    381
    
    
    
    228Commercial auto liability
    
    
    6,484
    
    
    
    6,396Workers compensation
    
    
    10,531
    
    
    
    8,074Commercial package
    
    
    16,964
    
    
    
    16,965General liability
    
    
    2,608
    
    
    
    2,581Other
    
    
    (228
    )
    
    
    (407
    )Total IBNR
    
    
    38,832
    
    
    
    38,209Reserve for LAE:PPA liability
    
    
    1,342
    
    
    
    2,004Homeowners
    
    
    522
    
    
    
    604Commercial auto liability
    
    
    1,523
    
    
    
    1,622Workers compensation
    
    
    2,364
    
    
    
    2,104Commercial package
    
    
    10,174
    
    
    
    11,493General liability
    
    
    3,322
    
    
    
    3,668Other
    
    
    165
    
    
    
    242Total reserve for LAE
    
    
    19,412
    
    
    
    21,737Subtotal
    
    
    93,339
    
    
    
    101,384Reinsurance recoverables
    
    
    11,575
    
    
    
    13,807Reserve for losses and LAE
    
    $
    104,914
    
    
    $
    115,191
 Deferred Policy Acquisition Costs
  37




---



##### Table of Contents



Investments
   Liquidity and Capital Resources
      38




---



##### Table of Contents



39




---



##### Table of Contents



Off-Balance Sheet Arrangements
  Contractual Obligations
   Less than
    
    
    1 - 3
    
    
    3 - 5
    
    
    More thanTotal
    
    
    1 Year
    
    
    Years
    
    
    Years
    
    
    5 YearsReserve for losses and
loss adjustment expenses
    
    $
    104,914
    
    
    $
    27,278
    
    
    $
    36,720
    
    
    $
    18,885
    
    
    $
    22,031
  Recently Issued Accounting Standards
  
    
    SFAS No. 155 Accounting for Certain Hybrid Instruments.
 
    
    SFAS No. 156 Accounting for Servicing Assets and Liabilities.
 
    
    SFAS No. 157 Fair Value Measurements.
 
    
    SFAS No. 158 Employers Accounting For Defined Benefit Pension and Other Post
Retirement Plans.
 
    
    SFAS No. 159 The Fair Value Option for Financial Assets and Financial Liabilities.
 
    
    FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes.
  Federal Legislation
  40




---



##### Table of Contents



Environmental Claims
  Inflation
  Relationship with Mutual
    41




---



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42




---



##### Table of Contents



Market Risk
    TOTALEstimatedThere-
    
    
    Amortized
    
    
    MarketAvailable for Sale
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    after
    
    
    Cost
    
    
    ValueU.S. Treasury
securities and
obligations of U.S.
Government
corporations
and agencies
    
    $
    0
    
    
    $
    3,002
    
    
    $
    2,998
    
    
    $
    4,245
    
    
    $
    0
    
    
    $
    0
    
    
    $
    10,245
    
    
    $
    10,139Average interest
rate
    
    
    0.0
    %
    
    
    3.2
    %
    
    
    4.9
    %
    
    
    4.8
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    
    
    
    
    Obligations of
states and
political
subdivisions
    
    
    5,807
    
    
    
    15,862
    
    
    
    5,946
    
    
    
    7,445
    
    
    
    0
    
    
    
    5,247
    
    
    
    40,307
    
    
    
    39,759Average interest
rate
    
    
    4.6
    %
    
    
    3.9
    %
    
    
    4.5
    %
    
    
    5.0
    %
    
    
    0.0
    %
    
    
    4.9
    %
    
    
    
    
    
    
    Corporate securities
    
    
    0
    
    
    
    3,247
    
    
    
    7,750
    
    
    
    5,151
    
    
    
    8,488
    
    
    
    2,145
    
    
    
    26,781
    
    
    
    26,448Average interest
rate
    
    
    0.0
    %
    
    
    3.7
    %
    
    
    4.5
    %
    
    
    5.0
    %
    
    
    5.5
    %
    
    
    6.3
    %
    
    
    
    
    
    
    Mortgage & asset
backed securities
    
    
    21,518
    
    
    
    14,085
    
    
    
    12,595
    
    
    
    10,367
    
    
    
    6,794
    
    
    
    17,095
    
    
    
    82,454
    
    
    
    80,518Average interest
rate
    
    
    4.8
    %
    
    
    4.8
    %
    
    
    4.8
    %
    
    
    4.9
    %
    
    
    4.9
    %
    
    
    5.0
    %
    
    
    
    
    
    
    Total
    
    $
    27,325
    
    
    $
    36,196
    
    
    $
    29,289
    
    
    $
    27,208
    
    
    $
    15,282
    
    
    $
    24,487
    
    
    $
    159,787
    
    
    $
    156,864
  43




---



##### Table of Contents



Three months ended3/31
    
    
    6/30
    
    
    9/30
    
    
    12/31(in thousands, except per share amounts)2006Net premiums earned
    
    $
    10,026
    
    
    $
    10,019
    
    
    $
    10,699
    
    
    $
    10,429Net investment income
    
    
    1,944
    
    
    
    2,002
    
    
    
    1,923
    
    
    
    2,069Net investment gains (losses)
    
    
    (110
    )
    
    
    42
    
    
    
    
    
    
    
    8Other revenues
    
    
    133
    
    
    
    77
    
    
    
    112
    
    
    
    167Total revenues
    
    $
    11,993
    
    
    $
    12,140
    
    
    $
    12,734
    
    
    $
    12,673Income before income taxes
    
    $
    3,295
    
    
    $
    2,172
    
    
    $
    1,652
    
    
    $
    1,245Net income
    
    $
    2,338
    
    
    $
    1,534
    
    
    $
    1,159
    
    
    $
    906Net income per diluted share
    
    $
    1.09
    
    
    $
    .71
    
    
    $
    .54
    
    
    $
    .432005Net premiums earned
    
    $
    11,977
    
    
    $
    12,767
    
    
    $
    12,155
    
    
    $
    12,222Net investment income
    
    
    1,936
    
    
    
    1,908
    
    
    
    1,890
    
    
    
    1,999Net investment gains
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other revenues
    
    
    136
    
    
    
    114
    
    
    
    163
    
    
    
    158Total revenues
    
    $
    14,049
    
    
    $
    14,789
    
    
    $
    14,208
    
    
    $
    14,379Income before income taxes
    
    $
    1,599
    
    
    $
    4,532
    
    
    $
    2,484
    
    
    $
    820Net income
    
    $
    1,188
    
    
    $
    3,178
    
    
    $
    1,721
    
    
    $
    612Net income per diluted share
    
    $
    .56
    
    
    $
    1.50
    
    
    $
    .81
    
    
    $
    .29
 44




---



##### Table of Contents



45




---



##### Table of Contents



46




---



##### Table of Contents



Directors
  Name, Position andTenure with the Company
    
    Age
    
    Principal Occupation and Business Experience For Past Five YearsDirector Whose Terms Expire In 2009Henry P. Semmelhack
Director since 1987
    
    
    70
    
    
    Chairman, President and Chief Executive
Officer from 1982 to 2002 of Barrister Global Services Network, Inc., a public computer software and services company.
Private investor since 2002.Directors Whose Terms Expire In 2008Andrew A. Alberti
Director since 1998
    
    
    61
    
    
    President of Cross River International, Inc.,
an insurance management consulting firm,
since 1993; President of Hanover Management
Services Inc., an insurance management
consulting firm, from 1989 to 1993.
Positions in the New York Insurance
Department Liquidation Bureau from 1973 to 1988.Frank J. Colantuono
Director since 1994
    
    
    58
    
    
    President and Chief Executive Officer of
Independent Health Association, Inc.,
a health maintenance organization, from 1984 to
2004. President Emeritus from 2004 to present.Directors Whose Terms Expire in 2007Brent D. Baird
Director since 1995
    
    
    68
    
    
    President and Chief Executive Officer of
the Company from 1995 to 2003; private
investor since 1991; limited partner of
Trubee Collins & Co. (member firm of New
York Stock Exchange, Inc.) from 1983 to 1991.Thomas E. Kahn
Director since 2000 and
Chairman of the Board
since May, 2004
    
