<PAGE>   1
                                    FORM 10-K

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                 ---------------
(Mark One)
[x]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 1996
                          -----------------
                                       OR
[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

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              (I.R.S. Employer
incorporation or organization)               Identification No.)

250 Main Street, Buffalo, New York                                 14202
--------------------------------------------------------------------------------
(Address of principal executive offices)                         (Zip Code)

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

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

<TABLE>
<CAPTION>
                                   Name of each exchange on
Title of each class                which registered
-------------------                ----------------
<S>                                <C>
Common Stock, $.01                 American Stock Exchange, Inc.
par value per share
</TABLE>

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

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

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

     As of March 17, 1997, 2,999,602 shares of common stock were outstanding.
The aggregate market value of the common shares held by non-affiliates of
Merchants Group, Inc. on March 1, 1997 was $47,797,840.

                       DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the definitive Proxy Statement for the 1997 Annual Meeting of
Stockholders are incorporated by reference into Part III.




<PAGE>   2

                              MERCHANTS GROUP, INC.

                           ANNUAL REPORT ON FORM 10-K

                                DECEMBER 31, 1996


<TABLE>
<CAPTION>
         PART I                                               PAGE
         ------                                               ----

<S>      <C>                                                   <C>
ITEM 1.  BUSINESS.                                              3

ITEM 2.  PROPERTIES.                                           24

ITEM 3.  LEGAL PROCEEDINGS.                                    25

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.  26


         PART II
         -------

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED     27
         STOCKHOLDER MATTERS.

ITEM 6.  SELECTED FINANCIAL DATA.                              28

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL     30
         CONDITION AND RESULTS OF OPERATIONS.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.          38

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON      38
         ACCOUNTING AND FINANCIAL DISCLOSURE.


         PART III
         --------

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.   39

ITEM 11. EXECUTIVE COMPENSATION.                               39

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS       39
         AND MANAGEMENT.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.       39


         PART IV
         -------

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND          40
         REPORTS ON FORM 8-K.
</TABLE>






                                        2


<PAGE>   3



                                     PART I

Item 1.  BUSINESS.

General
-------

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

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

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

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










                                       3
<PAGE>   4

     Any amendment or modification of the Management Agreement must be approved
by the New York Insurance Department. The Management Agreement may be terminated
by any party to the agreement upon five years written notice to each of the
other parties. Mutual and MNH have jointly developed and paid for all
accounting, computer and insurance marketing systems used in their businesses.
In the event of termination of the Management Agreement, each company has a
right, at no cost, to obtain copies of all these systems, together with the
right to use these systems in perpetuity.

     From 1975 through 1984, MNH and Mutual pooled their insurance businesses
pursuant to a pooling agreement (the "Pooling Agreement"). Prior to January 1,
1983, premiums and losses were allocated 10% to MNH and 90% to Mutual;
thereafter, pursuant to an amendment to the Pooling Agreement, the respective
pooling percentages were 25% for MNH and 75% for Mutual.

     The Pooling Agreement was terminated effective December 31, 1984. The
termination provided for the runoff of unearned premiums, losses and expenses
associated with insurance contracts effective prior to January 1, 1985 according
to the pooling percentages set forth in the Pooling Agreement. For insurance
contracts effective subsequent to December 31, 1984, premiums written and
related premiums earned, losses and loss adjustment expenses ("LAE"),
commissions, premium taxes, and assessments are retained by the company which
issues the insurance policies.

Marketing
---------

     The Company markets its products through approximately 660 independent
agents, which also represent Mutual. The Company primarily directs its marketing
efforts to its independent agents and believes the more closely it works with
those agents, the more likely it becomes that the agents will place business
with the Company. The Company believes the opportunity for growth exists through
further penetration of existing agents' new and renewal business, as well as
selective expansion of this group of agents in the future.

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







                                       4
<PAGE>   5

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

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

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

     In addition to standard commissions paid as a percentage of premiums
written, the Company's agents are eligible to participate in the Agents' Profit
Sharing Plan, which rewards agents based on premiums written and a two year loss
and allocated LAE ratio on business placed by the agent with the Company.
Payments under the Agents' Profit Sharing Plan for 1996 totalled $1,505,000 or
1.5% of direct premiums written, and increased participating agents' commissions
received from the Company by approximately 26%. The Company believes the terms
of its Agents' Profit Sharing Plan encourage its agents to increase the volume
of profitable business they place with the Company. In June 1994, the Company
instituted an Agent's Stock Option Program for MNH's agents which granted
options to purchase 22,500 shares of the Company's common stock to 54 agencies
based on their volume and profitability. The Company




                                       5
<PAGE>   6

believes the Agent's Stock Option Program aligns the interests of its agents
more closely with the interests of the Company and its stockholders.

     Unlike many of its competitors, the Company pays the same commission rate
on policies billed directly to the insured by the Company and on policies billed
to the agent and, in turn, re-billed to the insured by the agent. By offering to
bill the insured directly for both personal and commercial policies, the Company
helps its agents minimize their administrative costs without a reduction in
commission income. Approximately 75% of the voluntary premiums written by the
Company in 1995 and 1996 were billed directly to policyholders.

     In order to assist its independent agents to compete more effectively with
insurance companies that have direct sales forces, and to strengthen its
relationship with those agents, the Company is providing advanced automation
services, such as download capability, to many of its agents. Download
capability, the electronic transmission of policy transactions from a company to
an agency database, is a significant step in helping agents and the Company
achieve the goal of single-entry, multiple company interface. The benefits to
agents are simplified client management, more time available for sales
activities, and fewer errors. Currently, the Company is downloading policy
transactions to approximately 80 agents for private passenger automobile and
homeowners' policies. The Company plans to offer download capability for
commercial insurance policies when the property and casualty insurance industry
adopts standards for downloading. The Company believes that developing
automation capabilities to facilitate the sharing of information with its agents
will improve its competitive position compared to other property and casualty
insurers that do not have such capabilities.

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

     The Company is licensed to issue insurance policies in 13 states, primarily
in the northeastern United States. In 1996, net premiums written totaled
$96,622,000, with 55% of the net premiums written derived from commercial lines
of insurance and 45% from personal lines of insurance.







                                       6
<PAGE>   7

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

<TABLE>
<CAPTION>
              Years Ended December 31,
              ------------------------
                1994   1995   1996
                ----   ----   ----
<S>             <C>    <C>    <C>
New York         65%    64%    64%
New Jersey       11     14     15
New Hampshire    12     11     11
Rhode Island      4      4      3
Pennsylvania      3      3      3
Massachusetts     3      3      3
Other             2      1      1
                ---    ---    ---
  Total         100%   100%   100%
                ===    ===    ===
</TABLE>

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

     * Personal automobile - full coverage of family-owned standard performance
automobiles, generally requiring drivers with no violations or at-fault
accidents in the last three years, and minimal youthful operator exposure.

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

     * Commercial automobile - primarily light and medium use 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 no losses in the last three years and with three
years of business experience.

     * 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.





                                       7
<PAGE>   8

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

     Agents of the Company are also agents of Mutual, which generally sells the
same lines of insurance as the Company to standard risk individuals and
businesses. Applicants that meet the Company's preferred risk criteria are
issued policies by the Company. Applicants that do not meet the Company's
underwriting criteria, but which meet the less restrictive criteria of Mutual,
are issued policies by Mutual, generally at higher premium rates. During the
years 1993 through 1995, under a quota share agreement with Mutual, the Company
assumed 10% of the standard risks insured by Mutual, which would not generally
meet the Company's more stringent underwriting guidelines. The terms of the
agreement allow Mutual to reduce its cessions to MNH to 0% of Mutual's direct
voluntary premiums written for any calendar year prior to the beginning of that
calendar year. Mutual did not cede any of its voluntary direct written premiums
to MNH under this agreement in 1996 and has informed the Company that it will
not cede any of its voluntary direct written premiums to MNH in 1997.

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


                                       8
<PAGE>   9

     The following table shows, for each of the years in the three year period
ended December 31, 1996, (i) the amount of the Company's net premiums written
attributable to various personal lines and commercial lines and (ii)
underwriting results attributable to each such line as measured by the calendar
year loss ratio for such line. The loss ratio is the ratio of incurred losses to
net premiums earned for a given period.

<TABLE>
<CAPTION>
                                                      Year ended December 31,
                        -------------------------------------------------------------------------------
                                   1994                      1995                       1996
                        -------------------------------------------------------------------------------
                         Premiums                   Premiums                   Premiums
                         Written                    Written                    Written
                        -------------------------------------------------------------------------------
                                           Loss                       Loss                       Loss
                         Amount     %      Ratio    Amount     %      Ratio    Amount     %      Ratio
                        -------------------------------------------------------------------------------
                                                       (dollars in thousands
<S>                     <C>        <C>     <C>     <C>        <C>     <C>     <C>        <C>      <C>
Personal
   Auto Liability       $21,278    23.6%   79.2%   $22,556    23.1%   78.2%   $23,964    24.8%    80.9%
   Auto Physical
       Damage            10,603    11.8    53.0     11,546    11.8    52.1     12,241    12.7     60.3
   Homeowners'
       Multi-Peril        5,808     6.4    76.5      6,606     6.8    77.8      7,269     7.5     68.1
                        -------    ----            -------    ----            -------    ----

       Total             37,689    41.8    71.5     40,708    41.7    70.7     43,474    45.0     73.1
Commercial
   Auto Liability        12,572    13.9    74.9     13,496    13.8    69.5     13,050    13.5     43.4
   Auto Physical
       Damage             2,918     3.2    41.1      3,047     3.1    51.8      3,225     3.3     51.7
   Commercial
       Multi-Peril       19,034    21.1    76.4     20,845    21.4    71.3     20,725    21.5     59.9
   Workers'
       Compensation      10,229    11.3    54.0     12,223    12.5    94.7     10,023    10.4    110.7
   Other Lines            7,745     8.7    58.8      7,258     7.5    56.0      6,125     6.3     57.4
                        -------    ----            -------    ----            -------    ----
       Total             52,498    58.2    67.1     56,869    58.3    72.7     53,148    55.0     63.5
                        -------    ----            -------    ----            -------    ----
Total Personal
   and Commercial       $90,187   100.0%   68.9%   $97,577   100.0%   71.9%   $96,622   100.0%    67.7%
                        =======    ====            =======    ====            =======    ====
</TABLE>

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










                                       9
<PAGE>   10

     The following table sets forth the composition of voluntary direct premiums
written for 1992 through 1996:

<TABLE>
<CAPTION>
                            Years Ended December 31,
                            ------------------------
                         1992   1993   1994   1995   1996
                         ----   ----   ----   ----   ----
<S>                      <C>    <C>    <C>    <C>    <C>
Commercial                57%    60%    62%    62%    60%
Personal                  43     40     38     38     40
                         ---    ---    ---    ---    ---
  Total                  100%   100%   100%   100%   100%
                         ===    ===    ===    ===    ===
</TABLE>

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

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

     Despite the lack of significant premium rate increases since 1988 in most
of its commercial lines and the increased competition in the lines of business
that the Company targets, the Company believes it can insure commercial business
profitably by selecting those classes of risks that offer better profit
potential. The Company competes for commercial business based upon the service
it provides to agents and policyholders, the compensation it pays to its agents,
and in certain instances, the price of its products. The Company establishes
prices after considering its costs, the exposures inherent in a particular class
of risk, potential investment income, projected future trends in loss frequency
and severity, and the degree of competition within a specific territory.
Accordingly, the relative prices of the Company's commercial products vary
considerably in relation to competitors' prices.

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

     The Company offers personal automobile and homeowners' insurance to
preferred risk individuals, generally requiring experienced drivers with no
accidents or moving violations in the last three years for personal automobile
insurance, and medium to high value homes with systems that are less than thirty
years old in fire protected areas for homeowners' insurance. Personal


                                       10
<PAGE>   11

automobile premium rates attempt to cover costs associated with required
participation in involuntary personal automobile programs, in addition to the
costs directly associated with the policies written voluntarily.

     The Company and Mutual have developed automated underwriting procedures for
personal automobile and homeowners business, which perform an initial review of
policy applications based upon established underwriting guidelines. Applications
that do not meet the guidelines for automated acceptance are either referred to
personal lines underwriters who review the applications and assess exposure, or
rejected if the risk characteristics are such that neither the Company nor
Mutual would accept the insured.

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

     The Company's gross (direct and assumed) premiums written attributable to
involuntary policies were $9,274,000, $11,317,000 and $11,325,000 in 1994, 1995
and 1996, respectively, mostly in New York. The Company is unable to predict the
level of its annual involuntary business for 1997 or future years.

Claims
------

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





                                       11
<PAGE>   12

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

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

     The Company, like other insurance companies, establishes reserves for
losses and LAE. These reserves are estimates intended to cover the probable
ultimate cost of settling all losses incurred and unpaid, including those losses
not yet reported to the Company. An insurer's ultimate liability is likely to
differ from such estimates because during the life of a claim, which may be many
years, additional facts affecting an insurer's liability may become known. The
reserves of an insurer are frequently adjusted based on monitoring by the
insurer and periodic review by state insurance departments. Since 1989, the
Company has retained an independent actuarial firm to satisfy state insurance
departments' requirements with respect to the certification of reserves for
losses and LAE.

