e10vq
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2010
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     .
Commission file number 0-15341
Donegal Group Inc.
(Exact name of registrant as specified in its charter)
     
Delaware   23-2424711
     
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
1195 River Road, P.O. Box 302, Marietta, PA 17547
(Address of principal executive offices) (Zip code)
(717) 426-1931
(Registrant’s telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year, if changed since last report)
     Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
     Indicate by check mark whether the registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o 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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o   Accelerated filer þ   Non-accelerated filer o   Smaller reporting company o
        (Do not check if a smaller reporting company)    
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange 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: 19,994,226 shares of Class A Common Stock, par value $0.01 per share, and 5,576,775 shares of Class B Common Stock, par value $0.01 per share, outstanding on October 31, 2010.
 
 


 

Part I. Financial Information
Item 1. Financial Statements.
Donegal Group Inc. and Subsidiaries
Consolidated Balance Sheets
                 
    September 30, 2010     December 31, 2009  
    (Unaudited)          
Assets
               
 
               
Investments
               
Fixed maturities
               
Held to maturity, at amortized cost
  $ 66,005,469     $ 73,807,126  
Available for sale, at fair value
    563,276,871       517,703,672  
Equity securities, available for sale, at fair value
    12,714,676       9,914,626  
Investments in affiliates
    9,183,620       9,309,347  
Short-term investments, at cost, which approximates fair value
    28,631,483       56,100,415  
 
           
Total investments
    679,812,119       666,835,186  
Cash
    12,729,268       12,923,898  
Accrued investment income
    6,420,863       6,202,710  
Premiums receivable
    71,950,432       61,187,021  
Reinsurance receivable
    95,514,905       84,670,009  
Deferred policy acquisition costs
    34,843,612       32,844,179  
Deferred tax asset, net
    1,552,566       5,086,949  
Prepaid reinsurance premiums
    64,497,515       56,040,728  
Property and equipment, net
    6,326,177       6,592,223  
Accounts receivable — securities
    350,016       588,292  
Federal income taxes recoverable
          663,047  
Other
    2,104,526       1,967,685  
 
           
Total assets
  $ 976,101,999     $ 935,601,927  
 
           
 
               
Liabilities and Stockholders’ Equity
               
 
               
Liabilities
               
Unpaid losses and loss expenses
  $ 278,635,509     $ 263,598,844  
Unearned premiums
    268,150,466       241,821,419  
Accrued expenses
    9,699,243       10,578,695  
Reinsurance balances payable
    2,989,619       2,561,426  
Federal income taxes payable
    695,654        
Cash dividends declared to stockholders
          2,798,378  
Subordinated debentures
    15,465,000       15,465,000  
Accounts payable — securities
    1,553,931       6,828,873  
Due to affiliate
    893,040       3,813,294  
Drafts payable
    1,560,506       884,993  
Other
    1,683,525       1,745,306  
 
           
Total liabilities
    581,326,493       550,096,228  
 
           
 
               
Stockholders’ Equity
               
Preferred stock, $1.00 par value, authorized 2,000,000 shares; none issued
           
Class A common stock, $.01 par value, authorized 30,000,000 shares, issued 20,628,243 and 20,569,930 shares and outstanding 19,965,942 and 19,917,331 shares
    206,283       205,700  
Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares
    56,492       56,492  
Additional paid-in capital
    166,684,631       164,585,214  
Accumulated other comprehensive income
    22,473,601       15,007,044  
Retained earnings
    214,604,432       214,755,495  
Treasury stock
    (9,249,933 )     (9,104,246 )
 
           
Total stockholders’ equity
    394,775,506       385,505,699  
 
           
Total liabilities and stockholders’ equity
  $ 976,101,999     $ 935,601,927  
 
           
See accompanying notes to consolidated financial statements.