    
    54
    
    
    Vice President and Secretary of Clayton
Management Company, an investment
management company, since 1993.
 47




---



##### Table of Contents



Executive Officers
  Name, Position andTenure with the Company
    
    Age
    
    Principal Occupation and Business Experience for Past Five YearsRobert M. Zak
Senior Vice President and
Chief Operating Officer
    
    
    49
    
    
    President and Chief Executive Officer of
MNH and Mutual since November 1, 1995; Director of
MNH since 1990; Director of the Company from 1994 to 2006; Sr. Vice President of MNH and
Mutual from 1992 to 1995; Chief Financial Officer of the Company, MNH and Mutual from 1991 through
1996; Vice President  Financial Services of MNH and Mutual from 1989 through 1996; Secretary of
MNH and Mutual from 1990 through November 1, 1995.Edward M. Murphy
Vice President,
Chief Investment Officer and
Assistant Secretary since 1991
    
    
    56
    
    
    Vice President and Chief Investment Officer
of the Company, Mutual and MNH since
1991; Assistant Vice President of Mutual
and MNH from 1989 to 1991.Kenneth J. Wilson
Vice President,
Treasurer, and Chief Financial
Officer since 1996
and Secretary since 1999
    
    
    59
    
    
    Vice President, Treasurer and Chief Financial
Officer of the Company, Mutual and MNH since
1996; President and Chief Executive Officer of
Carbadon Corp. and its operating subsidiary,
Empire of America Realty Credit Corp., from December 1995 to December 1996 and Chief
Financial Officer from November 1992 to December 1996.
  Section 16(a) Beneficial Ownership Reporting Compliance
  48




---



##### Table of Contents



Compensation Discussion and Analysis
   Compensation Committee Report:
  Submitted by the Compensation Committee:
          Frank J. Colantuono, Chairman
          Andrew A. Alberti
          Thomas E. Kahn
  Summary Compensation Table:
  49




---



##### Table of Contents



Name and Principal Position
    
    Year
    
    Salary
    
    Total$(2)
    
    $(2)Robert M. Zak(1)
    
    
    2006
    
    
    $
    0
    
    
    $
    0Chief Operating OfficerKenneth J. Wilson
    
    
    2006
    
    
    $
    0
    
    
    $
    0Chief Financial Officer
 
 (1)
    
    Since November 30, 2004, Mr. Zak has assumed the duties of the principal executive
officer of the Company.(2)
    
    Under the Services Agreement, effective January 1, 2003, salaries for officers who are
employees of Mutual are allocated by Mutual to the various services (administrative,
underwriting, claims and investments) provided by Mutual pursuant to the Services Agreement
and, where applicable, Mutual used the allocations to determine the fees it charged to MNH.
As such, the exact portion of their compensation that Mutual charged to MNH for the
services of Mr. Zak and Mr. Wilson is not determinable. Based on information provided by
Mutual, the Company estimates that the portion of Mr. Zaks and Mr. Wilsons salaries for
2006 included in the fees charged to MNH pursuant to the Services Agreement was $96,000 and
$51,000, respectively. Grants of Plan-Based Awards:
  Outstanding Equity Awards at Fiscal Year-End:
  Option Exercises and Stock Vested:
  OPTIONS EXERCISED AND STOCK VESTED
 Option Awards
    
    Stock AwardsNumber of
    
    
    
    
    
    Number ofShares
    
    Value
    
    Shares
    
    ValueAcquired on
    
    Realized on
    
    Acquired
    
    Realized onName
    
    Exercise
    
    Exercise
    
    on Vesting
    
    Vesting(#)
    
    ($) (1)
    
    (#)
    
    ($)Robert M. Zak
    
    
    7,500
    
    
    
    66,750
    
    
    
    0
    
    
    
    0
 
 (1)
    
    Based upon the difference between the closing price of the common stock on the American Stock
Exchange on the date of exercise and exercise price of the stock option. Pension Benefits:
 50




---



##### Table of Contents



Non-Qualified Deferred Compensation:
  Directors Compensation:
  FeesEarnedOr PaidName
    
    In Cash
    
    Total($)
    
    ($)Andrew A. Alberti
    
    $
    38,500
    
    
    $
    38,500Brent D. Baird
    
    
    37,000
    
    
    
    37,000Frank J. Colantuono
    
    
    48,000
    
    
    
    48,000Thomas E. Kahn (1)
    
    
    141,500
    
    
    
    141,500Henry P. Semmelhack
    
    
    42,500
    
    
    
    42,500
 
 (1)
    
    Mr. Kahn received additional director fees for his participation in meetings,
conferences, interviews and negotiations with third parties as a representative of the
Board, which resulted in the Merger Agreement with AEG. Compensation Committee Interlocks and Insider Participation:
  51




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##### Table of Contents



Security Ownership of Certain Beneficial Owners
  Number of SharesBeneficially
    
    PercentName and Address of Beneficial Owner
    
    Owned (1)
    
    of ClassJohn D. Weil
200 N. Broadway
St. Louis, Missouri 63102
    
    
    256,155
    (2)
    
    
    11.9
    %Merchants Mutual Insurance Company
250 Main Street
Buffalo, New York 14202
    
    
    255,000
    (3)
    
    
    11.9
    %Brent D. Baird and others
1350 One M&T Plaza
Buffalo, New York 14203
    
    
    232,400
    (4)
    
    
    10.8
    %Franklin Resources, Inc.
777 Mariners Island Blvd.
San Mateo, California 94404
    
    
    155,800
    (5)
    
    
    7.3
    %Kahn Brothers & Co., Inc.
555 Madison Avenue
New York, New York 10022
    
    
    112,186
    (6)
    
    
    5.2
    %Dimensional Fund Advisors, Inc.
1299 Ocean Avenue, 11th Floor
Santa Monica, California 90401
    
    
    112,424
    (7)
    
    
    5.2
    %
 
 (1)
    
    The beneficial ownership information presented is based upon information furnished by each
person or contained in filings made with the Securities and Exchange Commission. Except as
otherwise indicated, each person has sole voting and investment power with respect to the
Shares indicated.(2)
    
    These shares are owned by Woodbourne Partners, LP, an investment partnership of which Clayton
Management Company is the sole general partner. Clayton Management has sole voting and
investment power over these shares. John D. Weil owns 100% of the outstanding stock of
Clayton Management. Includes 4,995 shares held in six individual retirement accounts
maintained for the benefit of certain persons holding limited partnership interests in
Woodbourne Partners, LP. Mr. Weil disclaims beneficial ownership of such shares.(3)
    
    Mutual operates its business in conjunction with Merchants Group, Inc. and Merchants
Insurance 52




---



##### Table of Contents



Company of New Hampshire, Inc., Merchants Group Inc.s wholly-owned subsidiary.(4)
    
    Mr. Baird has sole voting and dispositive powers with respect to 13,600 shares and Mr. Baird,
members of the Baird family, and entities owned or controlled by the Baird family have shared
voting and dispositive power with respect to 218,800 shares.(5)
    
    Franklin Resources, Inc. through its advisory subsidiary, Franklin Advisory Services, LLC,
has sole voting and dispositive power with respect to the 155,800 shares.(6)
    
    Based on a Schedule 13G/A dated February 2, 2005, which indicated Kahn Brothers & Co., Inc.
shares dispositive power but no voting power with respect to these shares.(7)
    
    Dimensional Fund Advisors has sole voting and dispositive power with respect to the 112,424
shares.  Security Ownership of Management
  Number of Shares
    
    PercentName
    
    Beneficially Owned (1)
    
    of Class (2)Andrew A. Alberti
    
    
    0
    
    
    
    Brent D. Baird
    
    
    232,400
    (3)
    
    
    10.8
    %Frank J. Colantuono
    
    
    1,000
    
    
    
    *Thomas E. Kahn
    
    
    0
    (4)
    
    
    Henry P. Semmelhack
    
    
    1,500
    
    
    
    *Robert M. Zak
    
    
    22,410
    (5)
    
    
    1.0
    %Kenneth J. Wilson
    
    
    1,000
    
    
    
    *Directors and officers as a group (7 persons)
    
    
    258,310
    
    
    