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

     The Company's reserving process is based on the assumption that past
experiences, adjusted for the effect of current developments and trends, are
relevant in predicting future events. In the absence of specific developments,
the process also assumes that the legal climate regarding the claims process and
underlying liabilities remains constant. Other assumptions employed by the
Company or its actuarial firm change from time to time as circumstances change.
In estimating loss and LAE reserves, the Company employs a number of actuarial
methods, depending on their applicability to each line of business, in order to
balance the advantages and disadvantages of each method. No single method is
used to estimate loss and LAE reserves. Although different actuarial methods may
give rise to different reserve estimates,



                                       12
<PAGE>   13

which could be higher or lower than the reserves actually established by the
Company, the Company believes that those differences are not material.

     The Company has recorded recent increases in reserves for prior accident
year losses in subsequent years. These increases were necessary because of
several factors, including inaccurate estimation of the extent of liability
associated with a number of claims involving serious injuries and claims
handling practices that did not produce accurate and timely reserve levels for a
broad range of claims. During 1996, the Company experienced greater than
anticipated severity (claim value) in liability claims primarily related to its
workers' compensation line of insurance.





                                       13
<PAGE>   14

The following table sets forth the changes in the reserve for
losses and LAE for 1994, 1995 and 1996.

<TABLE>
<CAPTION>
                                       Year Ended December 31,
                                  ------------------------------
                                      1994       1995       1996
                                      ----       ----       ----
                                           (in thousands)
<S>                               <C>        <C>        <C>
Reserve for losses and LAE
  at beginning of year            $ 93,896   $104,015   $119,722
  Less reinsurance recoverables      3,957      6,401      6,004
                                  --------   --------   --------
  Net balance at beginning of
    year                            89,939     97,614    113,718

Provision for losses and LAE
  for claims occurring in:
  Current year                      65,818     67,150     72,771
  Prior years                        4,982     11,045      6,832
                                  --------   --------   --------
                                    70,800     78,195     79,603
                                  --------   --------   --------
  Losses and LAE payments for
  claims occurring in:
  Current year                      28,574     25,175     28,512
  Prior years                       34,551     36,916     38,549
                                  --------   --------   --------
                                    63,125     62,091     67,061
                                  --------   --------   --------

Reserve for losses and LAE
  at end of year, net               97,614    113,718    126,260
  Plus reinsurance recoverables      6,401      6,004      7,219
                                  --------   --------   --------
  Balance at end of year          $104,015   $119,722   $133,479
                                  ========   ========   ========
</TABLE>

     In 1994, 1995 and 1996, the Company increased its reserves for prior years
by $4,982,000, $11,045,000 and $6,832,000, respectively. The increase in
reserves for prior years made in 1994 was primarily attributable to the
$3,135,000 settlement of the AIP matter discussed in Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations" as
well as higher than anticipated severity of liability claims on auto, commercial
multi-peril and workers' compensation policies. The increase in reserves for
prior years made in 1995 was primarily attributable to higher than anticipated
severity of liability claims on homeowners, businessowners, workers'
compensation and commercial package lines of insurance. The increase in reserves
for prior years made in 1996 was primarily attributable to higher than
anticipated severity of claims on workers' compensation policies.



                                       14
<PAGE>   15

     The first line of the following table presents, as of the end of the year
at the top of each column, the estimated amount of unpaid losses and LAE for
claims arising in that year and in all prior years, including claims that had
occurred but were not yet reported to the Company. For each column, the rows of
the table present, for the same group of claims, the amount of unpaid losses and
LAE as re-estimated as of the end of each succeeding year. The estimate is
modified as more information becomes known about the number and severity of
claims for each year. The "cumulative deficiency" represents the change in the
estimated amount of unpaid losses and LAE from the end of the year at the top of
each column through the end of 1996.

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

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






                                       15
<PAGE>   16

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

                                    1986     1987     1988     1989     1990     1991     1992     1993     1994    1995
                                    ----     ----     ----     ----     ----     ----     ----     ----     ----    ----
                                                                     (in thousands)

<S>                               <C>      <C>      <C>      <C>      <C>      <C>      <C>      <C>      <C>      <C>
Liability for losses and LAE      $32,137  $44,778  $55,412  $66,892  $71,222  $77,274  $86,159  $89,939  $97,614  $113,718

Liability re-estimated as of:
  One year later                   33,520   47,519   57,238   75,614   77,548   80,841   88,284   94,921  108,659   120,550
  Two years later                  33,873   47,112   61,534   76,310   75,987   81,743   91,224  100,607  113,091
  Three years later                34,429   51,023   61,928   73,578   78,106   83,693   95,396  106,382
  Four years later                 39,086   52,104   61,014   75,672   79,563   87,105   99,779
  Five years later                 38,404   51,249   61,787   76,746   81,308   90,428
  Six years later                  38,049   51,764   62,201   77,026   84,530
  Seven years later                38,411   52,141   62,332   79,690
  Eight years later                38,368   52,035   64,388
  Nine years later                 38,283   53,836
  Ten years later                  40,155

Cumulative Deficiency  - $         (8,018)  (9,058)  (8,976) (12,798) (13,308) (13,154) (13,620) (16,443) (15,477)   (6,832)
                       - %          (24.9)   (20.2)   (16.2)   (19.1)   (18.7)   (17.0)   (15.8)   (18.3)   (15.9)     (6.0)

Paid (Cumulative) as of:
  One year later                   15,225   20,649   21,393   32,538   32,666   30,082   35,724   34,551   36,916    38,549
  Two years later                  21,907   28,049   37,459   47,816   47,339   50,490   56,003   56,965   60,074
  Three years later                26,159   38,936   47,816   58,489   61,585   63,925   69,863   72,963
  Four years later                 31,943   44,819   52,758   66,466   70,219   72,917   80,156
  Five years later                 34,076   46,931   56,732   71,322   75,018   79,374
  Six years later                  35,356   48,985   59,162   73,558   78,398
  Seven years later                36,644   50,547   59,994   75,822
  Eight years later                37,495   50,815   61,546
  Nine years later                 37,525   51,795
  Ten years later                  38,432
</TABLE>

                                       16
<PAGE>   17

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

<TABLE>
<CAPTION>
                                         As of December 31,
                                   ------------------------------
                                       1994       1995       1996
                                       ----       ----       ----
                                             (in thousands)
<S>                                <C>        <C>        <C>
Loss and LAE reserves on a
  STAT basis                       $ 96,624   $113,059   $125,821
Adjustments:
  Loss reserves ceded under a
      quota share agreement with
      an unrelated party                927        595        379
  Ceded reinsurance balances
      recoverable                     6,401      6,004      7,219
  Write-down of reinsurance
      recoverable                        63         64         60
                                   --------   --------   --------
Loss and LAE reserves on a
  GAAP basis                       $104,015   $119,722   $133,479
                                   ========   ========   ========
</TABLE>

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

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

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




                                       17
<PAGE>   18

     Since 1980, most of the Company's treaty and facultative reinsurance has
been placed with a large United States domiciled reinsurer. The Company's excess
of loss arrangements for automobile liability, general liability and workers'
compensation insurance provide for recovery of losses over $500,000 up to a
maximum of $5,000,000 per occurrence. For claims occurring prior to 1993, the
$500,000 threshold is indexed for inflation for casualty lines other than
workers' compensation and New York State no-fault, and applies retroactively to
all occurrences until they are settled. There is no index provision for casualty
claims occurring after 1992. This coverage is supplemented by additional treaty
reinsurance covering losses up to $5,000,000 in excess of the first $5,000,000.

     Property reinsurance agreements provide for recovery of property losses
over $500,000 up to $2,000,000 per occurrence without any index provision.
Property catastrophe coverage placed with many reinsurers worldwide provides for
recovery of 95% of up to $40,000,000 above aggregate retained losses of
$5,000,000 for each natural disaster. The property catastrophe coverage limits
are shared by the Company and Mutual on a pro rata basis based upon the gross
reported losses of the Company and Mutual for a covered event. The reinsurance
premium rate paid varies for each line of business.

     As of December 31, 1996, the Company had $7,219,000 of reinsurance
recoverable on unpaid losses and paid losses, all of which it expects to
recover. The excess of loss reinsurance agreement has no definite term, but may
be renegotiated yearly. The property catastrophe reinsurance agreement expires
December 3l, 1997.

     In 1987, the Company and its primary reinsurer agreed to limit the losses
which could be recovered by the Company under its excess of loss treaties for
the 1980 through 1986 accident years in exchange for a cap on retrospective
premiums due the reinsurer. At December 31, 1996, recoverable losses have
exceeded the cap by $528,000, and the excess losses have been retained by the
Company.

     Effective January 1, 1993, Mutual and MNH entered into a quota share
reinsurance agreement under which MNH assumed 10% of Mutual's direct voluntary
written premiums and related losses and allocated LAE in exchange for a
reinsurance commission of 35%. The agreement also provides for MNH to pay a
contingent commission to Mutual equal to any underwriting profit on the premiums
assumed. Mutual pays the ceded premiums, net of commissions and paid losses, to
MNH on a monthly basis and MNH invests these funds and earns investment income.
To the extent commissions and paid losses exceed premiums, MNH is required to
pay the net monthly balance to Mutual. The agreement may be terminated by either
party effective as of any January 1 with the prior approval of the New York
Superintendent of Insurance and upon six months' notice to the other party. In
addition, the agreement may be terminated by MNH at any time if any amount
payable to MNH by


                                       18
<PAGE>   19

Mutual becomes more than 90 days overdue or if there is a change in control of
Mutual approved by the New York Superintendent of Insurance. Further, the
agreement allows Mutual to reduce its cessions to MNH to 0% of Mutual's direct
voluntary premiums written for any calendar year prior to the beginning of that
calendar year. Mutual notified the Company that it will not cede any voluntary
direct written premiums to MNH in calendar year 1997.

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

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

     The investments of the Company are regulated by New Hampshire insurance law
and are reviewed by the Board of Directors of the Company. Other than certain
short-term investments held to maintain liquidity, the Company primarily invests
in medium-term bonds, mortgage-backed and other asset-backed securities
including collateralized mortgage obligations, and tax-exempt securities. The
mortgage-backed securities he1d by the Company are typically purchased at
expected yields which are greater than comparable maturity Treasury securities
and are AAA or AA rated.

     The Company had $46,818,000 of tax-exempt bonds in its investment portfolio
at December 31, 1996. The Company believes these tax-exempt bonds are of high
quality (rated A or better) and offer an after-tax total return greater than
comparable taxable securities.

     At December 31, 1996, the Company had $8,248,000 of short-term investments
with maturities less than 30 days, and $3,329,000 of non-investment grade
securities. These non-investment grade securities represented 1.7% of its
investment portfolio.






                                       19
<PAGE>   20

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

<TABLE>
<CAPTION>
                                              As of December 31,
                          -----------------------------------------------------------
                                 1994                 1995                1996
                                 ----                 ----                ----
                          Amount        %     Amount        %     Amount        %
                         --------      ----  --------      ----  --------      ----
                                             (dollars in thousands)
<S>                      <C>           <C>   <C>           <C>   <C>           <C>
Fixed Maturities (1):
U.S. Government
and Agencies             $ 49,113      28.8% $ 58,421      30.4% $ 49,990      24.8%
Corporate Bonds            50,742      29.7    63,997      33.3    86,308      42.8
Tax-Exempt Bonds           62,050      36.3    60,837      31.7    46,818      23.2
                         --------      ----  --------      ----  --------      ----
  Total Bonds             161,905      94.8   183,255      95.4   183,116      90.8
Short-Term Invest-
  ments(2)                  4,455       2.6     4,470       2.3     8,248       4.1
Other(3)                    4,387       2.6     4,493       2.3    10,233       5.1
                         --------      ----  --------      ----  --------      ----
Total Invested
  Assets                 $170,747     100.0% $192,218     100.0% $201,597     100.0%
                         ========     =====  ========     =====  ========     =====

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

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

(3)  Shown at estimated fair value or unpaid principal balance which
     approximates estimated fair value.
</TABLE>

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

<TABLE>
<CAPTION>
                                      Year Ended December 31,
                                ----------------------------------
                                   1994         1995         1996
                                   ----         ----         ----
                                       (dollars in thousands)
<S>                            <C>         <C>           <C>
Average investments (1)        $176,791    $ 181,760     $194,677
Net investment income             9,849       10,368       11,724
Net investment income
  as a percentage of average
  investments (2)                   5.6%         5.7%         6.0%
Net realized gains (losses)
  on investments               $     20    $    (832)    $    996

<FN>
(1)  At amortized cost.

