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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly Report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
for the Quarterly Period Ended September 30, 2008,
or
Transition report pursuant to Section 13 or 15(d) Of the Exchange Act
for the Transition Period from                      to                     
No. 000-25425
 
(Commission File Number)
MERCER INSURANCE GROUP, INC.
(Exact name of Registrant as specified in its charter)
     
PENNSYLVANIA   23-2934601
     
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
10 North Highway 31, P.O. Box 278, Pennington, NJ   08534
     
(Address of principal executive offices)   (Zip Code)
(609) 737-0426
 
(Registrant’s telephone number, including area code)
 
(Former name, former address and former fiscal year, if changed since last report)
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 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer   o
(Do not check if a smaller reporting company)
  Smaller Reporting Company o  
Indicate by check mark if the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
     
    Number of Shares Outstanding as of October 31, 2008
COMMON STOCK (No Par Value)   6,453,560
(Title of Class)   (Outstanding Shares)
 
 

 


 

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Exhibits:
    47  
  EX-31.1
  EX-31.2
  EX-32.1
  EX-32.2
     
Exhibit No.   Title
3.1
  Articles of Incorporation of Mercer Insurance Group, Inc. (incorporated by reference herein to the Company’s Pre-effective Amendment No. 3 on Form S-1, SEC File No. 333-104897.)
 
   
3.2
  Bylaws of Mercer Insurance Group, Inc. (incorporated by reference herein to the Company’s Annual Report on Form 10-K, SEC File No. 000-25425, for the fiscal year ended December 31, 2003.)
 
   
31.1
  Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
 
   
31.2
  Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
 
   
32.1
  Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002
 
   
32.2
  Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002

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Forward-looking Statements
     Mercer Insurance Group, Inc. (the “Group”) may from time to time make written or oral “forward-looking statements,” including statements contained in the Group’s filings with the Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the exhibits hereto and thereto), in its reports to shareholders and in other communications by the Group, which are made in good faith by the Group pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.
     These forward-looking statements include statements with respect to the Group’s beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Group’s control). The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Group’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:
future economic conditions in the regional and national markets in which the Group competes which are less favorable than expected;
the effects of weather-related and other catastrophic events;
the concentration of insured accounts in California, New Jersey and Pennsylvania;
the effect of legislative, judicial, economic, demographic and regulatory events in the seven states in which we do the majority of our business as of September 30, 2008;
the continuation of an A.M. Best rating in the Excellent category;
the ability to enter new markets successfully and capitalize on growth opportunities either through acquisitions or the expansion of our producer network;
the ability to obtain regulatory approval for an acquisition, to close the transaction, and to successfully integrate an acquisition and its operations;
financial market conditions, including, but not limited to, changes in interest rates and the stock markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products;
the impact of acts of terrorism and acts of war;
the effects of terrorist related insurance legislation and laws;
inflation;
the cost, availability and collectibility of reinsurance;
estimates and adequacy of loss reserves and trends in losses and loss adjustment expenses;
heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors;
changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits;
our inability to obtain regulatory approval of, or to implement, premium rate increases;
the potential impact on our reported net income that could result from the adoption of future accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies;

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the inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market;
unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;
adverse litigation or arbitration results;
the ability to carry out our business plans; or
adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and environmental, tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products.
disruption in world financial markets, which could adversely affect demand for the Company’s products, and credit risk associated with agents, customers, and reinsurers, as well as adversely affecting the Company’s investment portfolio value and investment income. Disrupted markets could present difficulty if the Company needed to raise additional capital in the future.
     The Group cautions that the foregoing list of important factors is not exclusive. Readers are also cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this report. The Group does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Group.

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Part I — FINANCIAL INFORMATION
Item 1. Financial Statements
MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
                 
    September 30,     December 31,  
    2008     2007  
    (Dollars in thousands)  
    (Unaudited)          
Assets
               
Investments:
               
Fixed-income securities, available for sale, at fair value (cost $333,628 and $321,978, respectively)
  $ 328,548       324,238  
Equity securities, at fair value (cost $12,351 and $12,500, respectively)
    14,730       17,930  
Short-term investments, at cost, which approximates fair value
    9,998        
 
           
Total investments
    353,276       342,168  
 
Cash and cash equivalents
    14,690       21,580  
Premiums receivable
    39,431       36,339  
Reinsurance receivables
    89,104       83,844  
Prepaid reinsurance premiums
    7,460       9,486  
Deferred policy acquisition costs
    21,202       20,528  
Accrued investment income
    3,639       3,582  
Property and equipment, net
    15,357       13,056  
Deferred income taxes
    11,581       7,670  
Goodwill
    5,416       5,416  
Other assets
    3,286       2,766  
 
           
Total assets
  $ 564,442       546,435  
 
           
Liabilities and Equity
               
Liabilities:
               
Losses and loss adjustment expenses
  $ 298,991       274,399  
Unearned premiums
    86,271       88,024  
Accounts payable and accrued expenses
    13,549       14,622  
Other reinsurance balances
    11,824       14,734  
Trust preferred securities
    15,571       15,559  
Advances under line of credit
    3,000       3,000  
Other liabilities
    2,283       2,691  
 
           
Total liabilities
    431,489       413,029  
 
           
 
Stockholders’ Equity:
               
Preferred stock, no par value, authorized 5,000,000 shares, no shares issued and outstanding
           
Common stock, no par value, authorized 15,000,000 shares, issued 7,075,333 shares, outstanding 6,782,691 and 6,717,693 shares, respectively
           
Additional paid-in capital
    71,163       70,394  
Accumulated other comprehensive (loss)/income
    (2,073 )     4,896  
Retained earnings
    73,969       67,613  
Unearned ESOP shares
    (2,662 )     (3,131 )
Treasury stock, 567,158 and 505,814 shares
    (7,444 )     (6,366 )
 
           
Total stockholders’ equity
    132,953       133,406  
 
           
Total liabilities and stockholders’ equity
  $ 564,442       546,435  
 
           
See accompanying notes to consolidated financial statements.

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
Nine Months Ended September 30, 2008 and 2007
                 
    2008     2007  
    (Dollars in thousands, except per share data)  
    (Unaudited)  
Revenues:
               
Net premiums earned
  $ 115,590       106,367  
Investment income, net of expenses
    10,173       9,592  
Net realized investment (losses)/gains
    (2,944 )     267  
Other revenue
    1,555       1,494  
 
           
 
               
Total revenues
    124,374       117,720  
 
           
 
Expenses:
               
Losses and loss adjustment expenses
    71,564       65,398  
Amortization of deferred policy acquisition costs (related party amounts of $805 and $865, respectively)
    31,163       27,829  
Other expenses
    10,618       7,530  
Interest expense
    961       911  
 
           
 
Total expenses
    114,306       101,668  
 
               
Income before income taxes
    10,068       16,052  
 
               
Income taxes
    2,463       4,697  
 
           
Net income
  $ 7,605       11,355  
 
           
 
               
Earnings per common share:
               
Basic
  $ 1.22       1.85  
Diluted
  $ 1.19       1.80  
 
               
Weighted average shares:
               
Basic
    6,230,476       6,125,654  
Diluted
    6,382,740       6,318,029  
See accompanying notes to consolidated financial statements.

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
Three Months Ended September 30, 2008 and 2007
                 
    2008     2007  
    (Dollars in thousands, except per share data)  
    (Unaudited)  
Revenues:
               
Net premiums earned
  $ 37,869       37,303  
Investment income, net of expenses
    3,469       2,880  
Net realized investment losses
    (2,281 )     (366 )
Other revenue
    536       587  
 
           
Total revenues
    39,593       40,404  
 
           
 
               
Expenses:
               
Losses and loss adjustment expenses
    22,819       22,768  
Amortization of deferred policy acquisition costs (related party amounts of $263 and $287, respectively)
    10,460       9,870  
Other expenses
    3,776       3,315  
Interest expense
    328       300  
 
           
Total expenses
    37,383       36,253  
 
               
Income before income taxes
    2,210       4,151  
 
               
Income taxes
    430       1,139  
 
           
Net income
  $ 1,780       3,012  
 
           
 
               
Earnings per common share:
               
Basic
  $ 0.29       0.49  
Diluted
  $ 0.28       0.47  
 
               
Weighted average shares:
               
Basic
    6,237,804       6,174,842  
Diluted
    6,382,413       6,345,865  
See accompanying notes to consolidated financial statements.

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Nine Months Ended September 30, 2008
(Unaudited, dollars in thousands)
                                                                 
                            Accumulated                            
                    Additional     other             Unearned              
    Preferred     Common     paid-in     comprehensive     Retained     ESOP     Treasury        
    stock     stock     capital     income/(loss)     earnings     shares     stock     Total  
Balance, December 31, 2007
  $             70,394       4,896       67,613       (3,131 )     (6,366 )     133,406  
Net income
                                    7,605                       7,605  
Unrealized losses on securities:
                                                               
Unrealized holding losses arising during period, net of related income tax benefit of $4,465
                            (8,667 )                             (8,667 )
Less reclassification adjustment for losses included in net income, net of related income tax benefit of $932
                            1,809                               1,809  
Defined benefit pension plan, net of related income tax benefit of $57
                            (111 )                             (111 )
 
                                               
Other comprehensive loss
                                                            (6,969 )
 
                                                             
Comprehensive income
                                                            636  
 
                                                             
Stock compensation plan amortization
                    390                                       390  
Tax benefit from stock compensation plan
                    40                                       40  
ESOP shares committed
                    339                       469               808  
Purchase of treasury stock
                                                    (1,078 )     (1,078 )
Dividends to stockholders
                                    (1,249 )                     (1,249 )
 
                                               
Balance, September 30, 2008
  $             71,163       (2,073 )     73,969       (2,662 )     (7,444 )     132,953  
 
                                               
See accompanying notes to consolidated financial statements.

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2008 and 2007
                 
    2008     2007  
    (Dollars in thousands)  
    (Unaudited)  
Cash flows from operating activities:
               
Net income
  $ 7,605       11,355  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization of fixed assets
    1,760       1,605  
Net amortization of premium
    1,123       938  
Amortization of stock compensation
    390       876  
ESOP share commitment
    808       892  
Net realized investment losses/(gains)
    2,944       (267 )
Deferred income tax
    (321 )     (655 )
Change in assets and liabilities:
               
Premiums receivable
    (3,092 )     (5,672 )
Reinsurance receivables
    (5,260 )     (5,230 )
Prepaid reinsurance premiums
    2,026       6,448  
Deferred policy acquisition costs
    (674 )     (4,765 )
Other assets
    (784 )     (424 )
Losses and loss adjustment expenses
    24,592       20,551  
Unearned premiums
    (1,753 )     10,302  
Other reinsurance balances
    (2,910 )     (6,084 )
Other
    (1,081 )     4,383  
 
           
Net cash provided by operating activities
    25,373       34,253  
 
           
 
               
Cash flows from investing activities:
               
Purchase of fixed income securities, available for sale
    (50,816 )     (54,057 )
Purchase of equity securities
    (2,904 )     (2,471 )
(Purchase)/sale of short-term investments, net
    (9,998 )     1,949  
Sale and maturity of fixed income securities, available for sale
    34,819       17,505  
Sale of equity securities
    2,981       2,777  
Purchase of property and equipment, net
    (4,058 )     (1,822 )
 
           
Net cash used in investing activities
    (29,976 )     (36,119 )
 
           
 
               
Cash flows from financing activities:
               
Purchase of treasury stock
    (1,078 )     (40 )
Tax benefit from stock compensation plans
    40       153  
Proceeds from issuance of common stock
          40  
Dividends to stockholders
    (1,249 )     (942 )
 
           
Net cash used in financing activities
    (2,287 )     (789 )
 
           
 
               
Net decrease in cash and cash equivalents
    (6,890 )     (2,655 )
Cash and cash equivalents at beginning of period
    21,580       17,618  
 
           
Cash and cash equivalents at end of period
  $ 14,690       14,963  
 
           
 
               
Cash paid during the period for:
               
Interest
  $ 934       902  
Income taxes
  $ 2,758       4,750  
See accompanying notes to consolidated financial statements.