    12.0
    %
 
 *
    
    Less than 1% of the amount outstanding.(1)
    
    The beneficial ownership information presented is based upon information furnished by each
person 53




---



##### Table of Contents



or contained in filings made with the Securities and Exchange Commission. Unless as
otherwise indicated, each person has sole voting and investment power with respect to the
Shares indicated.(2)
    
    Percentage calculations for each individual and group in the table are based on 2,145,652
shares outstanding.(3)
    
    See note 4 to table under Security Ownership of Certain Beneficial Owners.(4)
    
    See note 2 to table under Security Ownership of Certain Beneficial Owners. Mr. Kahn is a
Vice President and the Secretary of Clayton Management.(5)
    
    Includes 2,800 shares that Mr. Zak owns jointly with his spouse, and 1,110 Shares held by the
Merchants Mutual Supplemental Executive Retirement Plan for the benefit of Mr. Zak. Does not
include 255,000 Shares owned by Mutual as to which Mr. Zak disclaims beneficial ownership.
Mr. Zak is President and Chief Executive Officer of Mutual. 54




---



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55




---



##### Table of Contents



2006
    
    
    2005Audit Fees
    
    $
    294,300
    
    
    $
    176,050Audit Related Fees
    
    
    18,000
    (b)
    
    
    6,285
    (a)Tax Fees (c)
    
    
    3,000
    
    
    
    2,500All Other Fees
    
    
    
    
    
    
    $
    315,300
    
    
    $
    184,835
 
 (a)
    
    Audit related fees consist primarily of consulting fees related to internal
controls in connection with planning for compliance with Section 404 of the Sarbanes
Oxley Act of 2002.(b)
    
    Audit related fees consist primarily of fees related to the Companys investigation
of strategic alternatives and the preparation of audit workpapers for due diligence
activities by potential acquirers of the company.(c)
    
    Principally tax compliance services. 56




---



##### Table of Contents



57




---



##### 



(a)(1)
    
    The following financial statements of Merchants Group, Inc. are included on pages F-1 to F-25:
  
 Report of Independent Registered Public Accounting Firm
    
    
    F-1Consolidated Balance Sheet  December 31, 2006 and 2005.
    
    
    F-2Consolidated Statement of Operations  Years ended December 31, 2006, 2005 and 2004.
    
    
    F-4Consolidated Statement of Changes in Stockholders Equity  Years ended December 31, 2006, 2005 and 2004.
    
    
    F-6Consolidated Statement of Cash Flows  Years ended December 31, 2006, 2005 and 2004.
    
    
    F-7Notes to Consolidated Financial Statements.
    
    
    F-9
  (a)(2)
    
    The following financial statement schedules of Merchants Group, Inc. are filed herewith pursuant to Item 8:
            (a)(3)
    
    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).(10
    )
    
    (a)
    
    
    
    Management Agreement dated as of September 29, 1986 by and among Merchants Mutual
Insurance Company, Registrant and Merchants Insurance Company of
 58




---



##### Table of Contents



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)
    
    
    
    Services Agreement Among Merchants Mutual Insurance Company, Merchants Insurance
Company of New Hampshire, Inc. and Merchants Group, Inc. dated January 1, 2003
(incorporated by reference to Exhibit No. 10b to the Companys 2003 Quarterly Report
on Form 10-Q filed on May 14, 2003).(c)
    
    
    
    Reinsurance Pooling Agreement between Merchants Insurance Company of New Hampshire,
Inc. and Merchants Mutual Insurance Company effective January 1, 2003 (incorporated
by reference to Exhibit No. 10c to the Companys 2003 Quarterly Report on Form 10-Q
filed on May 14, 2003).(d)
    
    
    
    Endorsement to the Casualty Excess of Loss Reinsurance agreement between Merchants
Mutual Insurance Company, Merchants Insurance Company of New Hampshire, Inc. and
American Reinsurance Company dated February 23, 2004 (incorporated by reference to
Exhibit 10(e) to the Companys 2004 Quarterly Report on Form 10-Q filed on November
10, 2004).(e)
    
    
    
    Property Per Risk Excess of Loss Reinsurance Agreement between Merchants Mutual
Insurance Company, Merchants Insurance Company of New Hampshire, Inc. and American
Reinsurance Company dated April 16, 2004 (incorporated by reference to Exhibit 10(f)
to the Companys 2004 Quarterly Report on Form 10-Q filed on November 10, 2004).(f)
    
    
    
    Property Catastrophe Excess of Loss Reinsurance Agreement between Merchants Mutual
Insurance Company, Merchants Insurance Company of New Hampshire, Inc. and the
various reinsurers as identified by the Interest and Liabilities Agreements
attaching to and forming part of this Agreement (filed herewith).(g)
    
    
    
    Quota Share Reinsurance Treaty Agreement between Merchants Insurance Company of New
Hampshire, Inc. and The Subscribing Underwriting Members of Lloyds, London
specifically identified on the schedules attached to this agreement dated January 1,
2000 (incorporated by reference to Exhibit 10(h) to the Companys 2000 Annual Report
on Form 10-K filed on March 28, 2001).*
    
    
    (h)
    
    
    
    Form of Amended Indemnification Agreement entered into by Registrant with each
director and executive officer 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).*
    
    
    (i)
    
    
    
    Merchants Mutual Insurance Company Adjusted Return on Equity Incentive Compensation
Plan January 1, 2000 (incorporated by reference to Exhibit 10p to the Companys 2000
Annual Report on Form 10-K filed on March 28, 2001).*
    
    
    (j)
    
    
    
    Amendment No. 1 to Employee Retention Agreement between Robert M. Zak and Merchants
Mutual Insurance Company originally dated as of May 31, 1999, dated February 6, 2002
(incorporated by reference to Exhibit 10(s) to the Companys 2002 Annual Report on
Form 10-K filed on March 31, 2003).
 59




---



##### Table of Contents



*
    
    
    (k)
    
    
    
    Amendment No. 1 to Employee Retention Agreement between Edward M. Murphy and
Merchants Mutual Insurance Company originally dated as of March 1, 1999 dated
February 6, 2002 (incorporated by reference to Exhibit 10(t) to the Companys 10-K
filed on March 31, 2003).*
    
    
    (l)
    
    
    
    Amendment No. 1 to Employee Retention Agreement between Kenneth J. Wilson and
Merchants Mutual Insurance Company originally dated as of March 1, 1999 dated
February 6, 2002 (incorporated by reference to Exhibit 10(u) to the Companys Annual
Report on Form 10-K filed on March 31, 2003).(m)
    
    
    
    Amendment to Services Agreement, dated June 12, 2006, among Merchants Group, Inc.,
Merchants Insurance Company of New Hampshire, Inc., and Merchants Mutual Insurance
Company (incorporated by reference to Exhibit 99.1 to the Companys form 8-K Report
dated June 12, 2006).(n)
    
    
    
    Amendment to Services Agreement, dated September 28, 2006 among Merchants Group,
Inc., Merchants Insurance Company of New Hampshire, Inc., and Merchants Mutual
Insurance Company (incorporated by reference to Exhibit 99.1 to the Companys Form
8-K Report dated September 28, 2006).(o)
    
    
    
    Agreement and Plan of Merger, dated as of October 31, 2006, by and between Merchants
Group, Inc., American European Group, Inc., and American European Financial, Inc.,
(incorporated by reference to Exhibit 99.1 to the Companys Form 8-K dated October
31, 2006).(p)
    
    
    
    Agreement, dated December 22, 2006 among Merchants Group, Inc., Merchants Insurance
Company of New Hampshire, Inc., Merchants Mutual Insurance Company, Merchants
Preferred Insurance Company, MPIC, Inc., American European Group, Inc., Rutgers
Casualty Insurance Company, and Rutgers Enhanced Insurance Company, relating to
renewal rights (incorporated by reference to Exhibit 99.1 to the Companys Form 8-K
dated December 22, 2006).(11
    )
    
    (a)
    
    
    
    Statement re computation of per share earnings (incorporated herein by reference to
Note 9 to the Consolidated Financial Statements included in Item 8).(14.1
    )
    
    
    
    
    
    Merchants Group, Inc. Code of Conduct and Ethics (incorporated by reference to
Exhibit 14.1 to the Companys Annual Report on Form 10-K filed on March 31, 2005).(14.2
    )
    
    
    
    
    
    Merchants Insurance Group Code of Business Conduct, amended 12/2004 (incorporated by
reference to Exhibit 14.2 to the Companys Annual Report on Form 10-K filed on March
31, 2005).(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).(23
    )
    
    
    
    
    
    Report and Consent of Independent Registered Public Accounting Firm (filed herewith).
 60




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##### Table of Contents



(31
    )
    
    
    
    
    
    Rule 13a-14(a)/15d-14(a) Certifications (filed herewith).(32
    )
    
    
    
    
    
    Certification Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 (subsections (a)
and (b) of Section 1350, Chapter 63 of Title 18, United States Code (filed
herewith).
 