(2)  The tax equivalent yield for the years ended December 31, 1994, 1995 and
     1996 were 6.4%, 6.6%, and 6.6%, respectively, assuming an effective tax
     rate of 34%.
</TABLE>







                                       20
<PAGE>   21

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


<TABLE>
<CAPTION>
                                              As of December 31,
                           --------------------------------------------------------
                                  1994                1995                1996
                           --------------------------------------------------------
                            Amount      %       Amount      %       Amount      %
                           --------   -----    --------   -----    --------   -----
                                            (dollars in thousands)
<S>                        <C>          <C>    <C>          <C>    <C>          <C>
1 year or less             $ 10,560     6.5%   $ 24,175     6.5%   $ 15,518     8.5%
1 year through 5 years       94,697    58.5     114,823    58.5     123,856    67.6
5 years through 10 years     49,825    30.8      36,967    30.8      32,452    17.7
More than 10 years            6,823     4.2       7,290     4.2      11,290     6.2
                           --------   -----    --------   -----    --------   -----

  Total                    $161,905   100.0%   $183,255   100.0%   $183,116   100.0%
                           ========   =====    ========   =====    ========   =====
</TABLE>


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

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

     Historically, the property and casualty industry has tended to be cyclical
in nature. During the "up" cycle, or "hard market," the industry is
characterized by price increases, strengthening of loss and LAE reserves,
surplus growth and improved underwriting results. Near the end of the "up"
cycle, an increase in capacity causes insurance companies to begin to compete
for market share on the basis of price. This price competition causes the
emergence of the "down" cycle, or "soft market," characterized by a reduction in
the premium growth rate and a general decline in profitability. Generally, the
down cycle is eventually accompanied by a decline in the adequacy of loss and
LAE reserves and a decrease in premium writing capacity. The property and
casualty insurance industry has experienced a cyclical downturn for the past ten
years due primarily to intense premium rate competition, which has resulted in
lower profitability. Many of the circumstances which led to the current cyclical
downturn in the property and casualty insurance



                                       21
<PAGE>   22

industry continue to exist, and the Company cannot predict when or if market
conditions for the industry will improve.

Regulation
----------

  General
  -------

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

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

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

     The Company depends on cash dividends from MNH to pay cash dividends to its
stockholders and to meet its expenses. MNH is subject to New Hampshire state
insurance laws which restrict its ability to pay dividends without the prior
approval of state regulatory authorities. These restrictions limit dividends to
those that, when added to all other dividends paid within the preceding twelve
months, would not exceed 10% of the insurer's




                                       22
<PAGE>   23

policyholders' surplus as of the preceding December 31st. The maximum amount of
dividends that MNH could pay during any twelve month period ending in 1997
without the prior approval of the New Hampshire Insurance Commissioner is
$4,391,000.

     In certain states in which it operates, MNH is required to maintain
deposits with the appropriate regulatory authority to secure its obligations
under certain insurance policies written in the jurisdiction. At December 31,
1996, investments of MNH having a par value of $1,800,000 were on deposit with
regulatory authorities.

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

     In 1993 the National Association of Insurance Commissioners ("NAIC")
adopted a risk-based capital measurement formula to be applied to all property
and casualty insurance companies. The formula calculates a minimum required
statutory net worth, based on the underwriting, investment, credit, loss reserve
and other business risks inherent in an individual company's operations. Any
insurance company that does not meet threshold risk-based capital measurement
standards could be forced to reduce the scope of its operations and ultimately
could become subject to statutory receivership proceedings. MNH's capital
substantially exceeds the statutory minimum as determined by the risk-based
capital measurement formula as of December 31, 1996.

     The NAIC has established eleven financial ratios (the Insurance Regulatory
Information System, or "IRIS") to assist state insurance departments in their
oversight of the financial condition of insurance companies operating in their
respective states. The NAIC calculates these ratios based on information
submitted by insurers on an annual basis and shares the information with the
applicable state insurance departments. The ratios relate to leverage,
profitability, liquidity and loss reserve development. Two of the Company's
ratios as of December 31, 1996 relating to profitability and loss reserve
development fell outside of the acceptable range of ratios. Both of the ratios
were outside of the acceptable ranges due to the $6,832,000 increase in the
provision for losses and LAE recorded in 1996, for claims occurring in years
prior to 1996, as discussed in this Item under the heading "Loss and LAE
Reserves".

  Rates
  -----

     Premium rate regulations vary greatly among states and lines of insurance,
but generally require approval of the regulatory authority or limited review by
the authority prior to changes in rates. However, in New York, insurers writing
in designated commercial risk, professional liability and public entity



                                       23
<PAGE>   24

insurance markets may periodically revise rates within the limits of applicable
flexibility bands ("flex-bands") on a file and use basis, but must obtain the
Department's prior approval in order to implement rate increases or decreases
beyond these flex-bands.

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

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

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

     As a condition to writing voluntary insurance in most of the states in
which it operates, the Company must participate in programs that provide
insurance for persons unable to obtain insurance voluntarily. Uncertainties as
to the size of the involuntary market population make it difficult to predict
the amount of involuntary business in a given year. Further complicating the
ability to predict assignments in New York is the Territorial Credit Program
("TCP") instituted by the Department in 1990. The TCP provides companies credits
against their NYAIP assignments based upon their voluntary automobile writings
in designated territories two years prior to the assignment year. Designated
territories are territories in which the ratio of NYAIP-insured car years to
total-insured car years exceeds the statewide average of the same ratio. The
designated territories are primarily in or near the New York City metropolitan
area, an area in which the Company does not have, or intend to develop, a
significant market presence. The Company's voluntary market share in the
designated territories is less than its statewide market share, which may result
in an increase in the Company's NYAIP assignments in 1997 and subsequent years.

Employees
---------

     The Company has no employees. At December 31, 1996, Mutual had 382
full-time employees. The Company believes that Mutual's relationship with its
employees is satisfactory.

Item 2.  PROPERTIES.

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



                                       24
<PAGE>   25

     The Company's corporate headquarters are located in Buffalo, New York in a
building owned by Mutual that contains approximately 113,000 square feet of
office space. Mutual also has regional underwriting and/or claims office
facilities in Buffalo, Albany and Central Islip, New York; Bedford, New
Hampshire; and Moorestown, New Jersey. All of the offices except the Buffalo
office are leased.

Item 3.  LEGAL PROCEEDINGS.

     In 1995, a New York State trial court dismissed a purported class action
lawsuit which was filed in 1993 against the Company, Mutual, MNH and certain
directors of the Company and of Mutual (the "defendants") on behalf of the then
minority shareholders of the Company. The court, in granting the defendants'
motion, held that plaintiff's claims, to the extent they have any merit, are
derivative in nature. The complaint, which sought equitable relief and
unspecified money damages, alleged that the defendants breached their fiduciary
obligations to the minority shareholders of the Company, and defrauded the
minority shareholders, by causing MNH to purchase from the Federal Deposit
Insurance Corporation ("FDIC") a surplus note issued by Mutual and
simultaneously reducing the principal amount plus accrued return on such surplus
note to $1,350,000, which is the amount MNH paid to the FDIC for the note, and
by approving the public sale of the Company's common stock in July 1993 at what
the plaintiff alleges was an inadequate price. In November 1995, the plaintiff
filed an amended complaint which asserts the same claims as were asserted in his
class action lawsuit but in the form of a derivative suit. In June 1996, the
Company and the other defendants moved to dismiss the derivative complaint. The
court has not yet rendered its decision on those motions.

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








                                       25
<PAGE>   26

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

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

     None.



                                       26
<PAGE>   27
                           PART II

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

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

<TABLE>
<CAPTION>
1996:                                           High     Low
-----                                           ----     ---
<S>                                            <C>      <C>
Fourth Quarter                                 $18.88   $18.00
Third Quarter                                   19.25    18.50
Second Quarter                                  19.50    17.00
First Quarter                                   18.75    17.50

1995:

Fourth Quarter                                 $19.38   $16.75
Third Quarter                                   19.63    16.38
Second Quarter                                  18.88    14.75
First Quarter                                   15.75    14.50
</TABLE>


     The number of stockholders of record of the Company's Common Stock as of
February 28, 1997 was 127. Securities held by nominees are counted as one
stockholder of record.

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

     As a holding company, the Company depends on dividends from its subsidiary,
MNH, to pay cash dividends to its stockholders. MNH is subject to New Hampshire
state insurance laws which restrict its ability to pay dividends without the
prior approval of state regulatory authorities. These restrictions limit
dividends to those that, when added to all other dividends paid within the
preceding twelve months, would not exceed 10% of the insurer's policyholders'
surplus as of the preceding December 31. The maximum amount of dividends that
MNH could pay during any twelve month period ending in 1997 without prior
approval of the New Hampshire Insurance Commissioner is $4,391,000.




                                       27
<PAGE>   28

Item 6.  SELECTED FINANCIAL DATA.

The selected financial data set forth in the following table for each of the
five years in the period ended December 31, 1996 have been derived from the
audited consolidated financial
statements of the Company.



<TABLE>
<CAPTION>
                                                  Year Ended December 31,
                                  -------------------------------------------------------
                                     1992      1993        1994         1995         1996
                                     ----      ----        ----         ----         ----
                                          (in thousands, except per share amounts)

<S>                               <C>       <C>       <C>          <C>          <C>
Net premiums written              $84,341   $91,192   $  90,187    $  97,577    $  96,622
                                  =======   =======   =========    =========    =========
Net premiums earned               $87,912   $88,181   $  90,845    $  94,749    $  95,752
Net investment income               9,003     9,155       9,849       10,368       11,724
Net realized investment
    gains (losses)                  1,066     1,467          20         (832)         996
Other revenues                        615       693         638          259          172
                                  -------   -------   ---------    ---------    ---------
Total revenues                     98,596    99,496     101,352      104,544      108,644
                                  -------   -------   ---------    ---------    ---------
Losses and loss
    adjustment expenses            61,803    62,407      70,800       78,195       79,603
Amortization of deferred
    policy acquisition costs       23,297    23,739      24,424       25,458       25,374
Other underwriting expenses         7,143     6,020       5,892        7,709        6,700
                                  -------   -------   ---------    ---------    ---------
Total expenses                     92,243    92,166     101,116      111,362      111,677
                                  -------   -------   ---------    ---------    ---------
Income (loss) before
    income taxes                    6,353     7,330         236       (6,818)      (3,033)
Provision (benefit)
    for income taxes                1,238     1,727        (895)      (2,999)      (1,885)
                                  -------   -------   ---------    ---------    ---------
Income (loss) before
    cumulative effect of change
    in accounting for income
    taxes                           5,115     5,603       1,131       (3,819)      (1,148)
Cumulative effect of change
    in accounting for income
    taxes                              --       306          --           --           --
                                  -------   -------   ---------    ---------    ---------
Net income (loss)                 $ 5,115   $ 5,909   $   1,131    $  (3,819)   $  (1,148)
                                  =======   =======   =========    =========    =========
</TABLE>




                                       28
<PAGE>   29

                              Merchants Group, Inc.
                       Selected Financial Data - continued

<TABLE>
<CAPTION>
                                                             Year Ended December 31,
                                           -------------------------------------------------------
                                               1992      1993       1994        1995         1996
                                               ----      ----       ----        ----         ----
                                                    (in thousands, except per share amounts)
<S>                                        <C>        <C>        <C>        <C>          <C>
Primary and fully diluted
    earnings (loss) per share:

Before cumulative effect of
    change in accounting for
    income taxes                           $   2.31   $   2.12   $    .36   $   (1.19)   $    (.36)

Cumulative effect of change
   in accounting for income
   taxes                                         --        .12         --          --           --
                                           --------   --------   --------   ---------    ---------
Primary and fully diluted
   earnings (loss) per share               $   2.31   $   2.24   $    .36   $   (1.19)   $    (.36)
                                           ========   ========   ========   =========    =========
Weighted average number of
   shares outstanding:
   Primary and fully diluted                  2,109      2,641      3,177       3,220        3,182

BALANCE SHEET DATA:
   (AT YEAR END)
Total investments                          $157,478   $175,762   $170,747   $ 192,218    $ 201,597
Total assets                                193,202    219,188    227,750     252,808      262,123
Reserve for losses and
   loss adjustment expenses                  86,159     93,896    104,015     119,722      133,479
Unearned premiums                            40,725     46,006     45,449      48,773       49,710
Stockholders' equity                         53,265     75,083     67,279      69,970       65,029

DIVIDEND DATA:
Cash dividend per common
   share                                   $     --   $    .10   $    .20   $     .20    $     .20
</TABLE>














                                       29
<PAGE>   30

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

1996 Compared to 1995.
----------------------

Total revenues for 1996 were $108,644,000, up 4% from $104,544,000 in 1995.

     Net premiums earned for 1996 were $95,752,000, an increase of $1,003,000,
or, 1% from $94,749,000 in 1995. Net premiums written for 1996 were $96,622,000,
an increase of 3% excluding the effect of the decision by Mutual to exercise its
option to not cede any of its direct voluntary premiums written to MNH for
calendar year 1996, under the quota share reinsurance agreement between Mutual
and MNH. In 1995, MNH assumed $2,110,000 of Mutual's direct voluntary premiums
written under this agreement. The increase in net premiums written resulted
primarily from a 2% increase in direct premiums written.

     Direct premiums written for 1996 were $101,007,000, an increase of 2% from
$98,553,000 in 1995 due to a 9% increase in voluntary personal lines direct
written premiums, a 3% decrease in voluntary commercial lines direct written
premiums and a 16% increase in involuntary direct written premiums.

     Voluntary personal lines direct premiums written for 1996 were $37,616,000,
an increase of 9% from $34,393,000 in 1995. Private passenger automobile direct
premiums written, which comprised 79% of total voluntary personal lines direct
premiums written in 1996 and 1995, increased 8% in 1996 compared to 1995. This
increase resulted from a 5% increase in policies in force and a 4% increase in
average premium per policy at December 31, 1996 compared to December 31, 1995.
Homeowners direct premiums written increased 14% in 1996 compared to 1995 due to
a 4% increase in policies in force and an 8% increase in average premium per
policy.