1


 

Donegal Group Inc. and Subsidiaries
Consolidated Statements of Income

(Unaudited)
                 
    Three Months Ended September 30,  
    2010     2009  
Revenues:
               
Net premiums earned
  $ 94,948,843     $ 87,997,723  
Investment income, net of investment expenses
    4,709,458       5,107,356  
Net realized investment gains
    2,460,462       189,230  
Lease income
    231,905       232,762  
Installment payment fees
    1,399,650       1,349,016  
Other income
          6,080  
 
           
Total revenues
    103,750,318       94,882,167  
 
           
 
               
Expenses:
               
Net losses and loss expenses
    67,401,697       58,609,247  
Amortization of deferred policy acquisition costs
    16,388,000       14,791,000  
Other underwriting expenses
    14,019,279       13,344,369  
Policyholder dividends
    220,536       251,573  
Interest
    183,616       185,315  
Other expenses
    502,279       335,410  
 
           
Total expenses
    98,715,407       87,516,914  
 
           
 
               
Income before income tax expense
    5,034,911       7,365,253  
Income tax expense
    125,032       620,402  
 
           
 
               
Net income
  $ 4,909,879     $ 6,744,851  
 
           
 
               
Earnings per common share:
               
Class A common stock — basic
  $ 0.20     $ 0.27  
 
           
Class A common stock — diluted
  $ 0.20     $ 0.27  
 
           
Class B common stock — basic and diluted
  $ 0.18     $ 0.24  
 
           
 
Consolidated Statements of Comprehensive Income
(Unaudited)
 
 
    Three Months Ended September 30,  
    2010     2009  
Net income
  $ 4,909,879     $ 6,744,851  
Other comprehensive income, net of tax
               
Unrealized income on securities:
               
Unrealized holding income during the period, net of income tax
    6,469,008       16,163,607  
Reclassification adjustment, net of income tax
    (1,623,905 )     (122,999 )
 
           
Other comprehensive income
    4,845,103       16,040,608  
 
           
Comprehensive income
  $ 9,754,982     $ 22,785,459  
 
           
See accompanying notes to consolidated financial statements.

2


 

Donegal Group Inc. and Subsidiaries
Consolidated Statements of Income

(Unaudited)
                 
    Nine Months Ended September 30,  
    2010     2009  
Revenues:
               
Net premiums earned
  $ 279,323,348     $ 263,887,611  
Investment income, net of investment expenses
    14,608,439       15,731,106  
Net realized investment gains
    4,447,065       893,225  
Lease income
    687,902       689,096  
Installment payment fees
    4,059,766       3,957,392  
Other income
          48,771  
 
           
Total revenues
    303,126,520       285,207,201  
 
           
 
               
Expenses:
               
Net losses and loss expenses
    203,892,799       186,461,543  
Amortization of deferred policy acquisition costs
    48,549,000       44,158,000  
Other underwriting expenses
    40,834,990       38,548,332  
Policyholder dividends
    465,319       586,784  
Interest
    537,309       1,588,560  
Other expenses
    1,665,778       1,152,946  
 
           
Total expenses
    295,945,195       272,496,165  
 
           
 
               
Income before income tax expense
    7,181,325       12,711,036  
Income tax expense
    296,960       1,408,757  
 
           
 
               
Net income
  $ 6,884,365     $ 11,302,279  
 
           
 
               
Earnings per common share:
               
Class A common stock — basic
  $ 0.28     $ 0.45  
 
           
Class A common stock — diluted
  $ 0.28     $ 0.45  
 
           
Class B common stock — basic and diluted
  $ 0.25     $ 0.41  
 
           
 
Consolidated Statements of Comprehensive Income
(Unaudited)
 
    Nine Months Ended September 30,  
    2010     2009  
Net income
  $ 6,884,365     $ 11,302,279  
Other comprehensive income, net of tax
               
Unrealized income on securities:
               
Unrealized holding income during the period, net of income tax
    10,401,620       22,084,037  
Reclassification adjustment, net of income tax
    (2,935,063 )     (580,596 )
 
           
Other comprehensive income
    7,466,557       21,503,441  
 
           
Comprehensive income
  $ 14,350,922     $ 32,805,720  
 
           
See accompanying notes to consolidated financial statements.

3


 

Donegal Group Inc. and Subsidiaries
Consolidated Statement of Stockholders’ Equity

(Unaudited)
Nine Months Ended September 30, 2010
                                                                         
                                            Accumulated                        
                                    Additional     Other                     Total  
                                    Paid-In     Comprehensive     Retained     Treasury     Stockholders’  
    Class A Shares     Class B Shares     Class A Amount     Class B Amount     Capital     Income     Earnings     Stock     Equity  
Balance, December 31, 2009
    20,569,930       5,649,240     $ 205,700     $ 56,492     $ 164,585,214     $ 15,007,044     $ 214,755,495     $ (9,104,246 )   $ 385,505,699  
 