 *
    
    Indicates a management contract or compensation plan or arrangement.  Investor Relations
Merchants Group, Inc.
250 Main Street
Buffalo, New York 14202
 61




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##### Table of Contents



Amount atwhich shownAmortized Cost/
    
    
    Market
    
    
    in the balanceType of Investment
    
    Cost
    
    
    Value
    
    
    sheetFixed maturities:United States Government and
government agencies and authorities
    
    $
    10,245
    
    
    $
    10,139
    
    
    $
    10,139Corporate securities
    
    
    26,781
    
    
    
    26,448
    
    
    
    26,448Mortgage and asset backed securities
    
    
    82,454
    
    
    
    80,518
    
    
    
    80,518Obligations of states and political subdivisions
    
    
    40,307
    
    
    
    39,759
    
    
    
    39,759Total fixed maturities
    
    
    159,787
    
    
    
    156,864
    
    
    
    156,864Preferred stocks
    
    
    3,250
    
    
    
    3,563
    
    
    
    3,563Short-term investments
    
    
    17,017
    
    
    
    17,017
    
    
    
    17,017Other
    
    
    26
    
    
    
    84
    
    
    
    84$
    180,080
    
    
    $
    177,528
    
    
    $
    177,528
 62




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##### Table of Contents



2006
    
    
    2005
    
    
    2004Receivable from (payable to)
related parties, primarily Merchants
Mutual Insurance Company (1):Balance at beginning of period
    
    $
    (113
    )
    
    $
    (5,571
    )
    
    $
    (2,090
    )Change during the period
    
    
    (701
    )
    
    
    5,458
    
    
    
    (3,481
    )Balance at end of period
    
    $
    (814
    )
    
    $
    (113
    )
    
    $
    (5,571
    )Retrospective commission
receivable from (payable to)
Merchants Mutual Insurance Company (2):Balance at beginning of period
    
    $
    (2,590
    )
    
    $
    (1,141
    )
    
    $
    305Change during the period
    
    
    675
    
    
    
    (1,449
    )
    
    
    (1,446
    )Balance at end of period
    
    $
    (1,915
    )
    
    $
    (2,590
    )
    
    $
    (1,141
    )
 
 (1)
    
    Under a Services Agreement, Merchants Mutual Insurance Company (Mutual) provides employees,
services and facilities for Merchants Insurance Company of New Hampshire, Inc. (MNH) to carry
on its traditional insurance business on a fee basis. Under a Reinsurance Pooling Agreement,
Mutual and MNH pool or share premiums and losses on their traditional insurance business.
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,
services and facilities provided to MNH.(2)
    
    A Pooling Agreement between the Company and Mutual provides for retrospective commission
income or expense based upon the actual cumulative experience of the pooled business since the
agreements inception, compared to a targeted loss and LAE ratio of 74%. Commissions are settled annually, six months after the end of the calendar
year. 63




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##### Table of Contents



BALANCE SHEET
 December 31,2006
    
    
    2005AssetsInvestment in subsidiary
    
    $
    77,275
    
    
    $
    73,033Other assets
    
    
    3,486
    
    
    
    2,974Total assets
    
    $
    80,761
    
    
    $
    76,007Liabilities and Stockholders EquityOther liabilities
    
    $
    540
    
    
    $
    113Total liabilities
    
    
    540
    
    
    
    113Stockholders 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,
2006 or 2005
    
    
    
    
    
    
    Common stock, $.01 par value, authorized 10,000,000 shares;
2,145,652 shares issued and outstanding at December 31,
2006 and 2,132,652 shares issued and outstanding at
December 31, 2005
    
    
    33
    
    
    
    33Additional paid in capital
    
    
    36,540
    
    
    
    36,267Treasury stock, 1,139,700 shares at December 31, 2006
and 2005
    
    
    (22,766
    )
    
    
    (22,766
    )Accumulated other comprehensive loss
    
    
    (2,276
    )
    
    
    (2,540
    )Accumulated earnings
    
    
    68,690
    
    
    
    64,900Total stockholders equity
    
    
    80,221
    
    
    
    75,894Total liabilities and stockholders equity
    
    $
    80,761
    
    
    $
    76,007
 64




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##### Table of Contents



INCOME STATEMENT
 Year ended December 31,2006
    
    
    2005
    
    
    2004Revenues:Equity in net income of subsidiary
    
    $
    6,978
    
    
    $
    7,004
    
    
    $
    4,209Investment income
    
    
    99
    
    
    
    27
    
    
    
    8Total revenues
    
    
    7,077
    
    
    
    7,031
    
    
    
    4,217Expenses:General and administrative expenses
    
    
    1,676
    
    
    
    489
    
    
    
    685Operating income before income taxes
    
    
    5,401
    
    
    
    6,542
    
    
    
    3,532Income tax benefit
    
    
    (536
    )
    
    
    (157
    )
    
    
    (230
    )Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762
 65




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##### Table of Contents



STATEMENT OF CASH FLOWS
  Year ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Cash flows from operating activities:
    
    $
    (996
    )
    
    $
    (179
    )
    
    $
    (655
    )Cash flows from investing activities:Receipt of subsidiary common stock dividend
    
    
    1,000
    
    
    
    3,400
    
    
    
    1,200Purchase of other investments, net
    
    
    1,834
    
    
    
    (2,412
    )
    
    
    210Cash flows from investing activities
    
    
    2,834
    
    
    
    988
    
    
    
    1,410Cash flows from financing activities:Cash dividends
    
    
    (2,147
    )
    
    
    (1,164
    )
    
    
    (845
    )Exercise of common stock options
    
    
    273
    
    
    
    389
    
    
    
    84Cash flows from financing activities
    
    
    (1,874
    )
    
    
    (775
    )
    
    
    (761
    )Net increase (decrease) in cash and cash equivalents
    
    
    (36
    )
    
    
    34
    
    
    
    (6
    )Cash and cash equivalents, beginning of year
    
    
    40
    
    
    
    6
    
    
    
    12Cash and cash equivalents, end of year
    
    $
    4
    
    
    $
    40
    
    
    $
    6Reconciliation of net income to net
cash provided by operations:Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762Adjustments to reconcile net income
to net cash provided by operations:Equity in income of subsidiary
    
    
    (6,978
    )
    
    
    (7,004
    )
    
    
    (4,209
    )Increase (decrease) in other liabilities
    
    
    427
    
    
    
    53
    
    
    
    2(Increase) decrease in other
(non-investment) assets
    
    
    (382
    )
    
    
    39
    
    
    
    (204
    )Other, net
    
    
    
    
    
    
    34
    
    
    
    (6
    )Net cash used in operating activities
    
    $
    (996
    )
    
    $
    (179
    )
    
    $
    (655
    )
 66




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##### Table of Contents



NOTES TO CONDENSED FINANCIAL STATEMENTS
   67




---



##### Table of Contents



Assumed
    
    
    
    
    
    PercentageCeded
    
    Ceded
    
    Assumed
    
    from
    
    
    
    
    
    of amountGross
    
    to third
    
    to affiliates
    
    from third
    
    affiliates
    
    Net
    
    assumedamount
    
    parties
    
    (1)
    
    parties
    
    (1)
    
    amount
    
    to netYear Ended December 31, 2006Property and Casualty Premiums
    
    $
    47,652
    
    
    $
    3,259
    
    
    $
    45,024
    
    
    $
    631
    
    
    $
    37,740
    
    
    $
    37,740
    
    
    