     Voluntary commercial lines direct premiums written for 1996 were
$55,467,000, a decrease of 3% from $57,304,000 in 1995. This decrease resulted
primarily from a 10% decrease in commercial lines policies in force at December
31, 1996, partially offset by a 15% increase in average premium per policy
outstanding at December 31, 1996 compared to December 31, 1995.

     In 1996 the Company continued the program initiated in 1995 to increase its
mandatory deductibles and its minimum premium levels on certain of its
commercial lines of business, primarily its businessowners and multi-peril
lines. In conjunction with these actions, the Company discounted its premium
rates 15% for its workers' compensation line of business. These discounted rates
combined with other refinements were designed to attract the entire insurance
business of preferred risk commercial accounts and to eliminate certain small
premium policies which were generally unprofitable. These actions contributed to
the decrease



                                       30
<PAGE>   31

in commercial lines policies in force and the increase in average premium per
policy. Also affecting the average policy premium has been New York State
mandated reductions in workers' compensation premium rates of 12%, 9% and 18%,
respectively, in 1994, 1995 and 1996.

     Involuntary direct premiums written, primarily involuntary private
passenger automobile insurance, which comprised 8% and 7% of total direct
premiums written during 1996 and 1995, respectively, were $7,923,000 for 1996
compared to $6,854,000 in 1995. This 16% increase resulted primarily from
additional policy premiums related to an increase in the legally required
minimum automobile policy limits in New York State, which became effective
January 1, 1996.

     Net investment income was $11,724,000 in 1996, an increase of 13% from
$10,368,000 in 1995, primarily due to a 7% increase in average invested assets.
On a taxable equivalent basis, net investment income increased 10% in 1996
compared to 1995.

     Realized investment gains were $996,000 in 1996 compared to a loss of
$832,000 in 1995. During 1996, the Company sold its investment in Signet Group
PLC ("Signet") cumulative auction rate preference shares and recognized a
realized gain of $900,000 before taxes. In 1995, the Company recorded an
$840,000 unrealized loss on its investment in Signet, which was included as a
component of realized investment gains and losses in the Company's 1995
consolidated statement of operations. In addition to the realized gain related
to its investment in Signet, the Company realized $96,000 of pre-tax gains on
the sale of other investments which were sold in 1996. The Company recorded
$8,000 of realized gains not related to Signet in 1995.

     Losses and loss adjustment expenses ("LAE") were $79,603,000 for 1996, an
increase of 2% from $78,195,000 in 1995. The loss and LAE ratio increased to
83.1% in 1996 from 82.5% in 1995. In 1996, the Company increased its reserve for
losses that occurred prior to 1996 for its workers' compensation line of
business. In turn, the Company increased its estimates of losses related to
workers' compensation claims for accidents that occurred in 1996 based upon the
increase in prior year's workers' compensation reserves. Partly offsetting these
increases was a reduction in the Company's estimate of losses for automobile
insurance claims that occurred prior to 1996. The net increase in the reserve
for prior year losses and LAE was $6,896,000 and added 7.2 percentage points to
the loss and LAE ratio in 1996.

     Losses and LAE in 1996 include $2,200,000 of higher than normal losses
related to unusually severe winter weather that affected the northeastern United
States during the first quarter of 1996. These higher than normal weather
related losses increased the 1996 loss and LAE ratio by 2.3 percentage points.




                                       31
<PAGE>   32

     Losses and LAE in 1995 included an $11,045,000 increase in reserves for
accidents that occurred prior to 1995 which added 11.6 percentage points to the
loss and LAE ratio in 1995.

     Involuntary automobile insurance business increased the Company's calendar
year loss and LAE ratio by approximately .7 percentage points and decreased the
Company's calendar year loss and LAE ratio by approximately .6 percentage points
for the years ended December 31, 1996 and 1995, respectively. The combined ratio
on involuntary automobile business was greater than the combined ratio on
voluntary automobile business.

     The ratio of policy acquisition costs and other underwriting expenses to
net premiums earned decreased to 33.5% in 1996 from 35.0% in 1995. In 1995,
other underwriting expenses included approximately $1,100,000 related to the
1995 resignation of the Company's former Chief Executive Officer. These expenses
added approximately 1.2 percentage points to the ratio of policy acquisition
costs and other underwriting expenses to net premiums earned in 1995.

     Commissions, premium taxes and other state assessments that vary directly
with the Company's premium volume represented 22.0% and 20.6% of net premiums
earned in 1996 and 1995, respectively. Certain other underwriting expenses, such
as salaries, employee benefits, and other operating expenses vary indirectly
with volume and comprise the remainder of the Company's underwriting expenses.

     The Company recorded an income tax benefit in 1996 and 1995. The benefits
recorded were larger than that calculated using the statutory federal income tax
rate due to tax exempt bond income.

1995 Compared to 1994.
----------------------

     Total revenues increased 3% from $101,352,000 in 1994 to $104,544,000 in
1995. Of the $3,192,000 increase, $3,904,000 was attributable to a 4% increase
in net premiums earned and $519,000 was attributable to a 5% increase in net
investment income. These increases were partly offset by an $852,000 decrease in
net realized investment gains and a $379,000 decrease in other revenues.

     Net premiums written increased 8% from $90,187,000 in 1994 to $97,577,000
in 1995, primarily due to a 10% increase in direct premiums written. This
increase in direct premiums written was partially offset by a 48% decrease in
premiums written assumed from Mutual in accordance with the quota share
reinsurance agreement between Mutual and MNH. In December 1995, Mutual informed
MNH that it would exercise its option to reduce its cessions to MNH under the
agreement to 0% of Mutual's direct voluntary premiums written effective for
calendar year 1996, including premiums written in 1995 which were unearned as of
December 31, 1995. As a result, premiums written assumed by the Company from
Mutual under this reinsurance agreement decreased



                                       32
<PAGE>   33

from $4,086,000 in 1994 to $2,110,000 in 1995.

     Voluntary personal lines direct premiums written increased 7% from
$32,101,000 in 1994 to $34,393,000 in 1995. Private passenger automobile direct
premiums written, which comprised 79% of total voluntary personal lines direct
premiums written in 1995, increased 5% in 1995 compared to 1994. Homeowners
direct premiums written increased 17% in 1995 compared to 1994 due to a 4%
increase in policies in force and a 13% increase in average premium per policy.

     Voluntary commercial lines direct premiums written increased 11% from
$51,602,000 in 1994 to $57,304,000 in 1995. Commercial lines retention rates
held constant and commercial lines policies in force increased 1% in 1995
compared to 1994. Average premium per policy increased 10% in 1995 compared to
1994. Direct premiums written in each commercial line of business, except
contractors' coverall, increased in 1995 compared to 1994.

     Net investment income increased 5% from $9,849,000 in 1994 to $10,368,000
in 1995, primarily due to a 3% increase in average invested assets. On a taxable
equivalent basis, net investment income increased 3% in 1995 compared to 1994.

     The Company's investment in Signet included in other long-term investments
was carried at fair value. During 1995, the Company recorded an $840,000 loss on
its investment in Signet which is included as a component of realized investment
gains and losses in the consolidated statement of operations. There were no
material gains or losses realized from the sale of investments in 1994 or 1995.

     Losses and LAE increased 10% from $70,800,000 in 1994 to $78,195,000 in
1995. The loss and LAE ratio increased from 77.9% in 1994 to 82.5% in 1995. As a
result of greater than expected reported loss experience during 1995, the
Company increased its estimate for claims that occurred in 1989 through 1994 for
the homeowners, businessowners, workers' compensation, and commercial package
lines of business. Partly offsetting these increases was a reduction in the
Company's estimate of automobile insurance claims that occurred in 1993 and
1994. The net increase in the reserve for prior year losses and LAE was
$11,045,000 and added 11.6 percentage points to the loss and LAE ratio in 1995.

     Losses in 1994 included $3,135,000 paid to Mutual as a one time settlement
for losses relating to the 1985 through 1994 accident years on involuntary
automobile insurance policies issued by Mutual under automobile insurance plans
("AIP").








                                       33
<PAGE>   34

     In accordance with various states' AIP rules, Mutual historically received
the assignment of MNH's, as well as its own, AIP policies based on its and MNH's
combined voluntary automobile market share, issued the policies and settled the
claims associated with those polices. Mutual then allocated the results of the
involuntary AIP business to MNH based on MNH's share of the combined voluntary
automobile business of Mutual and MNH.

     In July 1994, Mutual informed the Company that it had failed to identify
and bill to MNH during the period January 1, 1985 through June 30, 1994 for a
portion of MNH's share of AIP losses paid by Mutual in that period. The amount
of unbilled AIP losses was approximately $7,500,000. MNH paid Mutual $3,135,000
in full and complete settlement of the unbilled AIP paid losses for the period
noted above. This settlement increased the 1994 loss and LAE ratio by 3.5
percentage points.

     Also included in losses in 1994 was approximately $2,400,000 of losses
related to severe winter weather that struck the northeastern United States. The
losses from these storms increased the loss and LAE ratio in 1994 by 2.6
percentage points.

     In 1995, the Company increased its reserve for losses and LAE related to
prior years by $11,045,000, compared to an increase in reserve for losses and
LAE related to prior years of $4,982,000 recorded in 1994.

     Involuntary automobile insurance business increased the Company's calendar
year loss and LAE ratio by approximately 3.1 percentage points and decreased the
Company's calendar year loss and LAE ratio by .6 percentage points for the years
ended December 31, 1994 and 1995, respectively.

     The ratio of policy acquisition costs and other underwriting expenses to
net premiums earned increased from 33.4% in 1994 to 35.0% in 1995. In 1995,
other underwriting expenses included approximately $1,100,000 related to the
1995 resignation of the Company's former Chief Executive Officer. These expenses
added approximately 1.2 percentage points to the ratio of policy acquisition
costs and other underwriting expenses to net premiums earned in 1995.

     Commissions, premium taxes and other state assessments that vary directly
with the Company's premium volume represented 20.6% of net premiums earned in
1995 and 1994. Certain other underwriting expenses, such as salaries, employee
benefits, and other operating expenses vary indirectly with volume and comprise
the remainder of the Company's underwriting expenses.

     The Company recorded an income tax benefit in 1995 and 1994. The benefits
recorded were larger than that calculated using the statutory federal income tax
rate due to tax exempt bond income.




                                       34
<PAGE>   35

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

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

     Net cash provided by operations increased by $123,000 from $12,505,000 in
1995 to $12,628,000 in 1996. Increases in premiums collected of $3,504,000,
investment income received of $1,438,000 and income taxes recovered of
$2,792,000 were offset by increases in the payment of losses and LAE of
$4,954,000 and underwriting expenses of $2,408,000.

     Net cash used in investing activities decreased $3,364,000 from $12,473,000
in 1995 to $9,109,000 in 1996. This decrease primarily resulted from a
$12,500,000 net decrease in the purchase of fixed maturities which was offset by
net increases in purchases of other long-term and short-term investments of
$4,944,000 and $3,763,000, respectively.

     Net cash used in financing activities increased $3,536,000 from $11,000 in
1995 to $3,547,000 in 1996 primarily due to a $2,983,000 increase in cash used
by the Company to repurchase its common stock.

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

     The Company generally designates newly acquired fixed maturity investments
as available for sale and carries these investments at fair value. Unrealized
gains and losses related to these investments are recorded as a component of
stockholders' equity. At December 31, 1996, the Company had recorded $603,000 of
unrealized losses, net of tax, associated with its fixed maturity investments.
During 1996 the Company recorded a $246,000 increase in unrealized losses, net
of tax.





                                       35
<PAGE>   36

     At December 31, 1996, the Company's bond portfolio represented 90.8% of
invested assets. Management believes that this level of bond holdings is prudent
because it expects that cash receipts from net premiums written and investment
income will be sufficient to enable the Company to satisfy its cash obligations
in 1997. Furthermore, a portion of the Company's bond portfolio is invested in
mortgage-backed and other asset-backed securities which, in addition to interest
income, provide monthly paydowns of bond principal.

     At December 31, 1996, $108,001,000, or 59.0%, of the Company's bond
portfolio was invested in mortgage-backed and other asset-backed securities. The
Company invests in a variety of collateralized mortagage obligations ("CMO")
products but has not invested in the derivative type of CMO products such as
interest only, principal only or inverse floating rate securities. All of the
Company's CMO investments have an active secondary market and their effect on
the Company's liquidity does not differ from that of other fixed maturity
investments. The Company does not own any other derivative financial
instruments.

     At December 31, 1996, only $3,329,000, or 1.7%, of the Company's investment
portfolio was invested in non-investment grade securities.

     Prior to 1996 in connection with the Company's stock option program for its
agents, the Company's Board of Directors approved a plan to purchase up to
25,000 shares of the Company's common stock. During 1996, the Company's Board of
Directors authorized the repurchase of up to 200,000 additional shares of the
Company's common stock in the open market. During 1996 the Company repurchased
160,700 shares of its common stock and is holding theses shares in treasury as
of December 31, 1996.

     As a holding company, the Company is dependent upon cash dividends from MNH
to meet its obligations and pay any cash dividends. MNH is subject to New
Hampshire insurance laws which place certain restrictions on its ability to pay
dividends without the prior approval of state regulatory authorities. These
restrictions limit dividends to those that, when added to all other dividends
paid within the preceding twelve months, would not exceed 10% of the insurer's
policyholders' surplus as of the preceding December 31. The maximum amount of
dividends that MNH could pay during any twelve month period ending in 1997
without the prior approval of the New Hampshire Insurance Commissioner is
$4,391,000. The Company paid a $.05 per share quarterly cash dividend to its
common stockholders totalling $634,000 in 1996.