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MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) Basis of Presentation
     The financial information for the interim periods included herein is unaudited; however, such information reflects all adjustments which are, in the opinion of management, necessary to a fair presentation of the financial position, results of operations, and cash flows for the interim periods. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year.
     Mercer Insurance Group, Inc. (MIG) and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Queenstown Holding Company, Inc. (QHC) and its subsidiary Mercer Insurance Company of New Jersey, Inc. (MICNJ), Franklin Holding Company, Inc. (FHC) and its subsidiary Franklin Insurance Company (FIC), and BICUS Services Corporation (BICUS). On October 1, 2005, MIG acquired Financial Pacific Insurance Group, Inc. (FPIG) and its subsidiaries Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA), which is currently inactive after having sold the opportunity to solicit renewals to an unrelated agency for a fixed commission for one year, commencing in October, 2006. FPIG also holds an interest in three statutory business trusts that were formed for the purpose of issuing Floating Rate Capital Securities.
     The Group, through its property and casualty insurance subsidiaries, provides a wide array of property and casualty insurance products designed to meet the insurance needs of individuals in New Jersey and Pennsylvania, and small and medium-sized businesses throughout Arizona, California, Nevada, New Jersey, New York, Oregon and Pennsylvania.
     These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2007 included in the Group’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.
    Share-Based Compensation
     The Group makes grants of qualified (ISO’s) and non-qualified stock options (NQO’s), and non-vested shares (restricted stock) under its stock incentive plan. Stock options are granted at prices that are not less than market price at the date of grant, and are exercisable over a period of ten years for ISO’s and ten years and one month for NQO’s. Restricted stock grants vest over a period of three or five years.
     The Group applies the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment”, using the modified-prospective-transition method. The after-tax compensation expense recorded in the consolidated statements of earnings for stock options (net of forfeitures) for the nine months ended September 30, 2008 and 2007 was $163,000 and $366,000, respectively. The after-tax compensation expense recorded in the consolidated statements of earnings for restricted stock (net of forfeitures) for the nine months ended September 30, 2008 and 2007 was $142,000 and $277,000, respectively. The after-tax compensation expense recorded in the consolidated statements of earnings for stock options (net of forfeitures) for the three months ended September 30, 2008 and 2007 was $55,000 and $54,000, respectively. The after-tax compensation expense recorded in the consolidated statements of earnings for restricted stock (net of forfeitures) for the three months ended September 30, 2008 and 2007 was $48,000 and $47,000, respectively.
     As of September 30, 2008, the Group has $0.6 million of unrecognized total compensation cost related to non-vested stock options and restricted stock. That cost will be recognized over the remaining weighted-average vesting period of 1.5 years, based on the estimated grant date fair value.
     For the nine months ended September 30, 2008, the Group made no grants of restricted stock and stock options. In addition, there were no forfeitures of restricted stock and stock options and no options exercised during the first nine months of 2008.
    Fair Value Measurements  
     In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair

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value and expands disclosure about fair value measurements. It applies to other pronouncements that require or permit fair value but does not require any new fair value measurements. The statement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
     SFAS 157 establishes a fair value hierarchy to increase consistency and comparability in fair value measurements and disclosures. The hierarchy is based on the inputs used in valuation and gives the highest priority to quoted prices in active markets. The highest possible level should be used to measure fair value. SFAS 157 is effective for fiscal years beginning after November 15, 2007.
     In February 2008, the FASB issued FSP SFAS 157-2, Effective Date of FASB Statement No. 157 (FSP SFAS 157-2), which delays the effective date of SFAS 157 for all non-financial assets and non-financial liabilities until January, 2009, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).
     The Group adopted SFAS 157 and FSP SFAS 157-2 effective January 1, 2008. Accordingly, the provisions of SFAS 157 were not applied to goodwill and other intangible assets held by the Group and measured annually for impairment testing purposes only. The adoption of SFAS 157, for all other assets and liabilities held by the Group, did not have a material effect on the Group’s results of operations, financial position or liquidity. The Group will adopt SFAS 157 for non-financial assets and non-financial liabilities on January 1, 2009 and does not expect the provisions to have a material effect on its results of operations, financial position or liquidity.
     In October 2008, the FASB issued FSP SFAS 157-3, Determining the Fair Value of a Financial Asset When the Market For That Asset Is Not Active (FSP SFAS 157-3), with an immediate effective date, including prior periods for which financial statements have not been issued.  FSP SFAS 157-3 amends SFAS 157 to clarify the application of fair value in inactive markets and allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist.  The objective of SFAS 157 has not changed and continues to be the determination of the price that would be received in an orderly transaction between market participants that is not a forced liquidation or distressed sale at the measurement date.  The adoption of FSP SFAS 157-3 in the third quarter did not have a material effect on the Group’s results of operations, financial position or liquidity.
      Fair Value Option for Financial Assets and Financial Liabilities
     In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 permits an entity to irrevocably elect fair value on a contract-by-contract basis for new assets or liabilities within the scope as the initial and subsequent measurement attribute for those financial assets and liabilities and certain other items including property and casualty insurance contracts. Entities electing the fair value option would be required to recognize changes in fair value in earnings and to expense up-front costs and fees associated with the item for which the fair value option is elected. Entities electing the fair value option are required to distinguish on the face of the statement of financial position the fair value of assets and liabilities for which the fair value option has been elected, and similar assets and liabilities measured using another measurement attribute. An entity can accomplish this by either reporting the fair value and non-fair-value carrying amounts as separate line items or aggregating those amounts and disclosing parenthetically the amount of fair value included in the aggregate amount. The Group adopted SFAS 159 effective January 1, 2008 and the adoption did not have a material effect on the Group’s results of operations, financial position or liquidity. The Group did not elect to measure at fair value any assets or liabilities that were not otherwise already carried at fair value in accordance with other accounting pronouncements.
      New Accounting Pronouncements
     In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162) to identify the sources of accounting principles and provide a framework for selecting the principles to be used in the preparation of financial statements in accordance with generally accepted accounting principles in the United States. The hierarchy of authoritative accounting guidance is not expected to change current practice but is expected to facilitate the FASB’s plan to designate as authoritative its forthcoming codification of accounting standards. This Statement is effective November 15, 2008. The Group does not anticipate any significant financial statement impact resulting from its adoption of SFAS 162.
     In June 2008, the FASB issued FASB Staff Position (FSP) No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities (FSP 03-6-1) . FSP 03-6-1 addresses the treatment of unvested share-based payment awards containing nonforfeitable rights to dividends or dividend equivalents in the calculation of earnings per share

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and is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. The Group is currently evaluating the impact of FSP 03-6-1 on the calculation of earnings per share.
     In June 2007, the Emerging Issues Task Force (EITF) of FASB issued EITF Issue No. 06-11 Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (EITF 06-11). EITF 06-11 requires that the tax benefit from dividends or dividend equivalents that are charged to retained earnings and are paid to employees for equity classified nonvested equity shares, nonvested equity share units, and outstanding equity share options be recognized as an increase to additional paid-in capital. EITF 06-11, was effective on a prospective basis beginning with dividends declared in fiscal years beginning after December 15, 2007, and the Group adopted it in the first quarter of 2008. The adoption of EITF 06-11 did not have a material impact on the Group’s results of operations or financial condition.
(2) Segment Information
     The Group markets its products through independent insurance agents, which sell commercial lines of insurance primarily to small to medium-sized businesses and personal lines of insurance to individuals.
     The Group manages its business in three segments: commercial lines insurance (including surety), personal lines insurance, and investments. The commercial lines insurance and personal lines insurance segments are managed based on underwriting results determined in accordance with U.S. generally accepted accounting principles, and the investment segment is managed based on after-tax investment returns.
     Underwriting results for commercial lines and personal lines take into account premiums earned, incurred losses and loss adjustment expenses, and underwriting expenses. The investments segment is evaluated by consideration of net investment income (investment income less investment expenses) and realized gains and losses.
     In determining the results of each segment, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes.
     During 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Previously reported 2007 amounts have been reclassified below to reflect this change in allocation methodology.
     Financial data by segment is as follows:

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    Nine Months Ended September 30,  
    2008     2007  
    (In thousands)  
Revenues:
               
Net premiums earned:
               
Commercial lines
  $ 100,496     $ 90,287  
Personal lines
    15,094       16,080  
 
           
Total net premiums earned
    115,590       106,367  
Net investment income
    10,173       9,592  
Net realized investment (losses)/gains
    (2,944 )     267  
Other revenue
    1,555       1,494  
 
           
Total revenues
  $ 124,374     $ 117,720  
 
           
Income before income taxes:
               
Underwriting income (loss):
               
Commercial lines
  $ 2,981     $ 5,416  
Personal lines
    (736 )     194  
 
           
Total underwriting income
    2,245       5,610  
Net investment income
    10,173       9,592  
Net realized investment (losses)/gains
    (2,944 )     267  
Other
    594       583  
 
           
Income before income taxes
  $ 10,068     $ 16,052  
 
           
                 
    Three Months Ended September 30,  
    2008     2007  
    (In thousands)  
Revenues:
               
Net premiums earned:
               
Commercial lines
  $ 32,807     $ 31,975  
Personal lines
    5,062       5,328  
 
           
Total net premiums earned
    37,869       37,303  
 
           
Net investment income
    3,469       2,880  
Net realized investment losses
    (2,281 )     (366 )
Other revenue
    536       587  
 
           
Total revenues
  $ 39,593     $ 40,404  
 
           
Income before income taxes:
               
Underwriting income:
               
Commercial lines
  $ 741     $ 1,207  
Personal lines
    73       143  
 
           
Total underwriting income
    814       1,350  
Net investment income
    3,469       2,880  
Net realized investment losses
    (2,281 )     (366 )
Other
    208       287  
 
           
Income before income taxes
  $ 2,210     $ 4,151  
 
           

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(3) Reinsurance
     Premiums earned are net of amounts ceded of $16.5 million and $24.9 million for the nine months ended September 30, 2008 and 2007, respectively and $5.5 million and $7.4 million for the three months ended September 30, 2008 and 2007, respectively. Losses and loss adjustment expenses are net of amounts ceded of $14.9 million and $16.2 million for the nine months ended September 30, 2008 and 2007, respectively and $4.3 million and $2.8 million for the three months ended September 30, 2008 and 2007, respectively.
     Effective January 1, 2008, the Group renewed its reinsurance coverages with a number of changes. The retention on any individual property or casualty risk was increased to $850,000 from $750,000. Pollution coverage written by FPIC is now fully retained with a standard sub-limit of $150,000 (and up to $300,000 on an exception basis). Prior to 2008, FPIC reinsured 100% of its pollution coverage, which for the twelve months ended December 31, 2007 represented $1.8 million of ceded written premium. The Group also purchased an additional $1.0 million of surety coverage (subject to a 10% retention) which resulted in an increased reinsurance coverage to $4.5 million from $3.5 million per principal and a maximum retention of $900,000 per principal as compared to the previous $800,000.
     In conjunction with the renewal of the reinsurance program for both 2008 and 2007, the prior year reinsurance treaties were terminated on a run-off basis, which requires that for policies in force as of December 31, 2007 and 2006, respectively, these reinsurance agreements continue to cover losses occurring on these policies in the future. Therefore, the Group will continue to remit premiums to and collect reinsurance recoverables from the reinsurers on these prior year treaties as the underlying business runs off.
(4) Comprehensive Income / (Loss)
     The Group’s comprehensive income for the nine and three month period ended September 30, 2008 and 2007 is as follows:
                 
    Nine months ended  
    September 30,  
    2008     2007  
    (In thousands)  
Net income
  $ 7,605     $ 11,355  
Other comprehensive (loss)/income, net of tax:
               
Unrealized gains/(losses) on securities:
               
Unrealized holding (losses)/gains arising during period, net of related income tax (benefit)/expense of $(4,465) and $462, respectively
    (8,667 )     897  
Less reclassification adjustment for losses/(gains) included in net income, net of related income tax (benefit)/expense of $(932) and $161, respectively
    1,809       (312 )
Defined benefit pension plan, net of related income tax benefit of $57
    (111 )      
 
           
 
    (6,969 )     585  
 
           
Comprehensive income
  $ 636     $ 11,940  
 
           

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    Three months ended  
    September 30,  
    2008     2007  
    (In thousands)  
Net income
  $ 1,780     $ 3,012  
Other comprehensive (loss)/income, net of tax:
               
Unrealized gains/(losses) on securities:
               
Unrealized holding (losses)/gains arising during period, net of related income tax (benefit)/expense of $(2,741) and $1,461, respectively
    (5,321 )     2,836  
Less reclassification adjustment for losses/(gains) included in net income, net of related income tax (benefit)/expense of $(722) and $44, respectively
    1,404       (85 )
Defined benefit pension plan, net of related income tax benefit of $19
    (37 )      
 
           
 
    (3,954 )     2,751  
 
           
Comprehensive (loss)/income
  $ (2,174 )   $ 5,763  
 
           
(5) Share-based Compensation
     The Group adopted the Mercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16, 2004. Awards under the Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee Directors. At adoption, the Plan initially limited to 250,000 the number of shares that may be awarded as restricted stock, and to 500,000 the number of shares for which incentive stock options may be granted. The total number of shares initially authorized in the Plan was 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. As of September 30, 2008, the Plan’s authorization has been increased under this feature to 1,141,565 shares. The Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. The grants made under the plan employ graded vesting over vesting periods of 3 or 5 years for restricted stock, incentive stock options, and nonqualified stock option grants, and include only service conditions. Upon exercise, it is anticipated that newly issued shares will be issued to the option holder.
     For the nine months ended September 30, 2008, the Group made no grants of restricted stock and stock options. In addition, there were no forfeitures of restricted stock and stock options and no options exercised during the first nine months of 2008.
     Information regarding stock option activity in the Group’s Plan is presented below:

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            Weighted Average  
    Number of     Exercise Price  
    Shares     per Share  
Outstanding at December 31, 2007
    603,200     $ 13.24  
Granted - 2008
           
Exercised - 2008
           
Forfeited - 2008
           
 
           
Outstanding at September 30, 2008
    603,200     $ 13.24  
 
           
 
               
Exercisable at:
               
September 30, 2008
    522,533     $ 12.56  
Weighted-average remaining contractual life
          5.9 years
Compensation remaining to be recognized for unvested stock options at September 30, 2008 (millions)
          $ 0.3  
Weighted-average remaining amortization period
          1.5 years
Aggregate Intrinsic Value of outstanding options, September 30, 2008 (millions)
          $ 2.3  
Aggregate Intrinsic Value of exercisable options, September 30, 2008 (millions)
          $ 2.1  
 
             
     In determining the expense to be recorded for stock options in the consolidated statements of earnings, the fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. The significant assumptions utilized in applying the Black-Scholes-Merton option pricing model are the risk-free interest rate, expected term, dividend yield, and expected volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. The expected term of an option award is based on expected experience of the awards. The dividend yield is determined by dividing the per-share dividend by the grant date stock price. The expected volatility is based on the volatility of the Group’s stock price over a historical period.
     Information regarding unvested restricted stock activity in the Group’s Plan is below:
                 
            Weighted Average  
    Number of     Fair Value  
    Shares     per Share  
Unvested restricted stock at December 31, 2007
    44,584     $ 14.66  
Granted - 2008
           
Vested - 2008
    (18,125 )     12.24  
Forfeited - 2008
           
 
           
Unvested restricted stock at September 30, 2008
    26,459     $ 16.32  
 
           
Compensation remaining to be recognized for unvested restricted stock at September 30, 2008 (millions)
          $ 0.3  
Weighted-average remaining amortization period
          1.2 years

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(6)   Earnings per Share
The computation of basic and diluted earnings per share is as follows:
                 
    Nine months ended  
    September 30,  
    2008     2007  
    (Dollars in thousands, except per share data)  
Numerator for basic and diluted earnings per share:
               
Net income
  $ 7,605     $ 11,355  
 
           
Denominator for basic earnings per share — weighted-average shares outstanding
    6,230,476       6,125,654  
Effect of stock incentive plans
    152,264       192,375  
 
           
Denominator for diluted earnings per share
    6,382,740       6,318,029  
 
           
Basic earnings per share
  $ 1.22     $ 1.85  
 
           
Diluted earnings per share
  $ 1.19     $ 1.80  
 
           
                 
    Three months ended  
    September 30,  
    2008     2007  
    (Dollars in thousands, except per share data)  
Numerator for basic and diluted earnings per share:
               
Net income
  $ 1,780     $ 3,012  
 
           
Denominator for basic earnings per share — weighted-average shares outstanding
    6,237,804       6,174,842  
Effect of stock incentive plans
    144,609       171,023  
 
           
Denominator for diluted earnings per share
    6,382,413       6,345,865  
 
           
Basic earnings per share
  $ 0.29     $ 0.49  
 
           
Diluted earnings per share
  $ 0.28     $ 0.47  
 
           
     The denominator for diluted earnings per share does not include the effect of outstanding stock options that have an anti-dilutive effect. Options on 40,000 shares were considered to be anti-dilutive for both the three and nine month periods ended September 30, 2008 and 2007 and were excluded from the earnings per share calculation.
(7) Income Taxes
     In June 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes” which clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. On January 1, 2007, the Group adopted FIN 48. As a result of adoption, the Group recognized a previously unrecognized tax benefit of approximately $0.2 million relating to merger-related expenses for the FPIG acquisition that took place October 1, 2005. The application of FIN 48 for this unrecognized tax benefit resulted in a corresponding reduction to goodwill relating to the FPIG acquisition of $0.2 million. The adoption of FIN 48 did not result in any adjustments to beginning retained earnings, nor did it have a significant effect on operations, financial condition or liquidity. As of September 30, 2008, the Group has no unrecognized tax benefits.
(8) Fair Value of Assets and Liabilities

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     Effective January 1, 2008, upon adoption of SFAS 159, the Group did not elect to measure at fair value any assets or liabilities that were not otherwise already carried at fair value in accordance with other accounting pronouncements.
     In accordance with SFAS 157, the Group’s financial assets and financial liabilities measured at fair value are categorized into three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
    Level 1 - Valuations based on unadjusted quoted market prices in active markets for identical assets that the Group has the ability to access. Since the valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant amount or degree of judgment.
 