    101.7
    %Year ended December 31, 2005Property and Casualty Premiums
    
    $
    53,532
    
    
    $
    3,747
    
    
    $
    50,957
    
    
    $
    1,172
    
    
    $
    45,135
    
    
    $
    45,135
    
    
    
    102.6
    %Year ended December 31, 2004Property and Casualty Premiums
    
    $
    53,900
    
    
    $
    2,967
    
    
    $
    52,452
    
    
    $
    1,519
    
    
    $
    53,102
    
    
    $
    53,102
    
    
    
    102.9
    %
 
 (1)
    
    Amounts are comprised of premiums assumed or ceded in accordance with the Reinsurance Pooling
Agreement with Mutual. 68




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##### Table of Contents



Losses & lossReserves
    
    Discount
    
    
    
    
    
    
    
    
    
    
    
    
    
    adjustment expensesDeferred
    
    for losses
    
    if any,
    
    
    
    
    
    
    
    
    
    
    
    
    
    incurred related to
    
    Amortization of
    
    Paid lossespolicy
    
    and loss
    
    deducted
    
    
    
    
    
    Net
    
    Net
    
    (1)
    
    (2)
    
    deferred
    
    & loss
    
    Directacquisition
    
    adjustment
    
    from
    
    Unearned
    
    earned
    
    investment
    
    Current
    
    Prior
    
    acquisition
    
    adjustment
    
    premiumcosts
    
    expenses
    
    reserves
    
    premiums
    
    premiums
    
    income
    
    years
    
    years
    
    costs
    
    expenses
    
    writtenYear ended:December 31, 2006
    
    $
    5,635
    
    
    $
    104,914
    
    
    $
    3,593
    
    
    $
    25,371
    
    
    $
    41,173
    
    
    $
    7,938
    
    
    $
    26,317
    
    
    $
    (4,170
    )
    
    $
    10,705
    
    
    $
    30,192
    
    
    $
    47,652December 31, 2005
    
    $
    6,527
    
    
    $
    115,191
    
    
    $
    3,651
    
    
    $
    29,662
    
    
    $
    49,121
    
    
    $
    7,733
    
    
    $
    29,711
    
    
    $
    (3,303
    )
    
    $
    12,771
    
    
    $
    37,810
    
    
    $
    53,532December 31, 2004
    
    $
    7,570
    
    
    $
    128,415
    
    
    $
    4,531
    
    
    $
    33,685
    
    
    $
    57,123
    
    
    $
    7,881
    
    
    $
    38,524
    
    
    $
    (843
    )
    
    $
    14,852
    
    
    $
    48,655
    
    
    $
    53,900
 69




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm
 
   
 F-1




---



##### Table of Contents



CONSOLIDATED BALANCE SHEET
  December 31,2006
    
    
    2005AssetsInvestments:Fixed maturities available for sale at fair value
    
    $
    156,864
    
    
    $
    166,593Preferred stock at fair value
    
    
    3,563
    
    
    
    4,312Other long-term investments at fair value
    
    
    84
    
    
    
    734Short-term investments
    
    
    17,017
    
    
    
    10,650Total investments
    
    
    177,528
    
    
    
    182,289Cash
    
    
    23
    
    
    
    82Interest due and accrued
    
    
    1,110
    
    
    
    998Premiums receivable from affiliate, net of allowance for
doubtful accounts of $125 in 2006 and
$158 in 2005
    
    
    12,034
    
    
    
    13,540Deferred policy acquisition costs from affiliate
    
    
    5,635
    
    
    
    6,527Reinsurance recoverable on unpaid losses
    
    
    11,575
    
    
    
    13,807Prepaid reinsurance premiums from affiliate
    
    
    3,700
    
    
    
    4,559Income taxes receivable
    
    
    
    
    
    
    109Deferred income taxes
    
    
    5,220
    
    
    
    5,367Other assets
    
    
    5,970
    
    
    
    6,700Total assets
    
    $
    222,795
    
    
    $
    233,978
  F-2




---



##### Table of Contents



MERCHANTS GROUP, INC.
 CONSOLIDATED BALANCE SHEET
  December 31,2006
    
    
    2005Liabilities and Stockholders EquityLiabilities:Reserve for losses and loss adjustment expenses
(from affiliate $51,435 and $50,239)
    
    $
    104,914
    
    
    $
    115,191Unearned premiums from affiliate
    
    
    25,371
    
    
    
    29,662Payable to affiliate
    
    
    814
    
    
    
    113Retrospective commission payable to affiliate
    
    
    1,915
    
    
    
    2,590Federal income taxes payable
    
    
    285
    
    
    
    Other liabilities (from affiliate $3,903 and $5,044)
    
    
    9,275
    
    
    
    10,528Total liabilities
    
    
    142,574
    
    
    
    158,084Stockholders equity:Common stock, $.01 par value, 10,000,000 shares authorized,
2,145,652 shares issued and outstanding at December 31, 2006
and 2,132,652 shares issued and outstanding at December 31, 2005
    
    
    33
    
    
    
    33Additional paid in capital
    
    
    36,540
    
    
    
    36,267Treasury stock, 1,139,700 shares at December 31, 2006
and 2005
    
    
    (22,766
    )
    
    
    (22,766
    )Accumulated other comprehensive loss
    
    
    (2,276
    )
    
    
    (2,540
    )Accumulated earnings
    
    
    68,690
    
    
    
    64,900Total stockholders equity
    
    
    80,221
    
    
    
    75,894Commitments and contingencies
    
    
    
    
    
    
    Total liabilities and stockholders equity
    
    $
    222,795
    
    
    $
    233,978
  F-3




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##### Table of Contents



MERCHANTS GROUP, INC.
 CONSOLIDATED STATEMENT OF OPERATIONS
  Year ended December 31,2006
    
    
    2005
    
    
    2004Revenues:Net premiums earned from affiliate
    
    $
    41,173
    
    
    $
    49,121
    
    
    $
    57,123Net investment income
    
    
    7,938
    
    
    
    7,733
    
    
    
    7,881Net investment losses
    
    
    (60
    )
    
    
    
    
    
    
    (221
    )Other revenues from affiliate
    
    
    489
    
    
    
    571
    
    
    
    722Total revenues
    
    
    49,540
    
    
    
    57,425
    
    
    
    65,505Expenses:Net losses and loss adjustment expenses (from
affiliate $22,585, $26,558 and $35,137)
    
    
    22,147
    
    
    
    26,408
    
    
    
    37,681Amortization of deferred policy acquisition costs
from affiliate
    
    
    10,705
    
    
    
    12,771
    
    
    
    14,852Other underwriting expenses (from affiliate
$6,967, $7,888 and $6,433)
    
    
    8,324
    
    
    
    8,811
    
    
    
    8,291Total expenses
    
    
    41,176
    
    
    
    47,990
    
    
    
    60,824Income before income taxes
    
    
    8,364
    
    
    
    9,435
    
    
    
    4,681Income tax provision
    
    
    2,427
    
    
    
    2,736
    
    
    
    919Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762Earnings per share:Basic
    
    $
    2.77
    
    
    $
    3.17
    
    
    $
    1.78Diluted
    
    $
    2.77
    
    
    $
    3.16
    
    
    $
    1.78Weighted average number of shares outstanding:Basic
    
    
    2,145
    
    
    
    2,115
    
    
    
    2,114Diluted
    
    
    2,145
    
    
    
    2,118
    
    
    
    2,118
  F-4




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##### Table of Contents



MERCHANTS GROUP, INC.
 CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
  Year ended December 31,2006
    
    
    2005
    
    
    2004Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762Other comprehensive income (loss) before tax:Unrealized gains (losses) on securities
    
    
    459
    
    
    
    (3,039
    )
    
    
    (1,926
    )Reclassification adjustment for gains or
losses included in net income
    
    
    (60
    )
    
    
    
    
    
    
    221Other comprehensive income (loss) before tax
    
    
    399
    
    
    
    (3,039
    )
    
    
    (1,705
    )Income tax provision (benefit) related to items
of other comprehensive loss
    
    
    135
    
    
    