     MNH, like many other property and casualty insurance companies, is subject
to environmental damage claims asserted by or against its insureds. Management
of the Company is of the opinion that based on various court decisions
throughout the country, such claims should not be recoverable under the terms of
MNH's insurance policies because of either specific or general



                                       36
<PAGE>   37

coverage exclusions contained in the policies. However, there is no assurance
that the courts will agree with MNH's position in every case, nor can there be
assurance that material claims will not be asserted under policies which a court
will find do not explicitly or implicitly exclude claims for environmental
damages. Management, however, is not aware of any pending claim or group of
claims which would result in a liability that would have a material adverse
effect on the financial condition of the Company or MNH.

     Industry and regulatory guidelines suggest that the ratio of a property and
casualty insurer's annual net premiums written to its statutory surplus should
not exceed 3 to 1. The Company has consistently followed a business strategy
that would allow it to meet this 3 to 1 regulatory guideline. MNH's ratio of net
premiums written to statutory surplus for 1996 was 2.2 to 1.

Inflation
---------

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

Federal Taxation
----------------

     The Company and MNH are subject to federal income taxation under the
provisions of the Internal Revenue Code of 1986, as amended.





                                       37
<PAGE>   38

Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The consolidated financial statements required in response to
this Item are submitted as part of Item 14 (a) of this report.

Quarterly data for the two most recent fiscal years is set
forth below:
<TABLE>
<CAPTION>
                                             Three months ended
                                             ------------------
                                 3/31        6/30        9/30          12/31
                                 ----        ----        ----          -----
                                   (in thousands, except per share amounts)
<S>                            <C>         <C>         <C>            <C>
1996
Net premiums earned            $ 23,441    $ 24,432    $ 23,924       $ 23,955
Net investment income             2,800       2,807       2,921          3,196
Net realized investment
    gains (losses)                    7         935          58             (4)
Other revenues
    (expenses), net                 126         (68)        144            (30)
                               --------    --------    --------       --------
Total revenues                   26,374      28,106      27,047         27,117
                               ========    ========    ========       ========
Income (loss) before
    income taxes                   (328)      2,651         239         (5,595)
Net income (loss)
    as reported                    (261)      2,065         197         (3,262)
Net income (loss)
    as adjusted                    (261)      2,065         310(a)      (3,262)
Net income (loss) per
    common share as reported       (.08)        .64         .06          (1.05)
Net income (loss) per
    common share as adjusted       (.08)        .64         .10(a)       (1.05)

1995
Net premiums earned            $ 22,710    $ 23,392    $ 24,432       $ 24,215
Net investment income             2,523       2,588       2,559          2,698
Net realized investment
    gains (losses)                   --        (832)         --             --
Other revenues
    (expenses), net                 273        (224)         50            160
                               --------    --------    --------       --------
Total revenues                   25,506      24,924      27,041         27,073
                               ========    ========    ========       ========
Income (loss) before
    income taxes                  1,525      (7,899)     (2,198)         1,754
Net income (loss)                 1,111      (3,916)     (1,996)           982
Net income (loss) per
    common share                    .35       (1.23)       (.62)           .30

<FN>
(a)  The Company incorrectly calculated and reported its income tax benefit and
     its net income, for the the three months ended September 30, 1996.
</TABLE>

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

     None.



                                       38
<PAGE>   39

                                   PART III


Item 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The Company's definitive proxy statement which will be filed with the Commission
pursuant to Regulation 14A within 120 days after the end of the Company's fiscal
year is incorporated herein
by reference.

Item 11.  EXECUTIVE COMPENSATION.

     The Company's definitive proxy statement which will be filed with the
Commission pursuant to Regulation 14A within 120 days after the end of the
Company's fiscal year is incorporated herein by reference.

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

     The Company's definitive proxy statement which will be filed with the
Commission pursuant to Regulation 14A within 120 days after the end of the
Company's fiscal year is incorporated herein by reference.

Item 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The Company's definitive proxy statement which will be filed with the
Commission pursuant to Regulation 14A within 120 days after the end of the
Company's fiscal year is incorporated herein by reference.





                                       39
<PAGE>   40
                                     PART IV

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

  (a) (1) The following financial statements of Merchants Group, Inc. are
          included on pages F-1 to F-23:

                  Report of Independent Accountants
                  Consolidated Balance Sheet - December 31, 1995 and 1996.
                  Consolidated Statement of Income - Years ended December 31,
                    1994, 1995 and 1996.
                  Consolidated Statement of Changes in Stockholders' Equity -
                    Years ended December 31, 1994, 1995 and 1996.
                  Consolidated Statement of Cash Flows - Years ended December
                    31, 1994, 1995 and 1996.
                  Notes to Consolidated Financial Statements.

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

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

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

                    Schedule III -
                      Condensed Financial Information of Registrant.

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

                    Schedule VI - Reinsurance

                    Schedule X  -
                      Supplemental Insurance Information Concerning Property -
                      Casualty Subsidiaries

  (b) Reports on Form 8-K.
      There were no reports on Form 8-K filed for the quarter ended December 31,
      1996.

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

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



                                       40
<PAGE>   41

            (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 New Hampshire, Inc.
                 (incorporated by reference to Exhibit No. 10A to the Company's
                 Registration Statement (No. 33-9188) on Form S-1 filed on
                 September 30, 1986).

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

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

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

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

            (f)  Property Catastrophe Reinsurance Agreement (HCI Agreement No.
                 439) between Merchants Mutual Insurance Company, Merchants
                 Insurance Company of New Hampshire, Inc. and General
                 Reinsurance Corporation, et. al., dated January 1, 1997, (filed
                 herewith).





                                       41
<PAGE>   42

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

          * (h)  Merchants Mutual Capital Accumulation Plan, fourth amendment,
                 effective January 1, 1996 (filed herewith).

          * (i)  Merchants Mutual Capital Accumulation Plan Trust Agreement
                 (restated as of January 1, 1996 filed herewith).

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

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

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

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

          * (n)  Merchants Mutual Insurance Company Incentive Compensation Plan,
                 as amended January 24, 1996 (filed herewith).

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


                                       42
<PAGE>   43

                 March 31, 1995).

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

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

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

       (27)      Financial Data Schedule (filed herewith).

       (28) (a)  Schedule P furnished to state insurance regulatory
                 authorities by Merchants Insurance Company of New Hampshire,
                 Inc. for the year ended December 31, 1996 (filed herewith).

*    Indicates a management contract or compensation plan or arrangement.



                                       43
<PAGE>   44


                              MERCHANTS GROUP, INC.
                      SCHEDULE I - SUMMARY OF INVESTMENTS -
                    OTHER THAN INVESTMENTS IN RELATED PARTIES
                                December 31, 1996
                                 (in thousands)


<TABLE>
<CAPTION>
                                                                               Amount at
                                                                              which shown
                                                       Amortized    Market      in the
  Type of Investment                                     cost       value     balance sheet
  ------------------                                     ----       -----     -------------
<S>                                                    <C>        <C>        <C>
Fixed maturities:
United States Government
  and government agencies
  and authorities                                      $ 26,276   $ 25,909   $ 25,949
Corporate bonds                                           3,086      3,239      3,239
Mortgage and asset backed
  securities                                            107,003    107,522    107,110
Tax exempt bonds                                         46,684     46,818     46,818
                                                       --------   --------   --------
    Total fixed maturities                              183,049   $183,488    183,116
                                                       --------   ========   --------
Short-term investments                                    8,248                 8,248
Other                                                    10,233                10,233
                                                       --------              --------
                                                       $201,530              $201,597
                                                       ========              ========
</TABLE>




                                       44
<PAGE>   45

                              MERCHANTS GROUP, INC.
             SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES,
                 AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER
                              THAN RELATED PARTIES
                  Years ended December 31, 1994, 1995 and 1996
                                 (in thousands)


<TABLE>
<CAPTION>
                                  1994       1995       1996
                                  ----       ----       ----
<S>                              <C>      <C>        <C>
Receivable from (payable to)
  Merchants Mutual Insurance
  Company(1):

Balance at beginning of period   $(760)   $  (397)   $ 1,091
Increase (decrease)                363      1,488       (764)
                                 -----    -------    -------
Balance at end of period         $(397)   $ 1,091    $   327
                                 =====    =======    =======

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

</TABLE>





                                       45
<PAGE>   46

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

BALANCE SHEET
-------------
<TABLE>
<CAPTION>
                                                                                 December 31,
                                                                             --------------------
                                                                                1995        1996
                                                                                ----        ----
<S>                                                                          <C>         <C>
         Assets
         ------
Investment in subsidiary                                                     $ 66,362    $ 63,764
Other assets                                                                    3,908       1,346
                                                                             --------    --------
         Total Assets                                                        $ 70,270    $ 65,110
                                                                             ========    ========
         Liabilities and Stockholders' Equity
         ------------------------------------

Other liabilities                                                            $    300    $     81
                                                                             --------    --------
         Total liabilities                                                        300          81
                                                                             --------    --------

Stockholders' equity:
  Preferred stock, $.01 par value,
    authorized and unissued 3,000,000
    shares                                                                         --          --
  Preferred stock, no par value, $424.30
     stated value, no shares issued or
     outstanding at December 31, 1995
     or 1996                                                                       --          --
  Common stock, $.01 par value,
     authorized 10,000,000 shares;
     issued and outstanding of
     3,213,894 shares at December 31, 1995 and
     3,059,652 shares at December 31, 1996                                         32          32
  Additional paid in capital                                                   35,302      35,372
  Treasury stock, 160,700 shares at
     December 31, 1996                                                             --      (2,983)
  Unrealized investment gains (losses),
     net of tax                                                                  (357)       (603)
  Accumulated earnings                                                         34,993      33,211
                                                                             --------    --------

         Total stockholders' equity                                            69,970      65,029
                                                                             --------    --------

         Total liabilities and stockholders'
           equity                                                            $ 70,270    $ 65,110
                                                                             ========    ========
</TABLE>






                                       46
<PAGE>   47

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



INCOME STATEMENT
----------------
<TABLE>
<CAPTION>
                                                   Year ended
                                                   December 31,
                                         -----------------------------
                                           1994       1995       1996
                                         -------    -------    -------
<S>                                      <C>        <C>        <C>
Revenues:
         Equity in net income (loss)
           of subsidiary                 $ 1,307    $(2,856)   $(1,570)
         Investment income                    69         73        133
         Net realized investment gains
           (losses)                           --       (840)       902
                                         -------    -------    -------
               Total revenues              1,376     (3,623)      (535)

Expenses:
         General and administrative
           expenses                          336        246        281
                                         -------    -------    -------
Operating income before income taxes       1,040     (3,869)      (816)
Income tax expense (benefit)                 (91)       (50)       332
                                         -------    -------    -------
               Net income                $ 1,131    $(3,819)   $(1,148)
                                         =======    =======    =======
</TABLE>





                                       47
<PAGE>   48

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




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


Increase (Decrease) in Cash and Cash
  Equivalents:

<TABLE>
<CAPTION>
                                                   Year ended
                                                   December 31,
                                            -------------------------
                                             1994     1995       1996
                                                (in thousands)
<S>                                         <C>      <C>      <C>
Cash flows from operating activities:       $(129)   $(311)   $   560
                                            -----    -----    -------
Cash flows from investing activities:
         Receipt of subsidiary common
           stock dividend                     600      800         --
         Sale (purchase) of other
           investments, net                   143     (480)     2,992
                                            -----    -----    -------
           Cash flows from investing
              activities                      743      320      2,992
                                            -----    -----    -------

Cash flows from financing activities:
         Purchase of treasury stock            --       --     (2,983)
         Cash dividend on common stock       (631)    (635)      (634)
         Exercise of common stock options      19      624         70
                                            -----    -----    -------
           Cash flows from financing
              activities                     (612)     (11)    (3,547)
                                            -----    -----    -------
Net increase (decrease) in cash and
  cash equivalents                              2       (2)         5
Cash and cash equivalents, beginning
  of year                                       3        5          3
                                            -----    -----    -------
Cash and cash equivalents, end of year      $   5    $   3    $     8
                                            =====    =====    =======
</TABLE>





                                       48
<PAGE>   49

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


STATEMENT OF CASH FLOWS - continued


<TABLE>
<CAPTION>
                                                                                   Year ended
                                                                                   December 31,
                                                                           -----------------------------
                                                                             1994       1995       1996
                                                                             ----       ----       ----
                                                                                  (in thousands)
<S>                                                                       <C>        <C>        <C>
Reconciliation of Net Income to Net
  Cash Provided By Operations:

Net income (loss)                                                         $ 1,131    $(3,819)   $(1,148)

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

         Equity in (income) loss
           of subsidiary                                                   (1,307)     2,856      1,570
         Net realized investment
           (gains) losses                                                      --        840       (902)
         Increase (decrease) in liabilities                                   136         98       (219)
         (Increase) decrease in other
           (non-investment) assets                                           (292)        94        514
         Other, net                                                           203       (380)       745
                                                                          -------    -------    -------
Net cash provided by (used in)
  operating activities                                                    $  (129)   $  (311)   $   560
                                                                          =======    =======    =======
</TABLE>



NOTES TO CONDENSED FINANCIAL STATEMENTS
---------------------------------------

     Cash dividends of $600,000 and $800,000 were paid to the Registrant by its
consolidated subsidiary in the years ended December 31, 1994, 1995,
respectively. No cash dividends were paid to the Registrant by its consolidated
subsidiary in 1996.