    Level 2 - Valuations based on quoted prices for similar assets in active markets; quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
 
    Level 3 - Valuations that are derived from techniques in which one or more of the significant inputs are unobservable, including broker quotes which are non-binding.
     The Group uses quoted values and other data provided by a nationally recognized independent pricing service (pricing service) as inputs into its process for determining fair values of its investments. The pricing service covers over 99% of all asset classes, fixed-income and equity securities, domestic and foreign.
     The pricing service obtains market quotations and actual transaction prices for securities that have quoted prices in active markets. Fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis. For these securities, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Additionally, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.
     Relevant market information, relevant credit information, perceived market movements and sector news is used to evaluate each asset class. The market inputs utilized in the pricing evaluation, include but are not limited to: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data and industry and economic events. The extent of the use of each market input depends on the asset class and the market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities additional inputs may be necessary.
     The pricing service utilized by the Group has indicated that they will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Group would be required to produce an estimate of fair value using some of the same methodologies as the pricing service, but would have to make estimates for market based inputs that are not observable due to market conditions.
     The Group reviews its securities measured at fair value and discusses the proper classification of such investments with industry contacts and others. A review process is performed on prices received from the pricing service. In addition, a review is performed of the pricing service’s processes, practices and inputs, which include any number of financial models, quotes, trades and other market indicators. Pricing of the portfolio is reviewed on a monthly basis and securities with changes in prices exceeding defined tolerances are verified to other sources (e.g. broker, Bloomberg, etc.). Any price challenges resulting from this review are based upon significant supporting documentation which is provided to the pricing service for their review. The Group does not adjust quotes or prices obtained from the pricing service without first going through this process of challenging the price with the pricing service.
     The fair value estimates of most fixed maturity investments are based on observable market information rather than market quotes. Accordingly, the estimates of fair value for such fixed maturities, other than U.S. Treasury securities, provided by the pricing service are included in the amount disclosed in Level 2 of the hierarchy. The estimated fair values of U.S. Treasury securities are included in the amount disclosed in Level 1 as the estimates are based on unadjusted market prices. The Group determined that Level 2 securities would include corporate bonds, mortgage-backed securities, municipal bonds, asset-backed securities, certain U.S. government agencies, non-U.S. government securities, certain short-term securities and investments in mutual funds.

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     Securities are generally assigned to Level 3 in cases where non-binding broker/dealer quotes are significant inputs to the valuation and there is a lack of transparency as to whether these quotes are based on information that is observable in the marketplace. The Group’s Level 3 securities consist of five holdings totalling less than $2.6 million, or less than 1% of the Group’s total investment portfolio. These five securities were valued primarily through the use of non-binding broker quotes.
     Equities that trade on a major exchange are assigned a Level 1. Equities not traded on a major exchange are assigned a Level 2 or 3 based on the criteria and hierarchy described above. Short-term investments such as open ended mutual funds where the fund maintains a constant net asset value of one dollar, money market funds, cash and cash sweep accounts and treasuries bills are classified as Level 1.
     Included in Level 2, Other Liabilities are interest rate swap agreements which the Group is a party to in order to hedge the floating interest rate on its Trust Preferred Securities, thereby changing the variable rate exposure to a fixed rate exposure for interest on these obligations. The estimated fair value of the interest rate swaps is obtained from the third-party financial institution counterparties.
The table below presents the balances of assets and liabilities measured at fair value on a recurring basis.
                                 
    September 30, 2008  
(in thousands)   Total     Level 1     Level 2     Level 3  
 
Investments:
                               
Fixed-income securities, available for sale
  $ 328,548     $ 6,329     $ 319,636     $ 2,583  
Equity securities
    14,730       13,684       1,000       46  
 
                       
Total assets
  $ 343,278     $ 20,013     $ 320,636     $ 2,629  
 
                       
 
                               
Other liabilities
  $ 582     $     $ 582     $  
 
                       
Total liabilities
  $ 582     $     $ 582     $  
 
                       
 
                               
Net losses included in net income relating to assets held and liabilities at September 30, 2008
  $ (3,685 )   $ (255 )   $ (2,865 )   $ (565 )
 
                       
     The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
                 
    For the Nine Months Ended  
    September 30, 2008  
    Fixed-income        
    securities,        
    available     Equity  
(in thousands)   for sale     securities  
 
Balance, beginning of period
  $ 2,399     $ 823  
Total net (losses)/gains included in net income
    (562 )     657  
Total net losses included in other comprehensive income
    (186 )     (682 )
Purchases, sales, issuances and settlements, net
    932       (752 )
 
           
Balance, end of period
  $ 2,583     $ 46  
 
           

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    For the Three Months Ended  
    September 30, 2008  
    Fixed-income        
    securities,        
    available     Equity  
(in thousands)   for sale     securities  
 
Balance, beginning of period
  $ 3,357     $ 823  
Total net (losses)/gains included in net income
    (562 )     657  
Total net losses included in other comprehensive income
    (177 )     (682 )
Purchases, sales, issuances and settlements, net
    (35 )     (752 )
 
           
Balance, end of period
  $ 2,583     $ 46  
 
           
For the nine months ended September 30, 2008, there were no assets or liabilities measured at fair value on a nonrecurring basis.
(9) Retaliatory Tax Refund
     As previously disclosed in the Group’s SEC filings, the Group paid an aggregate of $3.5 million, including accrued interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory premium tax for the years 1999-2004. In conjunction with making such payments, the Group filed notices of protest with the Division with respect to the retaliatory tax imposed. The payments were made in response to notices of deficiency issued by the Division to the Group.
     Pursuant to the protests, the Group received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest, previously made by the Group for the periods 1999-2004. The refund was recorded, after reduction for federal income tax, in the amount of $2.8 million in the 2007 consolidated statement of earnings, with $2.5 million recorded in the quarter ended June 30, 2007, and $0.3 million recorded in the quarter ended September 30, 2007. The allocation of the refund to pre-tax earnings included an increase to net investment income of $720,000, with $687,000 of that amount recognized in the quarter ended June 30, 2007, and $33,000 recognized in the quarter ended September 30, 2007, for the interest received on the refund, and $3.6 million as a reduction to Other Expense to recognize the recovery of amounts previously charged to Other Expense, with $3.1 million of that amount recognized in the quarter ended June 30, 2007, and $0.5 million recognized in the quarter ended September 30, 2007. This is a non-recurring item which significantly affects the earnings of both the three and nine month periods ended September 30, 2007, and performance metrics such as the combined ratio.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
          The following presents management’s discussion and analysis of our financial condition and results of operations as of the dates and for the periods indicated. You should read this discussion in conjunction with the consolidated financial statements and notes thereto included in this report. This discussion contains forward-looking information that involves risks and uncertainties. Actual results could differ significantly from these forward-looking statements. See “Forward-Looking Statements”.
Overview
          Mercer Insurance Group, Inc. (MIG or the Holding Company) is a holding company owning, directly and indirectly, all of the outstanding shares of our four insurance companies and our non-insurance subsidiaries (collectively, the Group). Mercer Insurance Company, our oldest insurance company, has been engaged in the sale of property and casualty insurance since 1844. Our insurance companies underwrite property and casualty insurance principally in Arizona, California, New Jersey, New York, Nevada, Oregon, and Pennsylvania and are as follows:
    Mercer Insurance Company (MIC), a Pennsylvania property and casualty stock insurance company offering insurance coverages to businesses and individuals in New Jersey, New York and Pennsylvania;
 
    Mercer Insurance Company of New Jersey, Inc. (MICNJ), a New Jersey property and casualty stock insurance company offering insurance coverages to businesses and individuals located in New Jersey and businesses located in New York;
 
    Franklin Insurance Company (FIC), a Pennsylvania property and casualty stock insurance company offering private passenger automobile and homeowners insurance to individuals located in Pennsylvania; and
 
    Financial Pacific Insurance Company (FPIC), a California property and casualty stock insurance company offering insurance and surety products to small and medium sized commercial businesses in Arizona, California, Nevada and Oregon, and direct mail surety products to commercial businesses in various other states.
     The Group’s operating subsidiaries are licensed collectively in twenty-two states, but are currently focused on doing business in seven states: Arizona, California, Nevada, New Jersey, New York, Pennsylvania and Oregon. MIC and MICNJ write property and casualty insurance in New York which only supports existing accounts written in other states. FPIC holds an additional fifteen state licenses outside of the Group’s current focus area. Currently, only direct mail surety is being written in some of these states.
     The Group is subject to regulation by the insurance regulators of each state in which it is licensed to transact business. The primary regulators are the Pennsylvania Insurance Department, the California Department of Insurance, and the New Jersey Department of Banking and Insurance, because these are the regulators for the states of domicile of the Group’s insurance subsidiaries, as follows: MIC (Pennsylvania-domiciled), FPIC (California-domiciled), MICNJ (New Jersey-domiciled), and FIC (Pennsylvania-domiciled).
     The insurance affiliates within the Group participate in a reinsurance pooling arrangement (the “Pool”) whereby each insurance affiliate’s underwriting results are combined and then distributed proportionately to each participant. Each insurer’s share in the Pool is based on their respective statutory surplus from the most recently filed statutory annual statement as of the beginning of each year.
     All insurance companies in the Group have been assigned a group rating of “A” (Excellent) by A.M. Best. The Group has been assigned that rating for the past 7 years. An “A” rating is the third highest rating of A.M. Best’s 16 possible rating categories.
     We manage our business and report our operating results in three operating segments: commercial lines insurance, personal lines insurance and the investment function. Assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes. Our commercial lines insurance business consists primarily of multi-peril, general liability, commercial auto, and related insurance coverages. Our personal lines insurance business consists primarily of homeowners (in New Jersey and Pennsylvania) and private passenger automobile (in Pennsylvania only) insurance coverages.
     Our income is principally derived from written premiums received from insureds in the commercial lines (businesses insured) and personal lines (individuals insured) segments, less the costs of underwriting the insurance policies, the costs of settling and paying claims reported on the policies, and from investment income reduced by investment expenses and gains or losses on holdings in our investment portfolio. Written premiums are the total amount of premiums billed to the policyholder less the amount of premiums returned, generally as a result of cancellations, during a policy period. Written premiums become premiums earned as the policy ages.

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In the absence of premium rate changes, if an insurance company writes the same number and mix of policies each year, written premiums and premiums earned will be equal, and the unearned premium reserve will remain constant. During periods of growth, the unearned premium reserve will increase, causing premiums earned to be less than written premiums. Conversely, during periods of decline, the unearned premium reserve will decrease, causing premiums earned to be greater than written premiums.
     Variability in our income is caused by a variety of circumstances, some within the control of our companies and some not within our control. Premium volume is affected by, among other things, the availability and regular flow to our insurance companies of quality, properly-priced risks being produced by our agents, the ability to retain on renewal existing good-performing accounts, competition from other insurance companies, regulatory rate approvals, our reputation, and other limitations created by the marketplace or regulators. Our underwriting costs are affected by, among other things, the amount of commission and profit-sharing commission we pay our agents to produce the underwriting risks for which we receive premiums, the cost of issuing insurance policies and maintaining our customer and agent relationships, marketing costs, taxes we pay to the states in which we operate on the amount of premium we collect, and other assessments and charges imposed on our companies by the regulators in the states in which we do business. Our claim and claim settlement costs are affected by, among other things, the quality of our accounts, severe or extreme weather in our operating region, the nature of the claim, the regulatory and legal environment in our territories, inflation in underlying medical and property repair costs, and the availability and cost of reinsurance. Our investment income and realized gains and losses are determined by, among other things, market forces, the rates of interest and dividends paid on our investment portfolio holdings, the credit or investment quality of the issuers and the success of their underlying businesses, the market perception of the issuers, and other factors such as ratings by rating agencies and analysts.
Critical Accounting Policies
      General. The Group’s financial statements are prepared in conformity with U.S. generally accepted accounting principles (GAAP). We are required to make estimates and assumptions in certain circumstances that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. We believe the following policies are the most sensitive to estimates and judgments.
      Liabilities for Loss and Loss Adjustment Expenses. The liability for losses and loss adjustment expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported to our insurance companies. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss adjustment expenses are determined using historical information by line of insurance as adjusted to current conditions. Inflation is ordinarily implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results over multiple years.
     Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Some of our business relates to coverage for short-term risks, and for these risks loss development is comparatively rapid and historical paid losses, adjusted for known variables, have been a reliable predictive measure of future losses for purposes of our reserving. Some of our business relates to longer-term risks, where the claims are slower to emerge and the estimate of damage is more difficult to predict. For these lines of business, more sophisticated actuarial methods must be employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses. A substantial portion of FPIC’s business is this type of longer-tailed casualty business.
     Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at September 30, 2008.