    (1,035
    )
    
    
    (419
    )Other comprehensive income (loss)
    
    
    264
    
    
    
    (2,004
    )
    
    
    (1,286
    )Comprehensive income
    
    $
    6,201
    
    
    $
    4,695
    
    
    $
    2,476
  F-5




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##### Table of Contents



MERCHANTS GROUP, INC.
 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY
  Year ended December 31,2006
    
    
    2005
    
    
    2004Common stock:Beginning of year
    
    $
    33
    
    
    $
    33
    
    
    $
    32Exercise of common stock options
    
    
    
    
    
    
    
    
    
    
    1End of year
    
    
    33
    
    
    
    33
    
    
    
    33Additional paid in capital:Beginning of year
    
    
    36,267
    
    
    
    35,878
    
    
    
    35,795Exercise of common stock options
    
    
    273
    
    
    
    389
    
    
    
    83End of year
    
    
    36,540
    
    
    
    36,267
    
    
    
    35,878Treasury stock:Beginning and end of year
    
    
    (22,766
    )
    
    
    (22,766
    )
    
    
    (22,766
    )Accumulated other comprehensive income (loss):Beginning of year
    
    
    (2,540
    )
    
    
    (536
    )
    
    
    750Other comprehensive income (loss)
    
    
    264
    
    
    
    (2,004
    )
    
    
    (1,286
    )End of year
    
    
    (2,276
    )
    
    
    (2,540
    )
    
    
    (536
    )Accumulated earnings:Beginning of year
    
    
    64,900
    
    
    
    59,365
    
    
    
    56,448Net income
    
    
    5,937
    
    
    
    6,699
    
    
    
    3,762Cash dividends ($1.00/share in 2006,
$.55/share in 2005, and $.40/share in 2004),
(to affiliate, $255, $140 and $102)
    
    
    (2,147
    )
    
    
    (1,164
    )
    
    
    (845
    )End of year
    
    
    68,690
    
    
    
    64,900
    
    
    
    59,365Total stockholders equity
    
    $
    80,221
    
    
    $
    75,894
    
    
    $
    71,974
  F-6




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##### Table of Contents



MERCHANTS GROUP, INC.
 CONSOLIDATED STATEMENT OF CASH FLOWS
  Year ended December 31,2006
    
    
    2005
    
    
    2004Cash flows from operations:Collection of premiums from affiliate
    
    $
    38,889
    
    
    $
    47,175
    
    
    $
    53,924Payment of losses and loss adjustment expenses
(from affiliate $(21,389), $(20,413) and $(22,299))
    
    
    (29,862
    )
    
    
    (36,088
    )
    
    
    (50,276
    )Payment of underwriting expenses (from
affiliate $(17,837), $(17,437) and $(21,946))
    
    
    (19,306
    )
    
    
    (18,781
    )
    
    
    (23,550
    )Investment income received
    
    
    7,754
    
    
    
    8,002
    
    
    
    8,259Investment expenses paid
    
    
    (292
    )
    
    
    (380
    )
    
    
    (280
    )Income taxes paid
    
    
    (2,022
    )
    
    
    (2,152
    )
    
    
    (376
    )Other cash receipts from affiliate
    
    
    489
    
    
    
    571
    
    
    
    722Net cash used in operations
    
    
    (4,350
    )
    
    
    (1,653
    )
    
    
    (11,577
    )Cash flows from investing activities:Proceeds from fixed maturities sold or matured
    
    
    33,130
    
    
    
    56,653
    
    
    
    46,124Purchase of fixed maturities
    
    
    (22,949
    )
    
    
    (41,962
    )
    
    
    (37,547
    )Net (increase) decrease in preferred stock
    
    
    1,000
    
    
    
    (850
    )
    
    
    2,000Net (increase) decrease in other long-term investments
    
    
    650
    
    
    
    1,970
    
    
    
    (948
    )Net increase in short-term investments
    
    
    (6,367
    )
    
    
    (3,238
    )
    
    
    (6,294
    )Settlement of securities transactions, net
    
    
    
    
    
    
    (4,751
    )
    
    
    5,644Net cash provided by investing activities
    
    
    5,464
    
    
    
    7,822
    
    
    
    8,979Cash flows from financing activities:Settlement of affiliate balances, net
    
    
    701
    
    
    
    (5,457
    )
    
    
    3,481Proceeds from exercise of common stock options
    
    
    273
    
    
    
    389
    
    
    
    84Cash dividends (to affiliate $255, $140 and $102)
    
    
    (2,147
    )
    
    
    (1,164
    )
    
    
    (845
    )Net cash provided by (used in) financing activities
    
    
    (1,173
    )
    
    
    (6,232
    )
    
    
    2,720Increase (decrease) in cash
    
    
    (59
    )
    
    
    (63
    )
    
    
    122Cash, beginning of year
    
    
    82
    
    
    
    145
    
    
    
    23Cash, end of year
    
    $
    23
    
    
    $
    82
    
    
    $
    145
  F-7




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##### Table of Contents



MERCHANTS GROUP, INC.
 CONSOLIDATED STATEMENT OF CASH FLOWS
 RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATIONS
  Year ended December 31,2006
    
    
    2005
    
    
    2004Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762Adjustments:Net discount accretion on investments
    
    
    (363
    )
    
    
    (193
    )
    
    
    (83
    )Net investment losses
    
    
    60
    
    
    
    
    
    
    
    221(Increase) decrease in assets:Interest due and accrued
    
    
    (112
    )
    
    
    81
    
    
    
    181Premiums receivable from affiliate
    
    
    1,506
    
    
    
    1,596
    
    
    
    1,541Deferred policy acquisition costs from affiliate
    
    
    892
    
    
    
    1,043
    
    
    
    1,053Reinsurance recoverable on paid and unpaid losses
    
    
    2,232
    
    
    
    1,823
    
    
    
    7,085Prepaid reinsurance premiums from affiliate
    
    
    859
    
    
    
    36
    
    
    
    (1,529
    )Income taxes receivable
    
    
    109
    
    
    
    (109
    )
    
    
    881Deferred income taxes
    
    
    11
    
    
    
    696
    
    
    
    (113
    )Retrospective commission receivable from affiliate
    
    
    
    
    
    
    
    
    
    
    305Other assets
    
    
    730
    
    
    
    1,941
    
    
    
    (1,919
    )Increase (decrease) in liabilities:Reserve for losses and loss adjustment expenses
(from affiliate $1,196, $6,145 and $12,838)
    
    
    (10,277
    )
    
    
    (13,224
    )
    
    
    (18,059
    )Unearned premiums from affiliate
    
    
    (4,291
    )
    
    
    (4,023
    )
    
    
    (2,491
    )Retrospective commission payable to affiliate
    
    
    (675
    )
    
    
    1,449
    
    
    
    1,141Federal income taxes payable
    
    
    285
    
    
    
    
    
    
    
    Other liabilities (from affiliate $(1,141), $953
and $(3,087))
    
    
    (1,253
    )
    
    
    532
    
    
    
    (3,553
    )Net cash used in operations
    
    $
    (4,350
    )
    
    $
    (1,653
    )
    
    $
    (11,577
    )
  F-8




---



##### Table of Contents



MERCHANTS GROUP, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1.
    
    Sale of Company
  2.
    
    Significant Accounting Policies
 Principles of consolidation and basis of presentation
    F-9




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##### Table of Contents



Investments
    Net premiums earned
  Deferred policy acquisition costs
  Year Ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Beginning balance
    
    $
    6,527
    
    
    $
    7,570
    
    
    $
    8,623Acquisition cost deferred
    
    
    9,813
    
    
    
    11,728
    
    
    
    13,799Amortized to expense
    
    
    (10,705
    )
    
    
    (12,771
    )
    
    
    (14,852
    )Ending balance
    
    $
    5,635
    
    
    $
    6,527
    
    
    $
    7,570
 F-10




---



##### Table of Contents



Reinsurance
  Reserve for losses and loss adjustment expenses
    Income taxes
  F-11




---



##### Table of Contents



Other financial instruments
  3.
    