                                       49
<PAGE>   50

                              MERCHANTS GROUP, INC.
                            SCHEDULE VI - REINSURANCE
                    YEARS ENDED DECEMBER 31, 1994, 1995, 1996

                                 (in thousands)




<TABLE>
<CAPTION>
                                                                                                 Percentage
                                                        Ceded          Assumed                   of amount
                                           Gross       to other      from other        Net        assumed
                                           amount      companies      companies       amount       to net
                                          --------     ---------     ----------       -------    ---------
<S>                                       <C>           <C>            <C>            <C>            <C>
Year Ended December 31, 1994
Property and Casualty Premiums            $ 89,808      $6,876         $7,255         $90,187        8.0%

Year ended December 31, 1995
Property and Casualty Premiums            $ 98,553      $7,548         $6,572         $97,577        6.7%

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





                                       50
<PAGE>   51

                              MERCHANTS GROUP, INC.
           SCHEDULE X - SUPPLEMENTAL INSURANCE INFORMATION CONCERNING
                        PROPERTY - CASUALTY SUBSIDIARIES
                  Years ended December 31, 1994, 1995 and 1996
                                 (in thousands)


<TABLE>
<CAPTION>
                              Reserves                                          Losses & Loss        Amortiza-  Paid
                              for                                               adjustment expenses  tion of     losses
                    Deferred  losses     Discount                               incurred related     deferred    and
                    policy    & loss     if any,                       Net      to                   policy      loss
                    acqui-    adjust-    deducted            Net       invest-   (1)       (2)       acquisi-    adjust-   Direct
                    sition    ment       from      Unearned  earned    ment     Current   Prior      tion        ment      premiums
                    costs     expenses   reserves  premiums  premiums  income   years     years      costs       expenses  written
                    -----     --------   --------  --------  --------  ------   -----     -----      -----       --------  -------
<S>                 <C>        <C>        <C>       <C>       <C>       <C>      <C>       <C>        <C>         <C>       <C>
Year ended:

December 31, 1994   $11,587    $104,015   $  242    $45,449   $90,845   $ 9,849  $65,818   $ 4,982    $24,424     $63,125   $ 89,808

December 31, 1995   $12,165    $119,722   $  460    $48,773   $94,749   $10,368  $67,150   $11,045    $25,458     $62,091   $ 98,553

December 31, 1996   $12,396    $133,479   $1,113    $49,710   $95,752   $11,724  $72,771   $ 6,832    $25,374     $67,061   $101,007

</TABLE>


<PAGE>   52

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

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








                                       52
<PAGE>   53

                                   SIGNATURES

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

                            Merchants Group, Inc.

Date: March 25, 1997        BY: /s/Robert M. Zak, Senior Vice President
                                   -------------------------------------
                                   Robert M. Zak, Senior Vice President
                                   and Chief Operating Officer

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

<TABLE>
<CAPTION>
        SIGNATURE                        TITLE                                DATE
        ---------                        -----                                ----
<S>                                <C>                                    <C>
/s/Richard E. Garman               Director, Chairman                     March 25, 1997
-----------------------            of the Board
Richard E. Garman

/s/Brent D. Baird                  Director, President                    March 25, 1997
-----------------------
Brent D. Baird

/s/Robert M. Zak                   Director, Sr. VP &                     March 25, 1997
-----------------------            Chief Operating
Robert M. Zak                      Officer

/s/Kenneth J. Wilson               Vice President & CFO                   March 25, 1997
-----------------------            (principal finance
Kenneth J. Wilson                  and accounting officer)

/s/Frank J. Colantuono             Director                               March 25, 1997
-----------------------
Frank J. Colantuono

/s/Henry P. Semmelhack             Director                               March 25, 1997
-----------------------
Henry P. Semmelhack
</TABLE>






                                       53
<PAGE>   54



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


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



In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) and (2) on page 40 present fairly, in all material
respects, the financial position of Merchants Group, Inc. and its subsidiary at
December 31, 1996 and 1995, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1996, in
conformity with generally accepted accounting principles. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.


Price Waterhouse LLP
Buffalo, New York
February 27, 1997












                                      F-1
<PAGE>   55


                              MERCHANTS GROUP, INC.
                              ---------------------

                           CONSOLIDATED BALANCE SHEET
                           --------------------------

                                 (in thousands)

<TABLE>
<CAPTION>
                                                                   December 31,
                                                              -------------------
                                                                 1995       1996
<S>                                                           <C>        <C>
               Assets
               ------
Investments:
   Fixed maturities:
     Held to maturity at amortized cost                       $ 19,477   $ 19,549
Available for sale at fair value                               163,778    163,567
Other long-term investments at fair value                        4,493     10,233
Short-term investments                                           4,470      8,248
                                                              --------   --------
               Total investments                               192,218    201,597

Cash                                                                39         11
Interest due and accrued                                         1,886      1,793
Premiums receivable, net of allowance for doubtful accounts
   of $416 in 1995 and $571 in 1996                             20,360     20,501
Deferred policy acquisition costs                               12,165     12,396
Ceded reinsurance balances receivable                            7,014      7,835
Prepaid reinsurance premiums                                     2,866      2,932
Receivable from affiliate                                        1,091        327
Federal income taxes receivable                                  3,143      1,266
Deferred federal income tax benefit                              5,491      6,645
Other assets                                                     6,535      6,820
                                                              --------   --------

               Total assets                                   $252,808   $262,123
                                                              ========   ========
</TABLE>












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

                                      F-2
<PAGE>   56

                              MERCHANTS GROUP, INC.
                              ---------------------

                           CONSOLIDATED BALANCE SHEET
                           --------------------------

                       (in thousands except share amounts)

<TABLE>
<CAPTION>
                                                                     December 31,
                                                               -----------------------
                                                                  1995         1996
                                                                  ----         ----
<S>                                                            <C>          <C>
              Liabilities and Stockholders' Equity
              ------------------------------------

Liabilities:
   Reserve for losses and loss adjustment expenses             $ 119,722    $ 133,479
   Unearned premiums                                              48,773       49,710
   Other liabilities                                              14,343       13,905
                                                               ---------    ---------
                  Total liabilities                              182,838      197,094
                                                               ---------    ---------

Stockholders' equity:
   Preferred stock                                                    --           --
   Common stock, issued and outstanding 3,213,894
       shares at December 31, 1995 and 3,059,652
       shares at December 31, 1996                                    32           32
   Additional paid in capital                                     35,302       35,372
   Treasury stock, 160,700 shares at December 31, 1996                --       (2,983)
    Unrealized investment losses, net of tax                        (357)        (603)
   Accumulated earnings                                           34,993       33,211
                                                               ---------    ---------
                  Total stockholders' equity                      69,970       65,029
                                                               ---------    ---------
   Commitments and contingent liabilities                             --           --

                  Total liabilities and stockholders' equity   $ 252,808    $ 262,123
                                                               =========    =========
</TABLE>











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


                                      F-3
<PAGE>   57

                              MERCHANTS GROUP, INC.
                              ---------------------

                      CONSOLIDATED STATEMENT OF OPERATIONS
                      ------------------------------------

                     (in thousands except per share amounts)

<TABLE>
<CAPTION>
                                                              Year ended December 31,
                                                       ------------------------------------
                                                          1994         1995         1996
                                                          ----         ----         ----
<S>                                                    <C>          <C>          <C>
Revenues:
   Net premiums earned                                 $  90,845    $  94,749    $  95,752
   Net investment income                                   9,849       10,368       11,724
   Net realized investment gains (losses)                     20         (832)         996
   Other revenues                                            638          259          172
                                                       ---------    ---------    ---------
       Total revenues                                    101,352      104,544      108,644
                                                       ---------    ---------    ---------

Expenses:
   Net losses and loss adjustment expenses                70,800       78,195       79,603
   Amortization of deferred policy acquisition costs      24,424       25,458       25,374
   Other underwriting expenses                             5,892        7,709        6,700
                                                       ---------    ---------    ---------
       Total expenses                                    101,116      111,362      111,677
                                                       ---------    ---------    ---------

Income (loss) before income taxes                            236       (6,818)      (3,033)
Income tax benefit                                          (895)      (2,999)      (1,885)
                                                       ---------    ---------    ---------
       Net income (loss)                               $   1,131    $  (3,819)   $  (1,148)
                                                       =========    =========    =========

Primary and fully diluted earnings (loss) per share    $     .36    $   (1.19)   $    (.36)
                                                       =========    =========    =========

Weighted average number of shares outstanding:
   Primary                                                 3,177        3,219        3,182
   Fully diluted                                           3,177        3,220        3,182
</TABLE>















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

                                      F-4
<PAGE>   58

                              MERCHANTS GROUP, INC.
                              ---------------------

            CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
            ---------------------------------------------------------

                                 (in thousands)

<TABLE>
<CAPTION>
                                                          Year ended December 31,
                                                          -----------------------
                                                      1994        1995        1996
                                                      ----        ----        ----
<S>                                                 <C>         <C>         <C>
Common stock:
    Beginning and end of year                       $     32    $     32    $     32
                                                    --------    --------    --------

Additional paid in capital:
    Beginning of year                                 34,659      34,678      35,302
    Exercise of common stock options                      19         624          70
                                                    --------    --------    --------
    End of year                                       34,678      35,302      35,372
                                                    --------    --------    --------

Treasury stock:
    Beginning of year                                     --          --          --
    Purchase of treasury shares                           --          --      (2,983)
                                                    --------    --------    --------
    End of year                                           --          --      (2,983)
                                                    --------    --------    --------

Unrealized investment gains (losses), net of tax:
    Beginning of year                                  1,445      (6,878)       (357)
    Appreciation (depreciation)                      (12,611)      9,880        (373)
    Deferred income tax benefit (expense)              4,288      (3,359)        127
                                                    --------    --------    --------
    End of year                                       (6,878)       (357)       (603)
                                                    --------    --------    --------

Accumulated earnings:
    Beginning of year                                 38,947      39,447      34,993
    Net income (loss)                                  1,131      (3,819)     (1,148)
    Cash dividends                                      (631)       (635)       (634)
                                                    --------    --------    --------
    End of year                                       39,447      34,993      33,211
                                                    --------    --------    --------

                 Total stockholders' equity         $ 67,279    $ 69,970    $ 65,029
                                                    ========    ========    ========
</TABLE>










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

                                      F-5
<PAGE>   59

                              MERCHANTS GROUP, INC.
                              ---------------------
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                      ------------------------------------
                           INCREASE (DECREASE) IN CASH
                           ---------------------------
                                 (in thousands)

<TABLE>
<CAPTION>
                                                           Year ended December 31,
                                                      --------------------------------
                                                         1994        1995        1996
                                                         ----        ----        ----
<S>                                                   <C>         <C>         <C>
Cash flows from operations:
     Collection of premiums                           $ 92,397    $ 93,944    $ 97,448
     Payment of losses and loss adjustment expenses    (63,125)    (62,091)    (67,061)
     Payment of other underwriting expenses            (30,444)    (29,903)    (32,311)
     Investment income received                          9,775      10,479      11,917
     Investment expenses paid                             (166)       (125)       (287)
     Income taxes (paid) recovered                        (760)        (58)      2,734
     Other cash receipts                                   638         259         188
                                                      --------    --------    --------
         Net cash provided by operations                 8,315      12,505      12,628
                                                      --------    --------    --------

Cash flows from investing activities:
     Proceeds from fixed maturities sold or matured     21,696      15,321      55,899
     Purchase of fixed maturities                      (25,851)    (27,800)    (55,910)
     Net (increase) decrease in other long-term
         investments                                      (922)        164      (4,780)
     Net increase in short-term investments             (2,342)        (15)     (3,778)
     Purchase of equipment, net                           (269)       (143)       (540)
                                                      --------    --------    --------
         Net cash used in investing activities          (7,688)    (12,473)     (9,109)
                                                      --------    --------    --------

Cash flows from financing activities:
     Purchase of treasury stock                             --          --      (2,983)
     Proceeds from exercise of common stock options         --         624          70
     Cash dividends and other, net                        (613)       (635)       (634)
                                                      --------    --------    --------
         Net cash used in financing activities            (613)        (11)     (3,547)
                                                      --------    --------    --------
     Increase (decrease) in cash                            14          21         (28)
Cash, beginning of year                                      4          18          39
                                                      --------    --------    --------
Cash, end of year                                     $     18    $     39    $     11
                                                      ========    ========    ========
</TABLE>











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

                                      F-6
<PAGE>   60

                              MERCHANTS GROUP, INC.
                              ---------------------
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                      ------------------------------------
         RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATIONS
         ---------------------------------------------------------------
                                 (in thousands)

<TABLE>
<CAPTION>
                                                             Year ended December 31,
                                                       --------------------------------
                                                           1994        1995        1996
                                                           ----        ----        ----
<S>                                                    <C>         <C>         <C>
Net income (loss)                                      $  1,131    $ (3,819)   $ (1,148)

Adjustments:
     Depreciation and amortization                           22         100          33
     Net realized investment (gains) losses                 (20)        832        (996)

(Increase) decrease in assets:
     Interest due and accrued                               (88)         79          93
     Premiums receivable                                   (820)     (2,309)       (141)
     Deferred policy acquisition costs                      176        (578)       (231)
     Ceded reinsurance balances receivable                  984         618        (821)
     Prepaid reinsurance premiums                          (100)       (496)        (66)
     Receivable from affiliate                               --      (1,091)        764
     Federal income taxes receivable                     (1,197)     (1,946)      1,877
     Deferred federal income tax benefit                   (396)     (1,111)     (1,027)
     Other assets                                        (5,375)       (141)         35

Increase (decrease) in liabilities:
     Reserve for losses and loss adjustment expenses     10,119      15,707      13,757
     Unearned premiums                                     (557)      3,324         937
     Other liabilities                                    4,862       3,733        (438)
     Payable to affiliate                                  (363)       (397)         --
     Federal income taxes payable                           (63)         --          --
                                                       --------    --------    --------
        Net cash provided by operations                $  8,315    $ 12,505    $ 12,628
                                                       ========    ========    ========
</TABLE>













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

                                      F-7
<PAGE>   61

                              MERCHANTS GROUP, INC.
                              ---------------------

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   ------------------------------------------

1.   Significant Accounting Policies
     -------------------------------

     Principles of consolidation and basis of presentation
     -----------------------------------------------------

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

     The consolidated financial statements have been prepared in conformity with
     generally accepted accounting principles (GAAP) which differ in some
     respects from those followed in reports to insurance regulatory
     authorities. In the 1996 Annual Statement filed with regulatory
     authorities, MNH reported statutory capital of $31,458,000 and total
     surplus of $43,908,000. MNH's net income (loss) as reported in its Annual
     Statement was ($2,788,000) in 1996, ($4,490,000) in 1995 and $900,000 in
     1994. All significant intercompany balances and transactions have been
     eliminated.