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     The table below is a sensitivity chart included to provide the reader with a sense of the impact a range of differing estimates for unpaid losses and loss adjustment expenses would have on shareholders equity at September 30, 2008, in the event actual experience differs from the estimates and assumptions used by management in establishing loss and loss adjustment expense reserves as of that date. The changes described in the table are not intended to represent the range of reasonably likely changes to loss reserves and loss adjustment expense reserves in management’s opinion, nor are the changes included in the table intended to depict the best, worst, or likely scenarios:
                                 
    Adjusted Loss and           Adjusted Loss and    
Change in Loss   Loss Adjustment   Percentage   Loss Adjustment   Percentage
and Loss   Reserves Net of   Change in   Reserves Net of   Change in
Adjustment   Reinsurance as of   Equity as of   Reinsurance as of   Equity as of
Reserves Net of   September 30,   September 30,   December 31,   December 31,
Reinsurance   2008   2008 (1)   2007   2007 (1)
(Dollars in thousands)
(10.0)%
  $ 189,354       10.4 %   $ 172,815       9.5 %
(7.5)%
    194,614       7.8 %     177,616       7.1 %
(5.0)%
    199,873       5.2 %     182,416       4.7 %
(2.5)%
    205,133       2.6 %     187,217       2.4 %
Base
    210,393             192,017        
2.5%
    215,653       (2.6 )%     196,817       (2.4) %
5.0%
    220,913       (5.2) %     201,618       (4.7) %
7.5%
    226,172       (7.8) %     206,418       (7.1) %
10.0%
    231,432       (10.4) %     211,219       (9.5 )%
 
(1)   Net of tax
     The property and casualty industry has incurred substantial aggregate losses from claims related to asbestos-related illnesses, environmental remediation, product liability, mold, and other uncertain exposures. We have not experienced significant losses from these types of claims. Our subsidiary, FPIC, insures contractors for liability for construction defect risks, among other risks.
     The table below summarizes loss and loss adjustment reserves by major line of business:

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    September 30,     December 31,  
    2008     2007  
    (In thousands)  
Commercial lines:
               
Commercial multi-peril
  $ 217,196     $ 198,919  
Commercial automobile
    43,723       37,569  
Other liability
    11,103       11,854  
Workers’ compensation
    8,187       8,279  
Surety
    8,160       6,818  
Fire, allied, inland marine
    367       131  
 
           
 
    288,736       263,570  
 
           
 
               
Personal lines:
               
Homeowners
    7,032       7,029  
Personal automobile
    1,791       2,122  
Other liability
    1,273       1,142  
Fire, allied, inland marine
    111       490  
Workers’ compensation
    48       46  
 
           
 
    10,255       10,829  
 
           
Total
  $ 298,991     $ 274,399  
 
           
      Investments. Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. A decline in fair value of an investment below its cost that is deemed other than temporary is charged to earnings as a realized loss. We monitor our investment portfolio and review investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. These evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.
     The Group’s policy on impairment of value of investments is as follows: if a security has a market value below cost it is considered impaired. For any such security a review of the financial condition and prospects of the issuing company will be performed by the Investment Committee to assess whether the decline in market value is other than temporary. If the assessment is that the decline in market value is “other than temporary”, the carrying value of the security will be written down to “fair value” and the amount of the write-down accounted for as a realized loss. “Fair value” is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.
     In evaluating the potential impairment of fixed income securities, the Investment Committee will evaluate relevant factors, including but not limited to the following: the issuer’s current financial condition and ability to make future scheduled principal and interest payments, relevant rating history, analysis and guidance provided by rating agencies and analysts, the degree to which an issuer is current or in arrears in making principal and interest payments, and changes in price relative to the market, as well as the Group’s ability and intention to hold the security to maturity.
     In evaluating the potential impairment of equity securities, the Investment Committee will evaluate certain factors, including but not limited to the following: the relationship of market price per share versus carrying value per share at the date of acquisition and the date of evaluation, the price-to-earnings ratio at the date of acquisition and the date of evaluation, any rating agency announcements, the issuer’s financial condition and near-term prospects, including any specific events that may influence the issuer’s operations, the independent auditor’s report on the issuer’s financial statements; and any buy/sell/hold recommendations or price projections by outside investment advisors.
     In the first nine months of 2008, we incurred an impairment charge of $3.6 million for eighteen securities that were determined to be other than temporarily impaired. In the first nine months of 2007, we incurred an impairment charge of $28,000 for one security that was determined to be other than temporarily impaired.

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     The ongoing credit crisis and interest rate volatility continued into the third quarter of 2008. The difficult credit conditions worsened in September and inter-bank lending was reduced. The loss of confidence in the capital markets led to several significant events, including the nationalization of Fannie Mae and Freddie Mac, the bankruptcy filing of Lehman Brothers, an agreement for Merrill Lynch to be acquired by Bank of America, among others. The market value of credit obligations generally declined during the last month of the quarter.
     The decline in market values led to reduced valuations for a number of holdings. As a result, the Group incurred an impairment charge of $2.8 million for 9 fixed income securities and a preferred stock holding during the third quarter of 2008. The bankruptcy filing of Lehman Brothers led to a write down of a $1.0 million Lehman Brothers bond to 12.5% of par. In addition, based on the uncertain outlook for some other banking and finance institutions, five other securities were determined to be other than temporarily impaired, including both senior unsecured debt and one preferred equity holding. The continued deterioration of housing market indicators adversely impacted delinquency and loss severity assumptions, which led to the impairment of two asset backed security (ABS) home-equity positions and an A-rated CMO holding. Finally, the Group has decided to take a further write-down on a non-investment grade corporate security (GMAC) due to further market value declines and an unfavorable outlook by the rating agencies with regard to this credit.
     The Group holds no Fannie Mae or Freddie Mac common or preferred shares, nor any equity or fixed income obligations of AIG or Washington Mutual.
      Policy Acquisition Costs. We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are primarily related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs.
      Reinsurance. Amounts recoverable from property and casualty reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts.
     Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid loss and loss adjustment expenses are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve us of our legal liability to our policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid loss and loss adjustment expenses affect the estimates for the ceded portion of these liabilities. We continually monitor the financial condition of our reinsurers.
      Income Taxes. We use the asset and liability method of accounting for income taxes. Deferred income taxes are provided and arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
Results of Operations
     The key goal of the Group’s business model is the sale of properly priced and underwritten personal and commercial property and casualty insurance through independent agents and the investment of the premiums in a manner designed to assure that claims and expenses can be paid while providing a return on the capital employed. Loss trends and investment performance are critical factors in the success of the business model.
     Our results of operations are also influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry are subject to significant variations due to competition, weather, catastrophic events, regulation, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.
     The availability of reinsurance at reasonable pricing is an important part of our business. Effective, January 1, 2008, the Group increased its retention to $850,000 (from a maximum retention of $750,000 in 2007) on the casualty, property and workers’ compensation lines of business.

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As the Group increases the net retention of the business it writes, net premiums written and earned will increase and ceded losses will decrease.
     The Group writes homeowners insurance only in New Jersey and Pennsylvania, and personal automobile insurance only in Pennsylvania. Personal lines insurance is not written in any other states in which the Group does business.
Nine and three months ended September 30, 2008 compared to nine and three months ended September 30, 2007
     The components of income for the first nine months of 2008 and 2007, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative. During 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Previously reported 2007 amounts have been reclassified below to reflect this change in allocation methodology.
                                 
Nine months ended September 30,                
2008 vs. 2007 Income   2008   2007   Change   % Change
    (Dollars in thousands)                
Commercial lines underwriting income
  $ 2,981     $ 5,416     $ (2,435 )     (45.0) %
Personal lines underwriting (loss)/income
    (736 )     194       (930 )     N/M  
Total underwriting income
    2,245       5,610       (3,365 )     (60.0) %
Net investment income
    10,173       9,592       581       6.1 %
Net realized investment (losses)/gains
    (2,944 )     267       (3,211 )     N/M  
Other
    1,555       1,494       61       4.1 %
Interest expense
    (961 )     (911 )     (50 )     5.5 %
Income before income taxes
    10,068       16,052       (5,984 )     (37.3) %
Income taxes
    2,463       4,697       (2,234 )     (47.6) %
Net Income
    7,605       11,355       (3,750 )     (33.0) %
Loss/ LAE ratio (GAAP)
    61.9 %     61.5 %     0.4 %        
Underwriting expense ratio (GAAP)
    36.1 %     33.2 %     2.9 %        
Combined ratio (GAAP)
    98.0 %     94.7 %     3.3 %        
Loss/ LAE ratio (Statutory)
    61.9 %     61.5 %     0.4 %        
Underwriting expense ratio (Statutory)
    35.9 %     31.5 %     4.4 %        
Combined ratio (Statutory)
    97.8 %     93.0 %     4.8 %        

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Three months ended September 30,                
2008 vs. 2007 Income   2008   2007   Change   % Change
    (Dollars in thousands)                
Commercial lines underwriting income
  $ 741     $ 1,207     $ (466 )     (38.6) %
Personal lines underwriting income
    73       143       (70 )     (49.0) %
Total underwriting income
    814       1,350       (536 )     (39.7) %
Net investment income
    3,469       2,880       589       20.5 %
Net realized investment losses
    (2,281 )     (366 )     (1,915 )     N/M  
Other
    536       587       (51 )     (8.7) %
Interest expense
    (328 )     (300 )     (28 )     9.3 %
Income before income taxes
    2,210       4,151       (1,941 )     (46.8) %
Income taxes
    430       1,139       (709 )     (62.2) %
Net Income
    1,780       3,012       (1,232 )     (40.9) %
Loss/ LAE ratio (GAAP)
    60.3 %     61.0 %     (0.7) %        
Underwriting expense ratio (GAAP)
    37.6 %     35.4 %     2.2 %        
Combined ratio (GAAP)
    97.9 %     96.4 %     1.5 %        
Loss/ LAE ratio (Statutory)
    60.3 %     61.0 %     (0.7) %        
Underwriting expense ratio (Statutory)
    37.6 %     33.9 %     3.7 %        
Combined ratio (Statutory)
    97.9 %     94.9 %     3.0 %        
          (N/M means “not meaningful”)
     As previously disclosed in the Group’s SEC filings, the Group paid an aggregate of $3.5 million, including accrued interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory premium tax for the years 1999-2004. In conjunction with making such payments, the Group filed notices of protest with the Division with respect to the retaliatory tax imposed. The payments were made in response to notices of deficiency issued by the Division to the Group.
     The Group received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest thereon, previously made by the Group for the periods 1999-2004. The refund has been recorded, after reduction for Federal income tax, in the amount of $2.8 million in the consolidated statement of earnings, with $2.5 million recorded in the quarter ending June 30, 2007, and $0.3 million recorded in the quarter ended September 30, 2007. The allocation of the refund to pre-tax earnings included an increase to net investment income of $720,000, with $687,000 of that amount recognized in the quarter ended June 30, 2007, and $33,000 recognized in the quarter ended September 30, 2007, for the interest received on the refund, and $3.6 million as a reduction to Other Expense to recognize the recovery of amounts previously charged to Other Expense, with $3.1 million of that amount recognized in the quarter ended June 30, 2007, and $0.5 million recognized in the quarter ended September 30, 2007. This is a non-recurring item which significantly affects the earnings of both the three and nine month periods ended September 30, 2007, and related performance metrics such as the combined ratio.
     The Group’s GAAP combined ratio for the first nine months of 2008 was 98.0%, as compared to a combined ratio for the first nine months of 2007 of 94.7%. Excluding the effect of the non-recurring retaliatory tax refund described above, the GAAP combined ratio for the first nine months of 2007 was 98.1%. The statutory combined ratio for the first nine months of 2008 and 2007 was 97.8% and 93.0%, respectively. See discussion below relating to commercial and personal lines performance.
     The Group’s GAAP combined ratio for the third quarter of 2008 was 97.9%, as compared to a combined ratio for the third quarter of 2007 of 96.4%. Excluding the effect of the non-recurring retaliatory tax refund described above, the GAAP combined ratio for the third quarter of 2007 was 97.7%. The statutory combined ratio for the third quarter of 2008 and 2007 was 97.9% and 94.9%, respectively. See discussion below relating to commercial and personal lines performance.
     Net investment income totaled $10.2 million and $9.6 million in the first nine months of 2008 and 2007, respectively, representing an increase of $0.6 million or 6.1%. Net investment income for the first nine months of 2007 included $720,000 of interest income as a result of the non-recurring impact of the retaliatory tax refund. Average cash and invested assets totaled $366 million for the first nine months of 2008 as compared to $331 million for the first nine months of 2007, representing an increase of $35 million, driven by operating cash flow. Net investment income for the third quarter of 2008 increased $0.6 million to $3.5 million for the third quarter of 2008 as compared to $2.9 million

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for the third quarter of 2007. The increase is attributable to the increase in average cash and invested assets.
     Net realized investment losses amounted to $2.9 million in the first nine months of 2008, which is primarily driven by other than temporary impairments on investment securities, a realized loss on the mark-to-market valuation on the interest rate swaps for the trust preferred securities, offset in part by realized gains on the sales of investments. Net realized investment gains amounted to $0.3 million in the first nine months of 2007, which is primarily driven by realized gains on the sales of investments, offset in part by other than temporary impairments on investment securities and a realized loss on the mark-to-market valuation on the interest rate swaps for the trust preferred securities. See discussion of other than temporary impairments on investment securities in the Critical Accounting Policies section. Other revenue, which is primarily service charges recorded on insurance premiums, totaled $1.6 million and $1.5 million for the first nine months of 2008 and 2007, respectively. Interest expense of $1.0 and $0.9 million for the first nine months of 2008 and 2007, respectively, represents interest expense related to the trust preferred obligations.
     Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investment segment) follow with further discussion below. Changes have been made to the 2007 presentation of the commercial and personal lines segments to conform to the revised allocation methodology for commercial and personal lines results referred to above.
                                 