    Related Party Transactions
     F-12




---



##### Table of Contents



F-13




---



##### Table of Contents



Investments
 Investments in fixed maturities, preferred stock and other long-term investments
  Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    EstimatedCost/Cost
    
    
    Gains
    
    
    Losses
    
    
    Fair Value(in thousands)December 31, 2006Fixed maturities:U.S. Treasury securities and
obligations of U.S.
government corporations
and agencies
    
    $
    10,245
    
    
    $
    
    
    
    $
    106
    
    
    $
    10,139Obligations of states and
political subdivisions
    
    
    40,307
    
    
    
    4
    
    
    
    552
    
    
    
    39,759Corporate securities
    
    
    26,781
    
    
    
    36
    
    
    
    369
    
    
    
    26,448Mortgage and asset backed
securities
    
    
    82,454
    
    
    
    28
    
    
    
    1,964
    
    
    
    80,518Total
    
    $
    159,787
    
    
    $
    68
    
    
    $
    2,991
    
    
    $
    156,864Preferred stock
    
    $
    3,250
    
    
    $
    313
    
    
    $
    
    
    
    $
    3,563Other long-term investments
    
    $
    26
    
    
    $
    58
    
    
    $
    
    
    
    $
    84December 31, 2005Fixed maturities:U.S. Treasury securities and
obligations of U.S.
government corporations
and agencies
    
    $
    7,248
    
    
    $
    6
    
    
    $
    109
    
    
    $
    7,145Obligations of states and
political subdivisions
    
    
    45,927
    
    
    
    
    
    
    
    670
    
    
    
    45,257Corporate securities
    
    
    17,641
    
    
    
    2
    
    
    
    496
    
    
    
    17,147Mortgage and asset backed
securities
    
    
    98,850
    
    
    
    47
    
    
    
    1,853
    
    
    
    97,044Total
    
    $
    169,666
    
    
    $
    55
    
    
    $
    3,128
    
    
    $
    166,593Preferred stock
    
    $
    4,248
    
    
    $
    118
    
    
    $
    54
    
    
    $
    4,312Other long-term investments
    
    $
    676
    
    
    $
    58
    
    
    $
    
    
    
    $
    734
 F-14




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##### Table of Contents



Less than 12 months
    
    
    12 months or moreUnrealized
    
    
    
    
    
    
    UnrealizedFair Value
    
    
    Losses
    
    
    Fair Value
    
    
    Losses(in thousands)December 31, 2006Fixed maturities:U.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    4,228
    
    
    $
    15
    
    
    $
    5,911
    
    
    $
    91Obligations of states and
political subdivisions
    
    
    4,964
    
    
    
    22
    
    
    
    33,792
    
    
    
    530Corporate securities
    
    
    5,196
    
    
    
    31
    
    
    
    12,772
    
    
    
    338Mortgage and asset backed
securities
    
    
    3,008
    
    
    
    63
    
    
    
    74,752
    
    
    
    1,901Total
    
    $
    17,396
    
    
    $
    131
    
    
    $
    127,227
    
    
    $
    2,860Preferred stock
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Other long-term investments
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    December 31, 2005Fixed maturities:U.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    2,980
    
    
    $
    20
    
    
    $
    2,915
    
    
    $
    89Obligations of states and
political subdivisions
    
    
    20,877
    
    
    
    201
    
    
    
    20,224
    
    
    
    469Corporate securities
    
    
    8,278
    
    
    
    235
    
    
    
    8,766
    
    
    
    261Mortgage and asset backed
securities
    
    
    64,509
    
    
    
    938
    
    
    
    29,071
    
    
    
    915Total
    
    $
    96,644
    
    
    $
    1,394
    
    
    $
    60,976
    
    
    $
    1,734Preferred stock
    
    $
    1,296
    
    
    $
    54
    
    
    $
    
    
    
    $
    Other long-term investments
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
 F-15




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##### Table of Contents



EstimatedAmortized Cost
    
    
    Fair Value(in thousands)Due in one year or less
    
    $
    27,577
    
    
    $
    27,027Due after one year through five years
    
    
    104,846
    
    
    
    103,081Due after five years through ten years
    
    
    17,011
    
    
    
    16,590Due after ten years
    
    
    10,353
    
    
    
    10,166Total
    
    $
    159,787
    
    
    $
    156,864
    F-16




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##### Table of Contents



Year ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Proceeds from sales
    
    $
    4,211
    
    
    $
    
    
    
    $
    10,641Gross realized gains
    
    
    58
    
    
    
    
    
    
    
    479Gross realized losses
    
    
    
    
    
    
    
    
    
    
    Other-than-temporary impairments
    
    
    118
    
    
    
    
    
    
    
    700
 Net investment income
  Year ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Fixed maturities
    
    $
    7,379
    
    
    $
    7,573
    
    
    $
    7,873Short-term investments
    
    
    518
    
    
    
    206
    
    
    
    64Other
    
    
    333
    
    
    
    334
    
    
    
    297Total investment income
    
    
    8,230
    
    
    
    8,113
    
    
    
    8,234Investment expenses
    
    
    292
    
    
    
    380
    
    
    
    353Net investment income
    
    $
    7,938
    
    
    $
    7,733
    
    
    $
    7,881
 Reinsurance
  F-17




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##### Table of Contents



2006
    
    
    2005
    
    
    2004Premiums
    
    
    Premiums
    
    
    Premiums
    
    
    Premiums
    
    
    Premiums
    
    
    PremiumsWritten
    
    
    Earned
    
    
    Written
    
    
    Earned
    
    
    Written
    
    
    Earned(in thousands)Direct
    
    $
    47,652
    
    
    $
    50,732
    
    
    $
    53,532
    
    
    $
    53,603
    
    
    $
    53,900
    
    
    $
    55,528AssumedWith third parties
    
    
    631
    
    
    
    651
    
    
    
    1,172
    
    
    
    1,259
    
    
    
    1,519
    
    
    
    1,814Pooling Agreement
    
    
    37,740
    
    
    
    41,173
    
    
    
    45,135
    
    
    
    49,121
    
    
    
    53,102
    
    
    
    57,123Subtotal
    
    
    38,371
    
    
    
    41,824
    
    
    
    46,307
    
    
    
    50,380
    
    
    
    54,621
    
    
    
    58,937CededWith third parties
    
    
    (3,259
    )
    
    
    (3,162
    )
    
    
    (3,747
    )
    
    
    (3,398
    )
    
    
    (2,967
    )
    
    
    (2,891
    )Pooling Agreement
    
    
    (45,024
    )
    
    
    (48,221
    )
    
    
    (50,957
    )
    
    
    (51,464
    )
    
    
    (52,452
    )
    
    
    (54,451
    )Subtotal
    
    
    (48,283
    )
    
    
    (51,383
    )
    
    
    (54,704
    )
    
    
    (54,862
    )
    
    
    (55,419
    )
    
    
    (57,342
    )Net Premiums
    
    $
    37,740
    
    
    $
    41,173
    
    
    $
    45,135
    
    
    $
    49,121
    
    
    $
    53,102
    
    
    $
    57,123
  2006
    
    
    2005
    
    
    2004(in thousands)Direct
    
    $
    24,649
    
    
    $
    30,986
    
    
    $
    38,392AssumedWith third parties
    
    
    570
    
    
    
    1,414
    
    
    
    1,453Pooling Agreement
    
    
    22,585
    
    
    
    26,558
    
    
    
    35,137Subtotal
    
    
    23,155
    
    
    
    27,972
    
    
    
    36,590CededWith third parties
    
    
    (696
    )
    
    
    (4,209
    )
    
    
    (3,754
    )Pooling Agreement
    
    
    (24,961
    )
    
    
    (28,341
    )
    
    
    (33,547
    )Subtotal
    
    
    (25,657
    )
    
    
    (32,550
    )
    
    
    (37,301
    )Net losses and LAE
    
    $
    22,147
    
    
    $
    26,408
    
    
    $
    37,681
  F-18




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##### Table of Contents



Reserve for Losses and Loss Adjustment Expenses
  2006
    
    
    2005(in thousands)Reserve for losses and LAE at beginning of year
    
    $
    115,191
    
    
    $
    128,415Less reinsurance recoverables
    
    
    (13,807
    )
    