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

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

     Fixed maturities consist primarily of debt securities. The Company has
     classified its investments in fixed maturities as either held to maturity
     or available for sale. Fixed maturities classified as held to maturity are
     presented at amortized cost and consist of debt securities that management
     intends and has the ability to hold until maturity.

     Fixed maturities classified as available for sale are presented at fair
     value and consist of debt securities that management may not hold until
     maturity. The net aggregate unrealized gain or loss, net of applicable
     income taxes, related to fixed maturities available for sale is included as
     a component of stockholders' equity.



                                      F-8
<PAGE>   62

     In December 1995, the Company re-assessed the appropriateness of the
     accounting classification of its fixed maturity investments as permitted by
     the Financial Accounting Standards Board (FASB). As a result of this
     reassessment the Company reclassified certain fixed maturity securities
     with an amortized cost and fair value of $15,674,000 and $15,639,000,
     respectively, from held to maturity to available for sale which resulted in
     a $1,044,000 increase in stockholders' equity at December 31, 1995.

     Other long-term investments include collateralized mortgage obligation
     residuals, carried at unpaid principal balances which do not vary
     significantly from fair value, preferred stocks carried at fair value and a
     $1,350,000 capital advance carried at cost, which approximates fair value.
     Short-term investments, consisting primarily of money market mutual funds,
     have original maturities of three months or less, and are carried at cost,
     which approximates fair value. Realized gains and losses on the sale of
     investments are based on the cost of the specific investment sold.

     Other financial instruments
     ---------------------------

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

     Premium revenue
     ---------------

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

     Deferred policy acquisition costs
     ---------------------------------

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

     Reserve for losses and loss adjustment expenses
     -----------------------------------------------

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



                                      F-9
<PAGE>   63

     Structured settlements have been negotiated for claims on certain insurance
     policies. Structured settlements are agreements to provide periodic
     payments to claimants, and are funded by annuities purchased from various
     life insurance companies. The Company remains primarily liable for payment
     of these claims. Accordingly, a liability and a corresponding deposit in
     the amount $5,382,000 and $5,333,000 at December 31, 1995 and 1996,
     respectively, are recorded in the Company's consolidated balance sheet.

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

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

     Income taxes
     ------------

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

     Earnings per share
     ------------------

     Primary and fully diluted earnings (loss) per share were computed by
     dividing net income or loss by the weighted average number of shares of
     common stock outstanding during each year. Primary and fully diluted
     earnings per share for 1994, 1995 and 1996, assume the exercise of 65,164,
     22,083 and 40,750 shares of common stock options, respectively.

2.   Stockholders' Equity
     --------------------

     Preferred and common stock
     --------------------------

     Stockholders' equity is comprised of the following:

     Preferred stock, no par value, $424.30 stated value, 10,000 shares
     authorized; no shares issued or outstanding at December 31, 1995 or
     December 31, 1996. The Company also has 3,000,000 shares of $.01 par value
     preferred stock which is authorized and unissued.

     Common stock, $.01 par value, authorized 10,000,000 shares; issued and
     outstanding 3,213,894 shares at December 31, 1995 and 3,059,652 shares at
     December 31, 1996.





                                      F-10
<PAGE>   64

     Dividends
     ---------

     The Company may depend on dividends from its subsidiary, MNH, to pay cash
     dividends to its stockholders and to meet its expenses. MNH is subject to
     New Hampshire state insurance laws which restrict its ability to pay
     dividends without the prior approval of state regulatory authorities. These
     restrictions limit dividends to those that, when added to all other
     dividends paid within the preceding twelve months, would not exceed 10% of
     the insurer's policyholders' surplus as of the preceding December 31. The
     maximum amount of dividends that MNH could pay during any twelve month
     period ending in 1997, without the prior approval of the New Hampshire
     Insurance Commissioner is $4,391,000. The Company paid a quarterly cash
     dividend to its common stockholders in 1994, 1995 and 1996. Dividends paid
     during 1996 totaled to $634,000.

     Stock option plans
     ------------------

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

     During 1996, 53,000 options were granted under the Plan at $21.00 per
     share. No options were granted under the Plan in 1995 or in 1994. The
     weighted average fair value of options granted in 1996 was $6.48 per
     option.

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

     In October 1995, the FASB issued SFAS No. 123 "Accounting for Stock Based
     Compensation". In 1996, the Company adopted the disclosure provisions of
     SFAS No. 123 but opted to remain under the expense recognition provisions
     of APB Opinion No. 25 "Accounting for Stock Issued to Employees" in
     accounting for its stock option plans. No compensation expense was
     recognized for options granted under these plans in 1994, 1995 or 1996.







                                      F-11
<PAGE>   65

     Had compensation expense for stock options granted under the Company's
     stock option plans been determined based on the fair value at the grant
     date consistent with the method required by SFAS 123, the Company's net
     loss and loss per share for the year ended December 31, 1996 would have
     increased to the pro forma amounts shown below:

<TABLE>
         <S>                         <C>
         Net loss:
              As reported           ($1,148,000)
              Pro forma             ($1,316,000)
         Loss per share:
              As reported           ($.36)
              Pro forma             ($.41)
</TABLE>

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

     A summary of the status of the Company's outstanding options as of December
     31, 1996, 1995 and 1994, and changes during the years ending on those dates
     is presented below:

<TABLE>
<CAPTION>
                                     1994                  1995                    1996
                           ---------------------   -------------------     ----------------------
                                        Weighted              Weighted                  Weighted
                                        Average                Average                  Average
                             Options    Exercise     Options   Exercise      Options    Exercise
                           Outstanding   Price     Outstanding  Price      Outstanding    Price
                           -----------  --------   -----------  -------    -----------  ---------
<S>                           <C>        <C>         <C>        <C>            <C>       <C>
     Beginning
       of year                 84,491    $11.77      104,789    $12.74         49,083    $14.51
     Granted                   22,500     16.38           --        --         53,000     21.00
     Exercised                 (1,577)    12.03      (55,706)    11.20         (6,458)    12.01
     Forfeited                   (625)    14.38           --        --         (4,875)    18.50
                              -------                 ------                   ------
     End of year              104,789     12.74       49,083     14.51         90,750     18.28
                              =======                 ======                   ======

     Options exer-
     cisable  at year-
     end                       65,164     10.98       22,083     12.61         40,750     14.93
                              =======                 ======                   ======
</TABLE>









                                      F-12
<PAGE>   66

     The following table summarizes information about the Company's outstanding
     stock options at December 31, 1996:

<TABLE>
<CAPTION>
                                     Number             Remaining      Average       Number
                  Exercise           Outstanding        Contractual    Exercise   Exercisable
                    Price            at 12/31/96        Life in Years   Price     at 12/31/96
                  --------           -----------        -------------  --------   -----------
                  <S>                  <C>              <C>           <C>           <C>
                  $  9.38               4,000           2.2           $  9.38        4,000
                    14.38              15,500           5.1             14.38       15,500
                    16.38              21,250           7.4             16.38       21,250
                    21.00              50,000           9.1             21.00            0
                                       ------                                       ------
                                       90,750                                       40,750
                                       ======                                       ======
</TABLE>

     Common stock repurchases
     ------------------------

     Prior to 1996 in connection with the Company's stock option program for its
     agents, the Company's Board of Directors approved a plan to purchase up to
     25,000 shares of the Company's common stock. During 1996, the Company's
     Board of Directors authorized the repurchase of up to 200,000 additional
     shares of the Company's common stock in the open market. During 1996 the
     Company repurchased 160,700 shares of its common stock and is holding these
     shares in treasury as of December 31, 1996.

3.   Related Party Transactions
     --------------------------

     The Company and MNH do not have any paid employees. Under a management
     agreement Mutual, which owns 8.3% of the Company's outstanding common stock
     at December 31, 1996, provides the Company and MNH with the facilities,
     management and personnel required to manage their day-to-day business. All
     underwriting, administrative, claims and investment expenses incurred on
     behalf of Mutual and MNH are shared on an allocated cost basis, determined
     as follows: for underwriting and administrative expenses, the respective
     share of total direct premiums written for Mutual and MNH serves as the
     basis of allocation; for claims expenses, the average number of outstanding
     claims is used; investment expenses are shared based on each company's
     share of total invested assets. Mutual also receives an annual management
     fee of $50,000 from MNH. Management believes that the methods used to
     allocate expenses to MNH and Mutual are reasonable and fair to both
     companies. The management agreement may be terminated by either Mutual or
     the Company upon five years written notice.

     MNH's agents are also licensed to sell Mutual's products. The agents are
     informed of the underwriting criteria of each company as well as the
     classes of business that are acceptable to each company. Underwriters
     review each application submitted by an agent to determine which company's
     underwriting criteria the risk meets and then issue a policy in the
     appropriate company. Involuntary automobile policies are shared in
     accordance with the plan assignment ratios of the applicable governing
     jurisdictions. The payable to or receivable from Mutual is non-interest
     bearing and represents the net of premiums collected and loss and operating


                                      F-13
<PAGE>   67

     expense payments made by Mutual on behalf of MNH. This balance is settled
     in cash on a monthly basis.

     MNH owns an investment represented by a capital advance issued by Mutual in
     the amount of $1,350,000. This investment carries a dividend of 4% per
     annum. Mutual cannot repay the capital advance or pay dividends without the
     prior approval of the Superintendent of the New York Insurance Department.
     In December 1996, the Department granted Mutual permission to pay all
     unpaid dividends through October 1996. MNH received $203,000 of such
     dividends from Mutual in December 1996. This investment is included in
     other long-term investments.

     During 1994, Mutual filed an application with the New York Insurance
     Department to convert from a mutual company to a stock corporation. The
     Company had indicated to Mutual its willingness to consider sponsoring this
     conversion. During 1996, Mutual advised the Company that it had withdrawn
     its demutualization application with the Department.

     Effective January 1, 1993, Mutual and MNH entered into a quota share
     reinsurance agreement under which MNH assumes 10% of Mutual's direct
     voluntary written premium and related losses in exchange for a reinsurance
     commission of 35%. The agreement also provides for MNH to pay a contingent
     commission to Mutual equal to any underwriting profit on the premiums
     assumed. The agreement allows Mutual the option to reduce its cessions to
     MNH to 0% for any calendar year. Mutual did not cede any portion of its
     direct voluntary premiums written to MNH in 1996 and has informed MNH that
     it will not cede any of its direct voluntary written premiums to MNH for
     calendar year 1997.

     In accordance with various states' automobile insurance plan (AIP) rules,
     Mutual historically has received the assignment of AIP policies based upon
     its and MNH's combined voluntary automobile market share, issued the
     policies and settled the claims associated with those policies. Mutual then
     allocated the results of the involuntary AIP business to MNH through a
     series of accounting entries based on MNH's share of the combined voluntary
     business of Mutual and MNH. During 1994, Mutual informed the Company that
     it had failed to identify and bill to MNH during the period January 1, 1985
     through June 30, 1994 a portion of MNH's share of AIP losses paid by Mutual
     in that period. The amount of unbilled AIP losses was approximately
     $7,500,000. MNH paid Mutual $3,135,000 in full and complete settlement of
     the unbilled AIP paid losses for the period noted above. This amount is
     included in loss and loss adjustment expenses for the year ended December
     31, 1994.