Nine Months Ended September 30,                
2008 vs. 2007 Revenue   2008   2007   Change   % Change
    (In thousands)                
Direct premiums written
  $ 129,538     $ 140,506     $ (10,968 )     (7.8) %
Net premiums written
    115,863       123,116       (7,253 )     (5.9) %
Net premiums earned
    115,590       106,367       9,223       8.7 %
Net investment income
    10,173       9,592       581       6.1 %
Net realized investment (losses)/gains
    (2,944 )     267       (3,211 )     N/M  
Other revenue
    1,555       1,494       61       4.1 %
Total revenue
  $ 124,374     $ 117,720     $ 6,654       5.7 %
                                 
Three Months Ended September 30,                
2008 vs. 2007 Revenue   2008   2007   Change   % Change
    (In thousands)                
Direct premiums written
  $ 42,161     $ 47,027     $ (4,866 )     (10.3) %
Net premiums written
    37,575       41,110       (3,535 )     (8.6) %
Net premiums earned
    37,869       37,303       566       1.5 %
Net investment income
    3,469       2,880       589       20.5 %
Net realized investment losses
    (2,281 )     (366 )     (1,915 )     N/M  
Other revenue
    536       587       (51 )     (8.7) %
Total revenue
  $ 39,593     $ 40,404     $ (811 )     (2.0) %
          (N/M means “not meaningful”)
     Total revenues for the first nine months of 2008 increased $6.7 million or 5.7% to $124.4 million as compared to $117.7 million in the first nine months of 2007. This increase was due primarily to an increase in net premiums earned offset in part by an increase in net realized investment losses. Net premiums earned totaled $115.6 million for the first nine months of 2008 as compared to $106.4 million for the first nine months of 2007, representing an 8.7% or $9.2 million increase. Net premiums earned increased 8.7% despite a 5.9% decline in net premiums written, with the decline in net premiums written caused primarily by the 7.8% decline in direct premiums written, offset by the positive impact on net premiums written of the change in reinsurance structure (in 2007 retention increased to $750,000 from $250,000 and $350,000 in 2006 on FPIC’s casualty and property lines, respectively, and from $500,000 on MIC’s, MICNJ’s and FIC’s 2006 property, casualty and workers’ compensation lines, and in 2008 to $850,000 from $750,000). Direct premiums written included a reduction in audit premium recorded during 2008 which is earned immediately upon booking (see discussion below for discussion of audit premium and changes in reinsurance arrangements).

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     Net investment income totaled $10.2 million and $9.6 million for the first nine months of 2008 and 2007, respectively. Net investment income for the first nine months of 2007 was impacted by the $720,000 non-recurring impact of the retaliatory tax refund. Net realized investment losses amounted to $2.9 million in the first nine months of 2008 as compared to net realized investment gains of $0.3 million in the first nine months of 2007. The net realized loss in 2008 is primarily driven by other than temporary impairments on investment securities, a realized loss on the mark-to-market valuation on the interest rate swaps for the trust preferred securities, offset in part by realized gains on the sales of investments. The net realized investment gain in 2007 is primarily driven by realized gains on the sales of investments, offset in part by other than temporary impairments on investment securities and a realized loss on the mark-to-market valuation on the interest rate swaps for the trust preferred securities. See discussion of other than temporary impairments on investment securities in the Critical Accounting Policies section.
     Total revenues for the third quarter of 2008 decreased $0.8 million or 2.0% to $39.6 million as compared to $40.4 million in the third quarter of 2007. This decrease was due primarily to an increase in net realized investment losses offset in part by an increase in net premiums earned and net investment income. Net premiums earned totaled $37.9 million for the third quarter of 2008 as compared to $37.3 million for the third quarter of 2007, representing a 1.5% or $0.6 million increase.
     Net investment income for the third quarter of 2008 increased $0.6 million to $3.5 million for the third quarter of 2008 as compared to $2.9 million for the third quarter of 2007. The increase is primarily attributable to an increase in cash and invested assets. Net realized investment losses amounted to $2.3 million and $0.4 million in the third quarter of 2008 and 2007, respectively. The net realized loss in the third quarter of 2008 was primarily driven by other than temporary impairments on investment securities, a realized loss on the mark-to-market valuation on the interest rate swaps for the trust preferred securities, offset in part by realized gains on the sales of investments. The net loss in the third quarter of 2007 was primarily driven by a realized loss on the mark-to-market valuation on the interest rate swaps for the trust preferred securities, offset in part by realized gains on the sales of investments. See discussion of other than temporary impairments on investment securities in the Critical Accounting Policies section.
     In the first nine months of 2008, direct premiums written declined $11.0 million or 7.8% to $129.5 million as compared to $140.5 million in the first nine months of 2007. In the third quarter of 2008, direct premiums written declined $4.9 million or 10.3% to $42.2 million as compared to $47.0 million in the third quarter of 2007. The decline in direct premiums written is attributable to a more difficult economic environment and competitive market conditions. A decline in construction related activity and related audit premium in California, increased competition on large accounts, as well as the return of a number of competitors to the California contractor market and the East Coast habitational market contributed to this decline.
     The decline in audit premium, as compared to the prior year, relates to a general decline in construction related activity and failing businesses in the construction industry, specifically in California, driven by a slowdown of the residential housing market. Approximately 50% of FPIC’s business (and approximately one-third of the Group’s business in total) is related to contractor liability.
     Commercial multiple peril policies constitute a majority of the business written in FPIC’s contractor book of business. The premium on these policies is estimated at policy inception based on a prediction of the volume of the insured’s business operations during the policy period. In addition to endorsing the policy throughout the policy period based on known information, at policy expiration FPIC conducts an audit of the insured’s business operations in order to adjust the policy premium from an estimate to actual. Contractor liability policy premium tends to vary with local construction activity as well as changes in the nature of the contractor’s operations. The decline in construction related activity and failing businesses in the construction industry has impacted both the volume of premium for the contractor in-force book of business (and related exposures) and the related audit premium on expiring policies. Audits, primarily of construction related policies, generated return premium of $1.7 million in the first nine months of 2008, representing a decline of $3.9 million as compared to $2.2 million of additional premium that was generated in the first nine months of 2007. Audits, primarily of construction related policies, generated return premium of $0.6 million in the third quarter of 2008, representing a decline of $1.2 million as compared to $0.6 million of additional premium that was generated in the third quarter of 2007.
     The decline in year-to-date direct premiums written reflects a continuing competitive marketplace and declining levels of economic activity in our operating territories. The current market is highly competitive, with pricing and coverage competition being seen in virtually all classes of commercial accounts, package policies, commercial automobile policies and in the Pennsylvania personal auto market and Pennsylvania and New Jersey homeowners markets, all of which makes it more challenging to retain our accounts on renewal, or to renew a policy at expiring premium. Competition also continues on large accounts, particularly in the East Coast habitational and California construction contracting programs, as competitors aggressively compete for these higher premium accounts. Pricing in the property and casualty insurance industry historically has been and remains cyclical. During a soft market cycle, such as the current market conditions, price competition is prevalent, which makes it challenging to write and retain properly priced personal and commercial lines business. We continue to work with our agents

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to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, contracting risks, small business risks and property risks. Despite the pricing pressures of the marketplace, management maintains a strong focus on its policy of disciplined underwriting and pricing standards, declining business which it determines is inadequately priced for its level of risk. In spite of these competitive market conditions, the Group’s policy retention on renewal has been favorable across most product lines.
     In the fourth quarter of 2008, a new Businessowners product for California risks is being introduced. This product will target small to medium sized businesses which have been shown to be somewhat less price sensitive than larger accounts. This product will also help to balance FPIC’s business between property and casualty exposures. Additionally, a new contracting product which specializes in covering artisan contractors is being developed for Arizona, California, Nevada and Oregon and is targeted for introduction in early 2009. Artisan contractors primarily provide repair and maintenance services and this segment tends to experience less severe market fluctuations compared to the real estate construction industry.
     Both the California Businessowners and western states Artisan product will be transacted using an Internet-based rating process where agents will be able to rate and bind these products, subject to pre-programmed underwriting criteria. Additionally, Internet-based rating was updated for our Personal Automobile product in Pennsylvania in the third quarter of 2008. Our New Jersey and Pennsylvania agents writing Businessowners, Commercial Automobile, Workers’ Compensation and Artisan Contractors commercial lines business will begin to use our Internet-based rating applications, using a staggered implementation strategy starting in the fourth quarter of 2008. Plans to introduce Internet-based Commercial Automobile rating for our western states are currently being developed.
     Effective January 1, 2008, the Group increased its reinsurance retention to $850,000 (from a maximum retention of $750,000 in 2007) on the casualty, property and workers’ compensation lines of business. Pollution coverage written by FPIC is now fully retained with a standard sub-limit of $150,000 (and up to $300,000 on an exception basis). Prior to 2008, FPIC reinsured 100% of its pollution coverage which in the twelve months ended December 31, 2007 represented $1.8 million of ceded written premium. The Group also purchased an additional $1.0 million of surety coverage (subject to a 10% retention) which resulted in an increased reinsurance coverage to $4.5 million from $3.5 million per principal and a maximum retention of $900,000 per principal as compared to the previous $800,000. The net effect of these changes in reinsurance arrangements increases net premiums written for the first nine months of 2008.
     Growth in Net Investment Income is discussed below.
                                 
Nine Months Ended September 30,                
2008 vs. 2007 Investment Income and Realized Gains   2008   2007   Change   % Change
    (In thousands)                
Fixed income securities
  $ 11,058     $ 9,627     $ 1,431       14.9 %
Dividends
    254       219       35       16.0 %
Cash, cash equivalents & other
    356       1,458       (1,102 )     (75.6) %
Gross investment income
    11,668       11,304       364       3.2 %
Investment expenses
    (1,495 )     (1,712 )     217       12.7 %
Net investment income
    10,173       9,592     $ 581       6.1 %
Realized losses — fixed income securities
    (3,226 )     (8 )   $ (3,218 )     N/M  
Realized gains — equity securities
    486       481       5       N/M  
Mark-to-market valuation for interest rate swaps
    (204 )     (206 )     2       N/M  
Net realized (losses)/gains
    (2,944 )     267     $ (3,211 )     N/M  

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Three Months Ended September 30,                
2008 vs. 2007 Investment Income and Realized Gains   2008   2007   Change   % Change
    (In thousands)                
Fixed income securities
  $ 3,769     $ 3,209     $ 560       17.5 %
Dividends
    87       72       15       20.8 %
Cash, cash equivalents & other
    103       396       (293 )     (74.0) %
Gross investment income
    3,959       3,677       282       7.7 %
Investment expenses
    (490 )     (797 )     307       38.5 %
Net investment income
    3,469       2,880     $ 589       20.5 %
Realized losses — fixed income securities
    (2,767 )     (8 )   $ (2,759 )     N/M  
Realized gains — equity securities
    640       138       502       N/M  
Mark-to-market valuation for interest rate swaps
    (154 )     (496 )     342       N/M  
Net realized losses
    (2,281 )     (366 )   $ (1,915 )     N/M  
          (N/M means “not meaningful”)
     Net investment income totaled $10.2 million and $9.6 million in the first nine months of 2008 and 2007, respectively, representing an increase of $0.6 million or 6.1%. Net investment income for the first nine months of 2007 included $720,000 of interest income as a result of the non-recurring impact of the retaliatory tax refund. Average cash and invested assets totaled $366 million for the first nine months of 2008 as compared to $331 million for the first nine months of 2007, representing an increase of $35 million. The increase in invested assets is driven primarily by operating cash flow, including the benefits of the 2008 and 2007 reinsurance agreement changes, which result in less premium being ceded to reinsurers.
     In the first nine months of 2008, investment income on fixed income securities increased $1.4 million, or 14.9% to $11.1 million, as compared to $9.6 million in the same period in 2007. This was driven by an increase in the average investments held in fixed income securities. The Group’s tax equivalent yield (yield adjusted for tax-benefit received on tax-exempt securities) on fixed income securities remained stable at 5.15% and 5.24% for the first nine months of 2008 and 2007, respectively.
     Dividend income in the nine months ended September 30, 2008 was consistent to that of the same period in 2007. Interest income on cash and cash equivalents decreased $1.1 million to $0.4 million for the first nine months of 2008 as compared to $1.5 million for the first nine months of 2007, primarily as a result of the $720,000 of non-recurring interest received on the retaliatory tax refund in 2007. Investment expenses decreased 12.7%, or $0.2 million, to $1.5 million for the first nine months of 2008 from $1.7 million for the first nine months of 2007.
     Net investment income for the third quarter of 2008 increased $0.6 million or 20.5% to $3.5 million for the third quarter of 2008 as compared to $2.9 million for the third quarter of 2007. The increase is attributable to the increase in average cash and invested assets.
     Dividend income in the third quarter of 2008 was consistent from that of the same period in 2007. Interest income on cash and cash equivalents decreased $0.3 million to $0.1 million for the third quarter of 2008 as compared to $0.4 million for the third quarter of 2007. Investment expenses in the third quarter of 2008 decreased 38.5%, or $0.3 million, to $0.5 million in the third quarter of 2008 from $0.8 million in the same period in 2007.
     Net realized losses for the first nine months of 2008 were $2.9 million, as compared to net realized gains of $0.3 million in the same period of 2007. In the first nine months of 2008, net realized losses of $2.9 million included write-downs of securities determined to be other than-temporarily impaired of $3.6 million, net gains on securities sales of $0.7 million, a loss on the mark-to-market valuation on the interest rate swaps of $0.2 million. In the first nine months of 2007, net realized gains of $0.3 million included net gains on securities sales of $0.5 million, a loss on the mark-to-market valuation on the interest rate swaps of $0.2 million and write-downs of securities determined to be other than-temporarily impaired of $28,000. Securities determined to be other-than-temporarily impaired were written down to our estimate of fair market value at the time of the write-down. See discussion of other than temporary impairments on investment securities in the Critical Accounting Policies section. The Group has three ongoing interest rate swap agreements to hedge against interest rate risk on its floating rate trust preferred securities. The estimated fair value of the interest rates swaps is obtained from the third-party financial institution counterparties. The Group marks the investments to market using these valuations and records the change in the economic value of the interest rate swaps as a realized

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gain or loss in the consolidated statement of earnings.
     The following table sets forth consolidated information concerning our investments.
                                                 
    At September 30, 2008     At December 31, 2007     At December 31, 2006  
    Cost (2)     Fair Value     Cost (2)     Fair Value     Cost (2)     Fair Value  
    (In thousands)  
Fixed income securities (1):
                                               
United States government and government agencies (3)
  $ 87,372     $ 87,957     $ 84,736     $ 85,454     $ 75,683     $ 74,981  
Obligations of states and political subdivisions
    143,675       141,383       142,873       144,026       116,361       116,298  
Industrial and miscellaneous
    75,319       72,815       65,109       65,208       53,298       52,717  
Mortgage-backed securities
    27,262       26,393       29,260       29,550       29,427       29,458  
 
                                   
Total fixed income securities
    333,628       328,548       321,978       324,238       274,769       273,454  
Equity securities
    12,351       14,730       12,500       17,930       10,940       16,522  
Short-term investments
    9,998       9,998                   7,692       7,692  
 
                                   
Total
  $ 355,977     $ 353,276     $ 334,478     $ 342,168     $ 293,401     $ 297,668  
 
                                   
 
(1)   In our consolidated financial statements, investments are carried at fair value.
 