    
    (15,630
    )Net balance at beginning of year
    
    
    101,384
    
    
    
    112,785Provision for losses and LAE for claims occurring in:Current year
    
    
    26,317
    
    
    
    29,711Prior years
    
    
    (4,170
    )
    
    
    (3,303
    )22,147
    
    
    
    26,408Loss and LAE payments for claims occurring in:Current year
    
    
    (9,382
    )
    
    
    (10,359
    )Prior years
    
    
    (20,810
    )
    
    
    (27,450
    )(30,192
    )
    
    
    (37,809
    )Reserve for losses and LAE at end of year, net
    
    
    93,339
    
    
    
    101,384Plus reinsurance recoverables
    
    
    11,575
    
    
    
    13,807Balance at end of year
    
    $
    104,914
    
    
    $
    115,191
  Demand Loan
  F-19




---



##### Table of Contents



Income Taxes
  Year ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Current
    
    $
    2,416
    
    
    $
    2,040
    
    
    $
    1,032Deferred
    
    
    11
    
    
    
    696
    
    
    
    (113
    )Total income tax provision
    
    $
    2,427
    
    
    $
    2,736
    
    
    $
    919
  Year ended December 31,2006
    
    
    2005
    
    
    2004(in thousands)Computed provision at statutory rate
    
    $
    2,844
    
    
    $
    3,208
    
    
    $
    1,592Adjustments:Tax-exempt investment income
    
    
    (357
    )
    
    
    (368
    )
    
    
    (315
    )Dividend received deduction
    
    
    (65
    )
    
    
    (61
    )
    
    
    (47
    )Adjustments to prior years taxes
    
    
    
    
    
    
    
    
    
    
    (196
    )Reversal of excess tax reserves
related to uncertain tax positions
    
    
    
    
    
    
    (50
    )
    
    
    (120
    )Other
    
    
    5
    
    
    
    7
    
    
    
    5Total income tax provision
    
    $
    2,427
    
    
    $
    2,736
    
    
    $
    919
 F-20




---



##### Table of Contents



December 31,2006
    
    
    2005(in thousands)Deferred policy acquisition costs
    
    $
    (1,916
    )
    
    $
    (2,219
    )Other
    
    
    (125
    )
    
    
    (150
    )Total deferred tax liabilities
    
    
    (2,041
    )
    
    
    (2,369
    )Discounting of reserve for losses and
loss adjustment expenses
    
    
    4,486
    
    
    
    4,552Unearned premiums
    
    
    1,489
    
    
    
    1,726Unrealized net investment losses
    
    
    1,159
    
    
    
    1,295Other
    
    
    127
    
    
    
    163Total deferred tax assets
    
    
    7,261
    
    
    
    7,736Net deferred income taxes
    
    $
    5,220
    
    
    $
    5,367
   Stockholders Equity
 Dividends
  F-21




---



##### Table of Contents



Stock option plan
    2006
    
    
    2005
    
    
    2004Weighted
    
    
    
    
    
    
    Weighted
    
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    
    Average
    
    
    
    
    
    
    AverageOptions
    
    
    Exercise
    
    
    Options
    
    
    Exercise
    
    
    Options
    
    
    ExerciseOutstanding
    
    
    Price
    
    
    Outstanding
    
    
    Price
    
    
    Outstanding
    
    
    PriceBeginning of year
    
    
    13,000
    
    
    $
    21.00
    
    
    
    31,500
    
    
    $
    21.00
    
    
    
    35,500
    
    
    
    21.00Granted
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Exercised
    
    
    (13,000
    )
    
    
    21.00
    
    
    
    (18,500
    )
    
    
    21.00
    
    
    
    (4,000
    )
    
    
    21.00Forfeited
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    End of year
    
    
    
    
    
    
    21.00
    
    
    
    13,000
    
    
    
    21.00
    
    
    
    31,500
    
    
    
    21.00Options
exercisable
at year-end
    
    
    
    
    
    
    21.00
    
    
    
    13,000
    
    
    
    21.00
    
    
    
    31,500
    
    
    
    21.00
 Treasury stock
  Preferred stock
  F-22




---



##### Table of Contents



Earnings Per Share
  Year Ended December 31,2006
    
    
    2005
    
    
    2004(in thousands except per share amounts)Basic:Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762Weighted average shares outstanding
    
    
    2,145
    
    
    
    2,115
    
    
    
    2,114Basic earnings per share
    
    $
    2.77
    
    
    $
    3.17
    
    
    $
    1.78Diluted:Net income
    
    $
    5,937
    
    
    $
    6,699
    
    
    $
    3,762Weighted average shares outstanding
    
    
    2,145
    
    
    
    2,115
    
    
    
    2,114Plus incremental shares from assumed
conversion of stock options
    
    
    
    
    
    
    3
    
    
    
    4Weighted average shares
outstanding-adjusted
    
    
    2,145
    
    
    
    2,118
    
    
    $
    2,118Diluted earnings per share
    
    $
    2.77
    
    
    $
    3.16
    
    
    $
    1.78
 Underwriting Results by Product
  For The Year Ended December 31,(000s)2006
    
    
    2005
    
    
    2004Net
    
    
    Loss &
    
    
    Net
    
    
    Loss &
    
    
    Net
    
    
    Loss &Premiums
    
    
    ALAE
    
    
    Premiums
    
    
    ALAE
    
    
    Premiums
    
    
    ALAEEarned
    
    
    Ratio
    
    
    Earned
    
    
    Ratio
    
    
    Earned
    
    
    RatioPrivate passenger auto liability
    
    $
    3,446
    
    
    
    24.7
    %
    
    $
    5,870
    
    
    
    21.0
    %
    
    $
    9,543
    
    
    
    59.0
    %Homeowners
    
    
    3,869
    
    
    
    69.1
    %
    
    
    4,732
    
    
    
    50.3
    %
    
    
    5,541
    
    
    
    63.6
    %Commercial auto liability
    
    
    10,256
    
    
    
    40.9
    %
    
    
    11,616
    
    
    
    32.0
    %
    
    
    12,532
    
    
    
    53.5
    %Workers compensation
    
    
    4,284
    
    
    
    117.1
    %
    
    
    4,532
    
    
    
    9.1
    %
    
    
    4,535
    
    
    
    31.4
    %Commercial package
    
    
    13,894
    
    
    
    35.8
    %
    
    
    15,343
    
    
    
    63.9
    %
    
    
    15,764
    
    
    
    76.7
    %General liability
    
    
    781
    
    
    
    12.7
    %
    
    
    1,147
    
    
    
    244.5
    %
    
    
    700
    
    
    
    165.5
    %Other
    
    
    4,643
    
    
    
    41.1
    %
    
    
    5,881
    
    
    
    37.3
    %
    
    
    8,508
    
    
    
    43.5
    %Total
    
    $
    41,173
    
    
    
    47.9
    %
    
    $
    49,121
    
    
    
    45.9
    %
    
    $
    57,123
    
    
    
    59.9
    %
 F-23




---



##### Table of Contents



Benefit Programs
   Commitments and Contingencies
   F-24




---



##### Table of Contents



Merchants Group, Inc.Date: March 28, 2007
    BY:
    
    /s/ Robert M. ZakRobert M. Zak, Senior Vice President and Chief Operating Officer  SIGNATURE
    
    TITLE
    
    DATE/s/ Robert M. Zak

Robert M. Zak
    
    Director, Sr. VP &
Chief Operating
Officer (principal
executive officer)
    
    March 28, 2007/s/ Kenneth J. Wilson

Kenneth J. Wilson
    
    Vice President & CFO
(principal financial
and accounting officer)
    
    March 28, 2007/s/ Thomas E. Kahn

Thomas E. Kahn
    
    Director, Chairman
of the Board
    
    March 28, 2007/s/ Brent D. Baird

Brent D. Baird
    
    Director
    
    March 28, 2007/s/ Andrew A. Alberti

Andrew A. Alberti
    
    Director
    
    March 28, 2007/s/ Frank J. Colantuono

Frank J. Colantuono
    
    Director
    
    March 28, 2007/s/ Henry P. Semmelhack

Henry P. Semmelhack
    
    Director
    
    March 28, 2007