                                      F-14
<PAGE>   68

4.   Reserve for Losses and Loss Adjustment Expenses
     -----------------------------------------------

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

<TABLE>
<CAPTION>
                                                                                  1995                     1996
                                                                                  ----                     ----
                                                                                         (in thousands)
<S>                                                                             <C>                   <C>
     Reserve for losses and LAE at beginning of year                            $104,015              $119,722
         Less reinsurance recoverables                                             6,401                 6,004
                                                                                --------              --------
         Net balance at beginning of year                                         97,614               113,718
                                                                                --------              --------

     Provision for losses and LAE for claims occurring in:
         Current year                                                             67,150                72,771
         Prior years                                                              11,045                 6,832
                                                                                --------              --------
                                                                                  78,195                79,603
                                                                                --------              --------

     Losses and LAE payments for claims occurring in:
         Current year                                                             25,175                28,512
         Prior years                                                              36,916                38,549
                                                                                --------              --------
                                                                                  62,091                67,061
                                                                                --------              --------

     Reserve for losses and LAE at end of year, net                              113,718               126,260
         Plus reinsurance recoverables                                             6,004                 7,219
                                                                                --------              --------
         Balance at end of year                                                 $119,722              $133,479
                                                                                ========              ========
</TABLE>


     In 1995 and 1996, the Company increased its reserves for prior years by
     $11,045,000 and $6,896,000, respectively. The increase in reserves for
     prior years made in 1995 was primarily attributable to higher than
     anticipated severity of liability claims on homeowners, businessowners,
     workers' compensation and commercial package lines of business. The
     increase in reserves for prior years made in 1996 was primarily
     attributable to higher than anticipated severity of claims on workers'
     compensation policies.

















                                      F-15
<PAGE>   69

5.   Investments
     -----------

     Investments in fixed maturities
     -------------------------------
     The amortized cost and estimated fair values of investments in fixed
     maturities held to maturity and available for sale are as follows:

<TABLE>
<CAPTION>
                                                     Gross        Gross
                                    Amortized      Unrealized   Unrealized   Estimated
                                       Cost          Gains        Losses     Fair Value
                                    ---------      ----------   ----------   ----------
                                                       (in thousands)
<S>                                 <C>            <C>          <C>          <C>
     December 31, 1995
     -----------------

     Held to maturity
     ----------------

     U.S. Treasury securities and
          obligations of U.S.
          government corporations
          and agencies              $  2,157       $   15       $ 37         $  2,135
     Mortgage and asset backed
          securities                  17,320          902          9           18,213
                                    --------       ------       ----         --------
             Total                  $ 19,477       $  917       $ 46         $ 20,348
                                    ========       ======       ====         ========

     Available for sale
     ------------------

     U.S. Treasury securities and
          obligations of U.S.
          government corporations
          and agencies              $ 26,943       $   30       $277         $ 26,696
     Obligations of states and
          political subdivisions      60,423          580        166           60,837
     Corporate securities             12,037            4         73           11,968
     Mortgage and asset backed
          securities                  63,846          502         71           64,277
                                    --------       ------       ----         --------
             Total                  $163,249       $1,116       $587         $163,778
                                    ========       ======       ====         ========
</TABLE>







                                      F-16
<PAGE>   70




<TABLE>
<CAPTION>
                                                     Gross        Gross
                                    Amortized      Unrealized   Unrealized   Estimated
                                       Cost          Gains        Losses     Fair Value
                                    ---------      ----------   ----------   ----------
                                                       (in thousands)
<S>                                 <C>            <C>          <C>          <C>
     December 31, 1996
     -----------------

     Held to maturity
     ----------------

     U.S. Treasury securities and
          obligations of U.S.
          government corporations
          and agencies              $  2,153       $    7       $ 47         $  2,113
     Mortgage and asset backed
          securities                  17,396          412         --           17,808
                                    --------       ------       ----         --------
             Total                  $ 19,549       $  419       $ 47         $ 19,921
                                    ========       ======       ====         ========


     Available for sale
     ------------------

     U.S. Treasury securities and
          obligations of U.S.
          government corporations
          and agencies              $ 24,123       $    4       $331         $ 23,796
     Obligations of states and
          political subdivisions      46,684          336        202           46,818
     Corporate securities              3,086          153         --            3,239
     Mortgage and asset backed
          securities                  89,607          532        425           89,714
                                    --------       ------       ----         --------
             Total                  $163,500       $1,025       $958         $163,567
                                    ========       ======       ====         ========
</TABLE>















                                      F-17
<PAGE>   71

          The amortized cost and fair value of fixed maturities by expected
          maturity at December 31, 1996 are shown below. Mortgage and asset
          backed securities are distributed in the table based upon management's
          estimate of repayment periods. Expected maturities will differ from
          contractual maturities because borrowers may have the right to call or
          prepay obligations with or without call or prepayment penalties.


<TABLE>
<CAPTION>
                                                                                               Estimated Fair
                                                                    Amortized Cost                  Value
                                                                    --------------             --------------
                                                                                  (in thousands)
<S>                                                                     <C>                         <C>
         Held to maturity
         ----------------
         Due in one year or less                                        $ 2,080                     $  2,129
         Due after one year through five years                           11,386                       11,565
         Due after five years through ten years                           4,251                        4,352
         Due after ten years                                              1,832                        1,875
                                                                        -------                      -------
                 Total                                                  $19,549                      $19,921
                                                                        =======                      =======

         Available for sale
         Due in one year or less                                       $ 13,420                     $ 13,438
         Due after one year through five years                          112,656                      112,470
         Due after five years through ten years                          27,987                       28,201
         Due after ten years                                              9,437                        9,458
                                                                       --------                     --------
                 Total                                                 $163,500                     $163,567
                                                                       ========                     ========
</TABLE>



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

         Fixed maturities with a par value of $1,800,000 were on deposit at
         December 31, 1996 with various state insurance departments in
         compliance with applicable insurance laws.

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

<TABLE>
<CAPTION>
                                                               Year ended December 31,
                                                               -----------------------
                                                       1994              1995           1996
                                                       ----              ----           ----
                                                                  (in thousands)
<S>                                                   <C>               <C>           <C>
      Proceeds from sales                             $12,891           $1,797        $38,499
      Gross realized gains                                 29                8          1,012
      Gross realized losses                                 9              -               16
</TABLE>






                                      F-18
<PAGE>   72

     Net investment income
     ---------------------

     Net investment income consists of:

<TABLE>
<CAPTION>
                                    Year ended December 31,
                                    -----------------------
                                    1994      1995      1996
                                    ----      ----      ----
                                         (in thousands)
<S>                              <C>       <C>       <C>
     Short-term investments      $   252   $   238   $   443
     Fixed maturities              9,872    10,078    10,956
     Other                           188       177       612
                                 -------   -------   -------
       Total investment income    10,312    10,493    12,011
     Investment expenses             463       125       287
                                 -------   -------   -------
       Net investment income     $ 9,849   $10,368   $11,724
                                 =======   =======   =======
</TABLE>

     Investment in auction rate preference shares
     --------------------------------------------

     During 1996, the Company sold its investment in Signet Group, PLC (Signet)
     cumulative auction rate preference shares and recognized a realized gain of
     $900,000. These shares were included in other long term investments at
     December 31, 1995 and were carried at fair value.

     During 1995, the Company recorded an $840,000 unrealized loss on its Signet
     investment which was included as a component of realized gains and losses
     in the Company's 1995 Consolidated Statement of Operations.

6.   Reinsurance
     -----------

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

     MNH maintains a casualty excess of loss reinsurance agreement which
     provides for recovery of losses over $500,000 up to $5,000,000 per
     occurrence. This coverage is supplemented by a contingent casualty layer of
     reinsurance of $5,000,000 in excess of the first $5,000,000. MNH also
     maintains a property excess of loss reinsurance agreement which provides
     for recovery of property losses over $500,000 up to $2,000,000 per
     occurrence. Property catastrophe coverage provides for recovery of 95% of
     $40,000,000 above aggregate retained losses of $5,000,000 per each natural
     disaster. The limits of property catastrophe coverage are shared by MNH and
     Mutual on a pro rata basis based upon the gross reported losses of MNH and
     Mutual for a covered event.



                                      F-19
<PAGE>   73

     The effect of reinsurance on premiums written and earned for the years
     ended December 31, 1995 and 1996 is as follows:

<TABLE>
<CAPTION>
                              1995                      1996
                       --------------------    ---------------------
                       Premiums    Premiums     Premiums    Premiums
                       Written      Earned      Written      Earned
                       -------      ------      -------      ------
                                        (in thousands)
<S>                    <C>         <C>         <C>          <C>
     Direct            $ 98,553    $ 93,502    $ 101,007    $ 99,858
     Assumed              6,572       8,299        3,401       3,614
     Ceded               (7,548)     (7,052)      (7,786)     (7,720)
                       --------    --------    ---------    --------
        Net premiums   $ 97,577    $ 94,749    $  96,622    $ 95,752
                       ========    ========    =========    ========
</TABLE>

     Reinsurance ceded transactions decreased losses and LAE by $1,527,000 and
     $1,920,000 for the years ended December 31, 1995 and 1996, respectively.

     As a result of the reinsurance agreements maintained by MNH, MNH is exposed
     to certain credit risk if its primary reinsurer were to become financially
     unstable. As of December 31, 1996, MNH has recognized amounts to be
     recovered from its primary reinsurer related to ceded losses and ceded
     unearned premiums totaling $9,009,000. MNH generally does not require
     collateral for reinsurance recoverable.

7.   Benefit Programs
     ----------------

     Mutual maintains a capital accumulation plan which is a profit sharing plan
     under Section 401(a) of the Internal Revenue Code that covers all full-time
     employees who have completed one year of service. Mutual matches at least
     15% and up to 100% of employee contributions, based on the combined net
     operating profits of Mutual and MNH. Additional contributions may be made
     at the discretion of the Board of Directors of Mutual. Under the terms of
     the management agreement, the Company's portion of the total contribution
     was $404,000, $186,000 and $ 238,000 for the years ended December 31, 1994,
     1995 and 1996, respectively.















                                      F-20
<PAGE>   74

8.   Income Taxes
     ------------

     The benefit for federal income taxes consists of:

<TABLE>
<CAPTION>
                                                                       Year ended December 31,
                                                              ------------------------------------------------
                                                              1994                1995                    1996
                                                              ----                ----                    ----
                                                                             (in thousands)
<S>                                                           <C>               <C>                   <C>
    Income tax benefit:
         Current                                              $(500)            $(1,888)              $(1,208)
         Deferred                                              (395)             (1,111)                 (677)
                                                              -----             -------               -------
    Total income tax benefit                                  $(895)            $(2,999)              $(1,885)
                                                              =====             =======               =======
</TABLE>


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

<TABLE>
<CAPTION>
                                                                             December 31,
                                                              ----------------------------------------
                                                                1995                                1996
                                                                ----                                ----
                                                                             (in thousands)
<S>                                                           <C>                            <C>
    Deferred policy acquisition costs                         $   4,136                      $  4,215
    Other                                                           462                           400
                                                              ---------                      --------
    Gross deferred tax liabilities                                4,598                         4,615
                                                              ---------                      --------

    Discounting of reserve for losses and
         loss adjustment expenses                                (6,004)                       (5,993)
    Unearned premiums                                            (3,122)                       (3,181)
    Unrealized investment losses                                   (674)                         (311)
    Other                                                          (289)                         (466)
    Minimum tax credit carryforward                                 -                          (1,309)
                                                              ---------                      --------
    Gross deferred tax assets                                   (10,089)                      (11,260)
                                                              ---------                      --------
         Net deferred federal income tax
            benefit                                           $  (5,491)                     $ (6,645)
                                                              =========                      ========
</TABLE>


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










                                      F-21
<PAGE>   75

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

<TABLE>
<CAPTION>
                                                                       Year ended December 31,
                                                              --------------------------------------------------
                                                               1994                  1995               1996
                                                               ----                  ----               ----
                                                                               (in thousands)
<S>                                                          <C>                    <C>                 <C>
    Computed provision (benefit) at
      statutory rate                                         $       80             $(2,318)            $(1,031)
    Adjustments:
         Tax-exempt investment income                              (980)               (878)               (726)
         Other items                                                  5                 197                (128)
                                                              ---------             -------             -------
    Total income tax benefit                                  $    (895)            $(2,999)            $(1,885)
                                                              =========             =======             =======
</TABLE>


9.   Commitments and Contingencies
     -----------------------------

     In 1995, a New York State trial court dismissed a purported class action
     lawsuit which was filed in 1993 against the Company, Mutual, MNH and
     certain directors of the Company and of Mutual (the defendants) on behalf
     of the then minority shareholders of the Company. The court, in granting
     the defendants' motion, held that plaintiff's claims, to the extent they
     have any merit, are derivative in nature. The complaint, which sought
     equitable relief and unspecified money damages, alleged that the defendants
     breached their fiduciary obligations to the minority shareholders of the
     Company, and defrauded the minority shareholders, by causing MNH to
     purchase from the Federal Deposit Insurance Corporation (the FDIC) a
     surplus note issued by Mutual and simultaneously reducing the principal
     amount plus accrued return on such surplus note to $1,350,000, which is the
     amount MNH paid to the FDIC for the note, and by approving the public sale
     of the Company's common stock in July 1993 at what the plaintiff alleges
     was an inadequate price. In November 1995 the plaintiff filed an amended
     complaint which asserts the same claims as were asserted in his class
     action lawsuit but in the form of a derivative suit. In June 1996, the
     Company and the other defendants moved to dismiss the derivative complaint.
     The court has not yet rendered its decision on those motions.

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



                                      F-22
<PAGE>   76

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





                                      F-23
<PAGE>   77
                                 EXHIBIT INDEX