(2)   Original cost of equity securities; original cost of fixed income securities adjusted for amortization of premium and accretion of discount, as well as any impairment write-downs.
 
(3)   Includes approximately $65,704, $57,862 and $48,840 (cost) and $66,177, $58,376 and $48,548 (estimated fair value) of mortgage-backed securities issued by U.S. government agencies as of September 30, 2008 and December 31, 2007 and 2006, respectively.
     The following table shows our Industrial and miscellaneous fixed income securities and equity holdings by industry sector:

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    At September 30, 2008     At December 31, 2007  
    Cost (1)     Fair Value     Cost (1)     Fair Value  
    (In thousands)  
Industrial and miscellaneous fixed income securities
                               
Financial
  $ 33,968     $ 32,291     $ 35,784     $ 35,603  
Retail specialty
    27,574       27,242       19,434       19,601  
Energy
    9,679       9,273       4,298       4,355  
Pharmaceutical
    2,249       2,237       2,747       2,792  
Information technology
    1,849       1,772       2,846       2,857  
 
                       
Total
  $ 75,319     $ 72,815     $ 65,109     $ 65,208  
 
                       
 
                               
Equity securities
                               
Financial
  $ 3,287     $ 3,394     $ 4,364     $ 6,007  
Retail specialty
    4,760       5,958       4,083       6,037  
Energy
    1,320       1,656       953       1,620  
Pharmaceutical
    1,001       1,542       840       1,379  
Information technology
    1,410       1,486       1,637       2,115  
Transportation
    573       694       623       772  
 
                       
Total
  $ 12,351     $ 14,730     $ 12,500     $ 17,930  
 
                       
 
(1)   Original cost of equity securities; original cost of fixed income securities adjusted for amortization of premium and accretion of discount, as well as any impairment write-downs.
     We continue to maintain a conservative, diversified investment portfolio, with fixed maturity investments representing 93% of invested assets. As of September 30, 2008, the fixed income portfolio (including short term) consists of 99.8% investment grade securities, with the remaining 0.2% invested in two corporate securities held with a combined market value of $0.3 million, and one asset-backed security held with a market value of $0.4 million. The fixed income portfolio has an average rating of Aa2/AA, an average effective maturity of 5.3 years, and an average tax equivalent book yield of 5.20%.
     Among its portfolio holdings, the Group’s only subprime exposure consists of asset-backed securities (ABS) within the home equity subsector. The ABS home equity subsector totaled $1.1 million (book value) on September 30, 2008, representing 6.5% of the ABS holdings, 1.1% of the total structured product holdings, and 0.3% of total fixed income holdings. The subprime related exposure consists of four individual securities, two of which have a 100% credit enhancement, based on insurance against default as to principal and interest. However, since FGIC and AMBAC have been downgraded from AAA status, the two insured securities are now rated according to the higher of the underlying collateral or the monoline rating. One bond is rated Baa1/BB while the other is rated Aa3/AA. Among the two remaining securities without credit enhancement, one is rated Aaa/AAA and the other is rated Aa2/AA by Moody’s and S&P, respectively.
     The following table presents the Moody’s Investor Service (“Moody’s”) and S&P’s ratings of our fixed maturities portfolio:

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    September 30,   December 31,
Type/Ratings of Investment (1)(2)   2008 (3)   2007 (3)
U.S. government and agencies
    26.8 %     25.8 %
AAA
    26.5 %     48.3 %
AA
    28.9 %     11.1 %
A
    16.1 %     14.4 %
BBB
    1.5 %     0.3 %
BB
    0.1 %     0.1 %
B
    0.1 %     0.0 %
 
               
Total
    100.0 %     100.0 %
 
               
 
(1)   The ratings set forth in this table are based on the ratings assigned by Standard & Poor’s Corporation (S&P). If S&P’s ratings were unavailable, the equivalent ratings supplied by Moody’s Investors Services, Inc., Fitch Investors Service, Inc. or the NAIC were used where available.
 
(2)   The ratings shown above include, where applicable, credit enhancement by monoline bond insurers (see Item 3 for discussion of credit enhancement on municipal bond holdings)
 
(3)   Represents the fair value of the classification as a percentage of the total fair value of the portfolio.
     The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of September 30, 2008 are as follows:
                                                 
    Less than 12 Months     12 Months or Longer     Total  
    Estimated     Unrealized     Estimated     Unrealized     Estimated     Unrealized  
    Fair Value     Losses     Fair Value     Losses     Fair Value     Losses  
    (In Thousands)  
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 23,060     $ 183     $ 960     $ 30     $ 24,020     $ 213  
Obligations of states and political subdivisions
    85,736       2,781       1,034       60       86,770       2,841  
Corporate securities
    53,417       2,461       2,582       188       55,999       2,649  
Mortgage-backed securities
    18,593       843       1,187       102       19,780       945  
 
                                   
Total fixed maturities
    180,806       6,268       5,763       380       186,569       6,648  
 
                                   
Total equity securities
    4,403       723       1,225       139       5,628       862  
 
                                   
Total securities in a temporary unrealized loss position
  $ 185,209     $ 6,991     $ 6,988     $ 519     $ 192,197     $ 7,510  
 
                                   
     Unrealized losses for fixed maturity securities and equities increased due to further pressures in the credit and equity markets, with significantly wider credit spreads, particularly in the banking and finance sectors. The capital markets remained difficult at the end of the third quarter as participants continued to deleverage and reduce risk in an environment of general uncertainty and distress. However, broad changes in the overall market or interest rate environment do not, by themselves, lead to impairment charges and, therefore, based on our analyses, which includes our review of the credit worthiness of the issuers, coupled with our ability and intent to hold the securities through maturity and recovery, securities were not considered other-than-temporarily impaired simply because of significant recent price volatility. However, future

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write-downs may become necessary if there are continued unprecedented market and liquidity disruptions.
     Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment and anomalies in pricing in the current difficult market. At September 30, 2008 the Group has 10 fixed maturity securities with unrealized losses for more than twelve months. Of the 10 securities with unrealized losses for more than twelve months, all of them have fair values of no less than 90% of book value. The Group does not believe these declines are other than temporary due to the credit quality of the holdings. The Group currently has the ability and intent to hold these securities until recovery.
     In the first nine months of 2008, we incurred an impairment charge of $3.6 million for eighteen securities that were determined to be other than temporarily impaired. In the first nine months of 2007, we incurred an impairment charge of $28,000 for one security that was determined to be other than temporarily impaired. See discussion of recent downgrades and other than temporary impairments on investment securities in the Critical Accounting Policies section.
     There are 28 common stock securities that are in an unrealized loss position at September 30, 2008. All of these securities have been in an unrealized loss position for less than five months. There are six preferred stock securities that are in an unrealized loss position at September 30, 2008. Two preferred stock securities have been in an unrealized loss position for less than five months. Four preferred stock securities have been in an unrealized loss position for more than twelve months. The Group does not believe these declines are other than temporary as a result of reviewing the circumstances of each such security in an unrealized loss position. The Group currently has the ability and intent to hold these securities until recovery. However, future write-downs may become necessary in light of unprecedented market and liquidity disruptions.
     Results of our Commercial Lines segment were as follows. During 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Previously reported 2007 amounts have been reclassified below to reflect this change in allocation methodology:
                                 
Nine Months Ended September 30,                
2008 vs. 2007 Commercial Lines (CL)   2008   2007   Change   % Change
    (Dollars in thousands)                
CL Direct premiums written
  $ 112,871     $ 123,245     $ (10,374 )     (8.4) %
CL Net premiums written
  $ 100,852     $ 107,812     $ (6,960 )     (6.5) %
CL Net premiums earned
  $ 100,496     $ 90,287     $ 10,209       11.3 %
CL Loss/ LAE expense ratio (GAAP)
    61.1 %     59.9 %     1.2 %        
CL Expense ratio (GAAP)
    35.9 %     34.1 %     1.8 %        
CL Combined ratio (GAAP)
    97.0 %     94.0 %     3.0 %        
                                 
Three Months Ended September 30,                
2008 vs. 2007 Commercial Lines (CL)   2008   2007   Change   % Change
    (Dollars in thousands)                
CL Direct premiums written
  $ 36,237     $ 40,871     $ (4,634 )     (11.3) %
CL Net premiums written
  $ 32,187     $ 35,598     $ (3,411 )     (9.6) %
CL Net premiums earned
  $ 32,808     $ 31,975     $ 833       2.6 %
CL Loss/ LAE expense ratio (GAAP)
    59.9 %     61.9 %     (2.0) %        
CL Expense ratio (GAAP)
    37.7 %     34.3 %     3.4 %        
CL Combined ratio (GAAP)
    97.6 %     96.2 %     1.4 %        
     In the first nine months of 2008, our commercial lines direct premiums written decreased by $10.4 million or 8.4% to $112.9 million as compared to direct written premium in the first nine months of 2007 of $123.2 million. The decline in direct premiums written is attributed to several factors including a decline in construction related activity and related audit premium in California, increased competition on large accounts as well as the return of a number of competitors tothe California contractor market and the East Coast habitational market. Our

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California contractors book reflects the decreased economic activity in the California construction market. Since the insurance premiums for these contractors generally reflect their level of economic activity, the average premium per policy has fallen as the insured’s business has contracted, resulting in lower insurance exposures for these contractors. The retention levels in this book remain attractive, and policy count is up year-over-year, despite the decline in direct premium written. See additional discussion above in the 2008 vs. 2007 Revenue discussion.
     In the first nine months of 2008, our commercial lines net premiums earned increased by $10.2 million or 11.3% to $100.5 million as compared to net premiums earned in the first nine months of 2007 of $90.3 million. Net premiums earned increased 11.3% despite a 6.5% decline in net premiums written, with the decline in net premiums written caused primarily by the 8.4% decline in direct premiums written, offset by the positive impact on net premiums written of the change in reinsurance structure (in 2007 retention increased to $750,000 from $250,000 and $350,000 in 2006 on FPIC’s casualty and property lines, respectively, and from $500,000 on MIC’s, MICNJ’s and FIC’s 2006 property, casualty and workers’ compensation lines, and in 2008 to $850,000 from $750,000). Offsetting these factors was the reduction in audit premium recorded in 2008 which is earned immediately upon booking.
     In the third quarter of 2008, our commercial lines direct premiums written decreased by $4.6 million, or 11.3%, to $36.2 million as compared to direct premiums written in the same period of 2007 of $40.9 million. Net premiums earned in the same period increased 2.6%, or $0.8 million, to $32.8 million from $32.0 million in the third quarter of 2007.
     In the commercial lines segment for the first nine months of 2008, we had underwriting income of $3.0 million, a GAAP combined ratio of 97.0%, a GAAP loss and loss adjustment expense ratio of 61.1% and a GAAP underwriting expense ratio of 35.9%, compared to underwriting income of $5.4 million, a GAAP combined ratio of 94.0%, a GAAP loss and loss adjustment expense ratio of 59.9% and a GAAP underwriting expense ratio of 34.1% in the first nine months of 2007. Our commercial lines loss ratio for the first nine months of 2008 reflects a higher frequency and claim severity than the similar period in 2007 for casualty and property lines of business in our West Coast commercial lines business. The performance of the commercial lines in the first nine months of 2007 was impacted favorably by the non-recurring retaliatory tax refund.
     In the commercial lines segment for the third quarter of 2008, we had underwriting income of $0.7 million, a GAAP combined ratio of 97.6%, a GAAP loss and loss adjustment expense ratio of 59.9% and a GAAP underwriting expense ratio of 37.7%, compared to underwriting income of $1.2 million, a GAAP combined ratio of 96.2%, a GAAP loss and loss adjustment expense ratio of 61.9% and a GAAP underwriting expense ratio of 34.3% in the third quarter of 2007. The performance of the commercial lines in the third quarter of 2007 was impacted favorably by the non-recurring retaliatory tax refund.
     Results of our Personal Lines segment were as follows. During 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Previously reported 2007 amounts have been reclassified below to reflect this change in allocation methodology:
                                 
Nine Months Ended September 30,                
2008 vs. 2007 Personal Lines (PL)   2008   2007   Change   % Change
    (Dollars in thousands)                
PL Direct premiums written
  $ 16,667     $ 17,261     $ (594 )     (3.4 )%
PL Net premiums written
  $ 15,011     $ 15,304     $ (293 )     (1.9 )%
PL Net premiums earned
  $ 15,094     $ 16,080     $ (986 )     (6.1 )%
PL Loss/ LAE expense ratio (GAAP)
    67.3 %     70.6 %     (3.3 )%        
PL Expense ratio (GAAP)
    37.6 %     28.2 %     9.4 %        
PL Combined ratio (GAAP)
    104.9 %     98.8 %     6.1 %        

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Three Months Ended September 30,                
2008 vs. 2007 Personal Lines (PL)   2008   2007   Change   % Change
    (Dollars in thousands)                
PL Direct premiums written
  $ 5,924     $ 6,156     $ (232 )     (3.8 )%
PL Net premiums written
  $ 5,388     $ 5,512     $ (124 )     (2.2 )%
PL Net premiums earned
  $ 5,061     $ 5,328     $ (267 )     (5.0 )%
PL Loss/ LAE expense ratio (GAAP)
    62.8 %     55.9 %     6.9 %        
PL Expense ratio (GAAP)
    36.9 %     41.4 %     (4.5 )%        
PL Combined ratio (GAAP)
    99.7 %     97.3 %     2.4 %        
     Personal lines direct premiums written declined to $16.7 million in the first nine months of 2008 as compared to $17.3 million in the first nine months of 2007, representing a decline of $0.6 million or 3.4%. Personal lines direct premiums written declined to $5.9 million in the third quarter of 2008 as compared to $6.2 million in the third quarter of 2007, representing a decline of $0.2 million or 3.8%. Our personal lines have also been impacted by increased competition, similar to our commercial lines.
     In the personal lines segment for the first nine months of 2008, we had an underwriting loss of $0.7 million, a GAAP combined ratio of 104.9%, a GAAP loss and loss adjustment expense ratio of 67.3% and a GAAP underwriting expense ratio of 37.6%, compared to underwriting income of $0.2 million, a GAAP combined ratio of 98.8%, a GAAP loss and loss adjustment expense ratio of 70.6% and a GAAP underwriting expense ratio of 28.2% in the first nine months of 2007. Our personal lines loss ratio for the first nine months of 2007 reflected increased severity, due to large losses related to a variety of causes including an increase in water and freeze related claims.
     In the personal lines segment for the third quarter of 2008, we had underwriting income of $0.1 million, a GAAP combined ratio of 99.7%, a GAAP loss and loss adjustment expense ratio of 62.8% and a GAAP underwriting expense ratio of 36.9%, compared to underwriting income of $0.1 million, a GAAP combined ratio of 97.3%, a GAAP loss and loss adjustment expense ratio of 55.9% and a GAAP underwriting expense ratio of 41.4% in the third quarter of 2007. Our personal lines loss ratio for the third quarter of 2008 and 2007 reflects a frequency and severity of losses reported within the range of our expectations.
     Underwriting Expenses and the Expense Ratio is discussed below.
                                 
Nine Months Ended September 30,                
2008 vs. 2007 Expenses and Expense Ratio   2008   2007   Change   % Change
    (Dollars in thousands)                
Amortization of Deferred Acquisition Costs
  $ 31,163     $ 27,829     $ 3,334       12.0 %
As a % of net premiums earned
    27.0 %     26.2 %     0.8 %        
Other underwriting expenses
    10,618       7,530       3,088       41.0 %
Underwriting expenses
    41,781       35,359     $ 6,422       18.2 %
Underwriting expense ratio
    36.1 %     33.2 %     2.9 %        
     Underwriting expenses increased by $6.4 million, or 18.2%, to $41.8 million in the first nine months of 2008, as compared to $35.4 million in the first nine months of 2007. The increase in underwriting expenses primarily reflects an increase in the amortization of deferred acquisition costs in 2008 and the inclusion of the non-recurring retaliatory tax refund, which reduced other underwriting expenses by $3.6 million in the first nine months of 2007. The amortization of deferred acquisition costs increased in 2008 as compared to 2007 due to the increase in net earned premium. Underwriting expenses also reflect lower share-based compensation expense under SFAS 123R and lower net contingent commission expense. Lastly, underwriting expenses are impacted by the previously discussed changes in the 2008 and 2007 reinsurance program whereby less ceded premium is being recorded and accordingly less ceding commission is received, which increases underwriting expenses and net acquisition costs.
     Our Federal income tax was as follows:

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Nine Months Ended September 30,                
2008 vs. 2007 Income Taxes   2008   2007   Change   % Change
    (Dollars in thousands)                
Income before income taxes
  $ 10,068     $ 16,052     $ (5,984 )     (37.3 )%
Income taxes
    2,463       4,697       (2,234 )     (47.6 )%
Net income
    7,605       11,355     $ (3,750 )     (33.0 )%
Effective tax rate
    24.5 %     29.3 %     (4.8 )%        
     Federal income tax expense was $2.5 million and $4.7 million for the first nine months of 2008 and 2007, respectively. The effective tax rate was 24.5% and 29.3% for the first nine months of 2008 and 2007, respectively. The 2007 effective tax rate was impacted by an unusually high amount of taxable income in the period caused by the retaliatory tax refund, which increased the effective tax rate. The 2008 effective tax rate was impacted by the higher level of other than temporary investment impairments and by higher tax-advantaged income (municipal bond interest), which both reduce the effective tax rate.
LIQUIDITY AND CAPITAL RESOURCES
     Our insurance companies generate sufficient funds from their operations and maintain adequate liquidity in their investment portfolios to fund operations, including the payment of claims. The primary source of funds to meet the demands of claim settlements and operating expenses are premium collections, investment earnings and maturing investments.
     Our insurance companies maintain investment and reinsurance programs that are intended to provide sufficient funds to meet their obligations without forced sales of investments. This requires them to ladder the maturity of their portfolios and thereby maintain a portion of their investment portfolio in relatively short-term and highly liquid assets to ensure the availability of funds.
     The principal source of liquidity for the Holding Company (which has modest expenses and does not currently, or for the foreseeable future, need a significant regular source of cash flow to cover these expenses other than its debt service on its indebtedness to MIC, its quarterly dividend to shareholders, and the funding necessary for any stock repurchases pursuant to the currently authorized stock repurchase program) is dividend payments and other fees received from the insurance subsidiaries, and payments it receives on the 10-year note it received from the ESOP (see below) when the ESOP purchased shares at the time of the conversion from a mutual to a stock form of organization (the “Conversion”). The Holding Company also has access to an existing credit line under which it can draw up to $5 million dollars.
     On April 16, 2008, the Holding Company was authorized by the Board of Directors to repurchase, at management’s discretion, up to 5% of its outstanding stock. Any such purchases will be funded by the Holding Company’s existing resources, dividends from subsidiaries, or the credit line, or any combination of these resources. As of September 30, 2008, the Holding Company had purchased, pursuant to the authority granted by the Board on April 16, 2008, a total of 60,000 shares of outstanding stock at an average cost of $17.53 per share, and is holding the stock as treasury stock.
     The Group’s insurance companies are required by law to maintain a certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus may be restricted and may require prior approval of regulatory authorities. Additionally, there is a covenant in the Group’s line of credit agreement that requires the Group to maintain at least 50% of its insurance companies’ capacity to pay dividends without state regulation pre-approval.
     All dividends from MIC to MIG require prior notice to the Pennsylvania Insurance Department. All “extraordinary” dividends require advance approval. A dividend is deemed “extraordinary” if, when aggregated with all other dividends paid within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income (excluding unrealized capital gains) for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2007, the amount available for payment of dividends from MIC in 2008, without the prior approval, is approximately $6.2 million. In 2005, MIC applied for, and received, approval to pay an extraordinary dividend of $10 million, which was used in connection with the acquisition of FPIG.
     All dividends from FPIC to FPIG (wholly owned by MIG) require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval. A dividend is deemed “extraordinary” if, when aggregated with all other dividends paid

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within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income (excluding unrealized capital gains) for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2007, the amount available for payment of dividends from FPIC in 2008, without the prior approval, is approximately $6.0 million.
     As part of the funding of the acquisition of FPIG, MIC entered into a loan agreement with MIG, by which it advanced to MIG on September 30, 2005, a loan of $10 million with a 20-year term and a fixed interest rate of 4.75%, repayable in 20 equal annual installments. MIG has no special limitations on its ability to take periodic dividends from its insurance subsidiaries except for normal dividend restrictions administered by the respective domiciliary state regulators as described above. The Group believes that the resources available to MIG, will be adequate for it to meet its obligation under the note to MIC, the line of credit and its other expenses.
     MIG began paying quarterly dividends of $0.05 per common share in the second quarter of 2006. On April 16, 2008, MIG’s Board of Directors increased the quarterly dividend from $0.05 per share of common stock to $0.075 per share of common stock, effective with the payment of the June 27, 2008 dividend. The amount of dividends paid during the first nine months of 2008 and 2007 totaled $1.2 million and $0.9 million, respectively. The shareholder dividend was funded from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators.
     The Group maintains an Employee Stock Ownership Plan (ESOP), which purchased 626,111 shares from the Group at the time of the Conversion in return for a note bearing interest at 4% on the principal amount of $6,261,110. MIC makes annual contributions to the ESOP sufficient for it to make its required annual payment under the terms of the loan to the Holding Company. It is anticipated that approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge is booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair market value of the Group’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the Additional Paid-in Capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the Stockholders’ Equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price. Shareholder dividends received on unallocated ESOP shares are used to pay-down principal and interest owed on the loan to the Holding Company.
          The Group adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, Mercer Insurance Group may issue a total of 876,555 shares, which amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At September 30, 2008, the number of shares authorized under the plan has been increased under this provision to 1,141,565 shares. For the nine months ended September 30, 2008, the Group made no grants of restricted stock and stock options. In addition, there were no forfeitures of restricted stock and stock options and no options exercised during the first nine months of 2008.
          Total assets increased 3%, or $18.0 million, to $564.4 million, at September 30, 2008, as compared to $546.4 million at December 31, 2007. The Group’s cash and invested assets increased $4.2 million or 1%, primarily due to net cash provided by operating activities, offset by declines in market value of securities within the portfolio. Premiums receivable increased $3.1 million or 9%, primarily due to timing differences in the writing and collecting of premium. Reinsurance receivables increased $5.3 million or 6%, primarily due to an increase in ceded loss and loss adjustment expense reserves. Prepaid reinsurance premiums decreased $2.0 million or 21%, primarily due to a change in certain of the Group’s reinsurance contracts, whereby fewer unearned premium reserves are ceded. Property and equipment increased $2.3 million or 18% due to purchases of hardware and software. Additionally, deferred income taxes increased $3.9 million or 51%, due to changes in a variety of tax preference items.
     Total liabilities increased 4% or $18.5 million, to $431.5 million at September 30, 2008 as compared to $413.0 million at December 31, 2007, primarily as a result of the increase in loss and loss adjustment expense reserves of $24.6 million or 9%, offset by a decline in unearned premiums of $1.8 million or 2%, a decline in accounts payable and accrued expenses of $1.1 million or 7% and a decline in other reinsurance balances of $2.9 million or 20%. Unearned premiums declined primarily due to the decline in written premium. Accounts payable and accrued expenses declined primarily due to payments for agents profit sharing, state premium taxes, Group salary bonuses and retirement funding and other payments normally made after year-end. Other reinsurance balances declined primarily due to a change in certain of the Group’s reinsurance contracts, whereby fewer premium is ceded.
     Total stockholders’ equity declined $0.4 million, to $133.0 million, at September 30, 2008, from $133.4 million at December 31, 2007, primarily due to net income of $7.6 million, stock compensation plan amortization of $0.4 million, and ESOP shares committed to be allocated to participants of $0.8 million, offset by stockholder dividends of $1.2 million, the purchase of treasury stock of $1.1 million, changes in

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valuation for the defined benefit pension plan of $0.1 million and changes in unrealized holding gains and losses on securities of $6.9 million.
IMPACT OF INFLATION
          Inflation increases an insured’s need for property and casualty insurance coverage. Inflation also increases the cost of claims incurred by property and casualty insurers as property repairs, replacements and medical expenses increase. These cost increases reduce profit margins to the extent that rate increases are not implemented on an adequate and timely basis. We establish property and casualty insurance premiums levels before the amount of losses and loss expenses, or the extent to which inflation may affect these expenses, are known. Therefore, our insurance companies attempt to anticipate the potential impact of inflation when establishing rates, and if inflation is not adequately factored into rates, the rate increases will lag behind increases in loss costs resulting from inflation. Because inflation has remained relatively low in recent years, financial results have not been significantly affected by inflation.
          Inflation also often results in increases in the general level of interest rates, and, consequently, generally results in increased levels of investment income derived from our investments portfolio, although increases in investment income will generally lag behind increases in loss costs caused by inflation.
OFF BALANCE SHEET COMMITMENTS AND CONTRACTUAL OBLIGATIONS
     The Group was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at September 30, 2008 which would give rise to previously undisclosed market, credit or financing risk.
     The Group has no significant contractual obligations at September 30, 2008, other than its insurance obligations under its policies of insurance, trust preferred securities interest and principal, a line of credit obligation, and operating lease obligations. Projected cash disbursements pertaining to these obligations have not materially changed since December 31, 2007, and the Group expects to have the resources to pay these obligations as they come due.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
           General.
          Market risk is the risk that we will incur losses due to adverse changes in market rates and prices. We have exposure to three principal types of market risk through our investment activities: interest rate risk, credit risk and equity risk. Our primary market risk exposure is to changes in interest rates. We have not entered, and do not plan to enter, into any derivative financial instruments for hedging, trading or speculative purposes, other than the interest rate swap agreements that hedge the floating rate trust preferred securities which were assumed as part of the FPIG acquisition.
           Interest Rate Risk.
          Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes primarily results from our significant holdings of fixed rate investments. Fluctuations in interest rates have a direct impact on the market valuation of these securities. Our available-for-sale portfolio of fixed-income securities is carried on the balance sheet at fair value. Therefore, an adverse change in market prices of these securities would result in losses reflected in the balance sheet.
           During the quarter ended September 30, 2008, there were significant disruptions in the financial markets. A number of large financial institutions failed, were supported by the United States government or were merged into other organizations. This market disruption resulted in reduced liquidity in the credit markets and a widening of credit spreads, which, in turn, lowered the value of our fixed income portfolio. As a result, the Company had a pre-tax net unrealized loss of $5.1 million in its fixed income portfolio at September 30, 2008, as compared with a pre-tax net unrealized gain of $2.3 million at December 31, 2007.
           Credit Risk.
          The quality of our interest-bearing investments is generally good. Our fixed maturity securities at September 30, 2008, have an average rating of AA or better.
           The credit crisis in 2008 and the disruption in the financial markets has resulted in recognition of impairment losses in 2008, including the write-down of a $1 million par value Lehman Brothers security (see discussion of other than temporary impairments under the Investments section of the Critical Accounting Policies discussion in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations).
      Municipal Bond Holding Exposure.
     The overall credit quality, based on weighted average Standard & Poor’s (S&P) ratings or equivalent when the S&P rating is not available, of the total $141.4 million municipal fixed income portfolio is:

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  o   “AA+” including insurance enhancement
 
  o   “AA” excluding insurance enhancement
    99% of the underlying ratings are “A-” or better
 
    84% of the underlying ratings are “AA-” or better
     The municipal fixed income portfolio with insurance enhancement represents $101.3 million, or 72% of the total municipal fixed income portfolio.
  o   The average credit quality with insurance enhancement is “AA+”
 
  o   The average credit quality of the underlying, excluding insurance enhancement, is “AA”
 
  o   Each municipal fixed income investment is evaluated based on its underlying credit fundamentals, irrespective of credit enhancement provided by bond insurers
     The municipal fixed income portfolio without insurance enhancement represents $40.1 million, or 28% of the total municipal fixed income portfolio.
  o   The average credit quality of those securities without enhancement is “AA+”
The following represents the Group’s municipal fixed income portfolio as of September 30, 2008:
                                 
    Average Credit   Market   % of Total Muni   Unrealized
    Rating   Value   Portfolio   Loss
    (dollars in thousands)
Uninsured Securities
  AA+   $ 40,081,117       28 %   $ (672,361 )
Securities with Insurance Enhancement
  AA+     101,301,550       72 %     (1,619,610 )
 
                               
             
Total
          $ 141,382,667       100 %   $ (2,291,971 )
             
                 
    Market        
Credit Enhancement   Value     % of Total  
(dollars in thousands)  
AMBAC
  $ 10,833,856       8 %
FGIC
    28,100,839       20 %
FSA
    28,728,327       20 %
MBIA
    27,227,677       19 %
No Enhancement
    31,773,013       23 %
Other Enhancement
    5,811,268       4 %
Escrowed to Maturity
    8,907,687       6 %
       
Grand Total
  $ 141,382,667       100 %
       
The following represents the Group’s ratings on the municipal fixed income portfolio as of September 30, 2008:

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                                                    Total Municipal   Total Municipal
                                    Underlying Rating   Fixed Income   Fixed Income
                    Insurance   of Insurance   Portfolio   Portfolio
    Uninsured   Enhanced   Enhanced   (with Insurance   (without Insurance
    Securities   Securities   Securities   Enhancement)   Enhancement)
    (1)   (2)   (3)   (1) + (2)   (1) + (3)
    (dollars in thousands)
S&P or                                
equivalent   Market   % of   Market   % of   Market   % of   Market   % of   Market   % of
ratings   Value   Total   Value   Total   Value   Total   Value   Total   Value   Total
AAA
  $ 20,845,743       52 %   $ 37,096,474       37 %   $ 11,550,400       11 %   $ 57,942,217       41 %   $ 32,396,143       23 %
AA+
    4,010,409       10 %     20,040,095       20 %     26,150,711       26 %     24,050,504       17 %     30,161,120       20 %
AA
    12,896,639       32 %     35,310,837       35 %     30,745,394       30 %     48,207,476       34 %     43,642,033       31 %
AA-
    2,328,326       6 %     7,618,534       8 %     17,041,563       17 %     9,946,860       7 %     19,369,889       14 %
A+
                    202,020       0 %     6,376,417       6 %     202,020       0 %     6,376,417       5 %
A
                                    5,503,865       6 %                     5,503,865       4 %
A-
                                    2,899,610       3 %                     2,899,610       2 %
BBB-
                    1,033,590       1 %     1,033,590       1 %     1,033,590       1 %     1,033,590       1 %
                             
Total
  $ 40,081,117       100 %   $ 101,301,550       100 %   $ 101,301,550       100 %   $ 141,382,667       100 %   $ 141,382,667       100 %
                               
Average Rating
  AA+             AA+             AA             AA+             AA          
                     
     The Group’s municipal portfolio has experienced ratings migration in 2008 as a result of the downgrade of the claims paying ratings of nearly all of the monoline insurance companies. There were no further downgrades during the third quarter of 2008 following the changes during the second quarter. As of September 30, 2008, AMBAC was rated AA-/Aa3 by S&P and Moody’s respectively; MBIA was rated AA/A2 and FGIC was rated BB/B1. FSA retained its AAA/Aaa ratings but is weakly positioned in this rating category due to higher risk residential mortgage-backed security exposure in both its insured book and Financial Products segment.
     Insured municipals generally carry two ratings: a standalone rating based on individual fundamentals and an insured rating based on the claims paying ability of the issuer’s monoline insurer (if the issue is insured). The monoline insurers’ downgrades triggered ratings downgrades in the Group’s insured municipal portfolio during the second quarter of 2008. When the monoline insurers are downgraded, the ratings on insured municipal bonds are downgraded to the municipality or revenue bonds’ underlying credit rating or the insured rating, whichever is higher.
     As of September 30, 2008, all of the Group’s municipal bonds carry an underlying rating of at least an A- or better by S&P or Moody’s, except $1 million of Puerto Rico Commonwealth bonds due in 2013. These bonds are rated Baa3/BBB-. The bonds were originally rated A3/A due to the insurance provided by the monoline insurer, FGIC. When FGIC was downgraded, the Puerto Rico municipal bonds were downgraded to their underlying or standalone rating of Baa3/BBB-, as FGIC’s rating is lower.
           Structured Product Exposure.
     The Group’s structured product exposure includes commercial mortgage backed securities (CMBS), residential mortgage backed securities (MBS) and asset backed securities (ABS). The total book value, as of September 30, 2008, was $90.4 million and represented 27% of the total fixed income portfolio.
     As of September 30, 2008, CMBS holdings totaled $9.4 million (book value), representing 10% of the total structured product holdings. All CMBS securities are rated Aaa/AAA by either Moody’s, S&P, or Fitch.
     As of September 30, 2008, MBS holdings totaled $67.3 million (book value), representing 72% of the total structured product holdings. The MBS securities consist of both pass-through and collateralized mortgage obligation (CMO) structures. The pass-throughs are all agency

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sponsored securities and have a Aaa/AAA rating. Among the CMO’s, a majority are agency sponsored and as a result, also have a Aaa/AAA rating. The non-agency backed securities represent 15% of the CMO holdings and 5% of total MBS holdings; five of six of such securities have a Aaa/AAA rating by Moody’s or S&P and one security is rated A by S&P.
     As of September 30, 2008, ABS holdings totaled $16.3 million (book value), representing 18% of the total structured product holdings. The ABS securities consist of a diversified blend of subsectors including, automobile loan and credit card receivables, equipment financing, home equity, rate reduction bonds, among other ABS. Outside of three holdings of home equity (sub-prime), all ABS securities are rated Aaa/AAA by Moody’s and S&P.
     The ABS home equity subsector (collateral of sub-prime home equity loans) totaled $1.1 million (book value) on September 30, 2008, representing 6.5% of the ABS holdings and 1.1% of the total structured product holdings. This subsector exposure consists of four individual securities; two have a 100% credit enhancement due to insurance. However, since FGIC and AMBAC were downgraded, the ratings were impacted. The FGIC insured security is now rated as according to the underlying collateral, or Baa1/BB. The other insured security is rated Aa3/AA based on AMBAC’s claim paying ability. Among the two remaining securities without credit enhancement, one is rated Aaa/AAA and one is rated Aa2/AA by Moody’s and S&P, respectively.
     There are two sectors where the Group has indirect exposure to subprime securities. These are the U.S. agency and investment grade corporate sectors. As of September 30, 2008, the Group held $15.0 million (book value) of agency debt, consisting predominately of Fannie Mae, Federal Home Loan Bank, Freddie Mac, and Federal Farm Credit Bank securities.
     The second sector of the market in which the Group has indirect exposure to subprime securities is the investment grade corporate market. As of September 30, 2008, the Group’s portfolio held $75.3 million (book value) of corporate bonds. Among the corporate credit exposure, $28.5 million or 38% of the holdings, were in the financial industry. The banking, brokerage, and finance sectors of the investment grade corporate market continue to face stresses and challenges. Although some issuers, particularly banks, will continue to need to strengthen their reserves and write-off bad debts which will impact their earnings, it is expected that these issuers will continue to pay principal and interest when due.
           Equity Risk.
          Equity price risk is the risk that we will incur economic losses due to adverse changes in equity prices. Our exposure to changes in equity prices primarily results from our holdings of common stocks, mutual funds and other equities. Our portfolio of equity securities is carried on the balance sheet at fair value. Therefore, an adverse change in market prices of these securities would result in losses reflected in the balance sheet.
            Approximately 4% of our investment portfolio at September 30, 2008 is comprised of equity securities, down from 5% of the investment portfolio at December 31, 2007. The decline is due primarily to lower valuations caused by declines in the volatile equity markets in 2008. The Company had a pre-tax net unrealized gain of $2.4 million in its equity portfolio at September 30, 2008, as compared with a pre-tax net unrealized gain of $5.4 million at December 31, 2007.
           Investments Outlook
          The escalating credit crisis and interest rate volatility continued into the third quarter of 2008. Economic indicators pointed to further signs of deterioration for both the U.S. and global economies although inflationary pressures lessened and the price of oil and other commodities fell during the quarter. Furthermore, the difficult credit conditions worsened in September and interbank lending seized up, as evidenced by a 300+ basis point widening of the spread of the three-month LIBOR rate over the three-month T-bill rate. Modern financial markets have not experienced such a “credit crunch” as of late and the implications of a sustained reduction in lending has prompted unprecedented actions by the Federal Reserve and Federal Government to allay fears and provide liquidity.
          For fixed maturity securities, yield and income generation remain the key drivers to our investment strategy and our overall philosophy is to invest with a long-term horizon and a “buy-and-hold” principle. Reliance on independent investment research to avoid potential difficulties will continue to be a key driver behind our investment decisions. The continued volatility in fixed income spreads may provide attractive investment opportunities, particularly in the municipal and corporate bond sector.
          With all these risks present, we are increasingly cautious in the equities markets and will continue to manage through this period of uncertainty by investing in companies with more defensive characteristics, such as strong balance sheets and reasonable valuations. Other considerations are favorable long-term corporate performance and attractive relative historical valuations.

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Item 4. Controls and Procedures
     Under the supervision and with the participation of our management, including the President and Chief Executive Officer and the Senior Vice President and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of September 30, 2008. Based on that evaluation, the President and Chief Executive Officer and the Senior Vice President and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of September 30, 2008. There were no changes in our internal control over financial reporting during the nine months ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Part II — OTHER INFORMATION
Item 1. Legal Proceedings.
     None
Item 1A. Risk Factors.
      During 2008, there have been significant disruptions in the financial and equity markets. This resulted from, in part, failures of financial institutions on an unprecedented scale, and caused reduced liquidity in the credit markets and a widening of credit spreads, which resulted in lowered valuations for fixed income securities and equity securities held by the Company. If the financial and equity markets continue their adverse 2008 performance, the Company’s business and Stockholders’ Equity could be adversely affected.
      Please also see risk factors previously disclosed in the registrant’s Form 10-K for the year ended December 31, 2007.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
                                 
                    Total Number of Shares Purchased as   Maximum Number of Shares That
    Total Number of   Average Price   Part of Publicly Announced Plans or   May Yet Be Purchased Under The
Period   Shares Purchased   Paid per Share   Programs (Note 1)   Plans or Programs (Note 1)
July 1-31, 2008
    0       N/A       0       303,476  
 
August 1-31, 2008
    0       N/A       0       303,476  
 
September 1-30, 2008
    35,000     $ 17.43       35,000       268,476  
 
Total
    35,000     $ 17.43       35,000       268,476  
Note 1 — On April 16, 2008, the Group’s Board of Directors authorized the repurchase of up to 5% of outstanding common shares of the Group. The repurchased shares will be held as treasury shares available for issuance in connection with Mercer Insurance Group’s 2004 Stock Incentive Plan. In addition to the shares described above, in June, 2008, the Group purchased 1,344 shares from employees in connection with the vesting of restricted stock. These repurchases were made to satisfy tax withholding obligations with respect to those employees and the vesting of their restricted stock. These shares were purchased at the current market value of the Group’s common stock on the date of purchase, and were not purchased as part of the publicly announced program.
Item 3. Defaults Upon Senior Securities
     None

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Item 4. Submission of Matters to a Vote of Security Holders
     None
Item 5. Other Information
     None
Item 6. Exhibits
      Exhibits
     
Exhibit No.   Title
3.1
  Articles of Incorporation of Mercer Insurance Group, Inc. (incorporated by reference herein to the Group’s Pre-effective Amendment No. 3 on Form S-1, SEC File No. 333-104897.)
 
   
3.2
  Bylaws of Mercer Insurance Group, Inc. (incorporated by reference herein to the Group’s Annual Report on Form 10-K, SEC File No. 000-25425, for the fiscal year ended December 31, 2003.)
 
   
31.1
  Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)
 
   
31.2
  Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)
 
   
32.1
  Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)
 
   
32.2
  Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)

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SIGNATURES
     In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  MERCER INSURANCE GROUP, INC. (Registrant)  
 
Dated: November 10, 2008  By:   /s/ Andrew R. Speaker    
    Andrew R. Speaker,   
    President and Chief Executive Officer   
 
     
Dated: November 10, 2008  By:   /s/ David B. Merclean    
    David B. Merclean,   
    Senior Vice President and Chief Financial Officer   

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