                                                                       
Issuance of common stock (stock compensation plans)
    58,313               583               799,921                               800,504  
 
                                                                       
Net income
                                                    6,884,365               6,884,365  
 
                                                                       
Cash dividends declared
                                                    (5,735,932 )             (5,735,932 )
 
                                                                       
Grant of stock options
                                    1,299,496               (1,299,496 )              
 
                                                                       
Repurchase of treasury stock
                                                            (145,687 )     (145,687 )
 
                                                                       
Other comprehensive income
                                            7,466,557                       7,466,557  
 
                                                     
 
                                                                       
Balance, September 30, 2010
    20,628,243       5,649,240     $ 206,283     $ 56,492     $ 166,684,631     $ 22,473,601     $ 214,604,432     $ (9,249,933 )   $ 394,775,506  
 
                                                     
See accompanying notes to consolidated financial statements.

4


 

Donegal Group Inc. and Subsidiaries
Consolidated Statements of Cash Flows

(Unaudited)
                 
    Nine Months Ended September 30,  
    2010     2009  
Cash Flows from Operating Activities:
               
Net income
  $ 6,884,365     $ 11,302,279  
 
           
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    2,054,392       1,961,738  
Net realized investment gains
    (4,447,065 )     (893,225 )
Equity loss (income)
    292,742       (48,771 )
Changes in assets and liabilities:
               
Losses and loss expenses
    15,036,665       11,222,678  
Unearned premiums
    26,329,047       18,145,206  
Premiums receivable
    (10,763,411 )     (8,171,563 )
Deferred acquisition costs
    (1,999,433 )     (2,242,635 )
Deferred income taxes
    (486,071 )     (66,092 )
Reinsurance receivable
    (10,844,896 )     (5,246,931 )
Prepaid reinsurance premiums
    (8,456,787 )     (6,824,930 )
Accrued investment income
    (218,153 )     338,405  
Due to affiliate
    (2,920,254 )     (2,345,677 )
Reinsurance balances payable
    428,193       1,991,578  
Current income taxes
    1,358,701       2,264,731  
Accrued expenses
    (879,452 )     (3,487,075 )
Other, net
    476,909       1,018,363  
 
           
Net adjustments
    4,961,127       7,615,800  
 
           
Net cash provided by operating activities
    11,845,492       18,918,079  
 
           
 
               
Cash Flows from Investing Activities:
               
Purchases of fixed maturities:
               
Available for sale
    (152,968,758 )     (93,510,595 )
Purchases of equity securities, available for sale
    (44,168,645 )     (25,815,019 )
Maturity of fixed maturities:
               
Held to maturity
    7,503,370       20,981,616  
Available for sale
    53,870,605       30,353,892  
Sales of fixed maturities:
               
Available for sale
    62,607,346       12,121,541  
Sales of equity securities, available for sale
    42,088,169       25,847,613  
Payments to Sheboygan policyholders
          (5,676,678 )
Net increase in investment in affiliates
          (50,000 )
Net purchases of property and equipment
    (561,648 )     (826,047 )
Net sales of short-term investments
    27,468,932       32,103,338  
 
           
Net cash used in investing activities
    (4,160,629 )     (4,470,339 )
 
           
 
               
Cash Flows from Financing Activities:
               
Cash dividends paid
    (8,534,310 )     (8,197,741 )
Issuance of common stock
    800,504       934,653  
Purchase of treasury stock
    (145,687 )     (198,879 )
 
           
Net cash used in financing activities
    (7,879,493 )     (7,461,967 )
 
           
 
               
Net (decrease) increase in cash
    (194,630 )     6,985,773  
Cash at beginning of period
    12,923,898       1,830,954  
 
           
Cash at end of period
  $ 12,729,268     $ 8,816,727  
 
           
 
               
Cash paid during period — Interest
  $ 517,038     $ 675,193  
Net cash received during period — Taxes
  $ (600,000 )   $ (792,582 )
See accompanying notes to consolidated financial statements.

5


 

DONEGAL GROUP INC. AND SUBSIDIARIES
(Unaudited)
Notes to Consolidated Financial Statements
1 — Organization
     Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as a downstream insurance holding company on August 26, 1986. Our six insurance subsidiaries and Donegal Mutual conduct business as the Donegal Insurance Group. The Donegal Insurance Group writes personal and commercial lines of property and casualty insurance exclusively through a network of independent insurance agents in 20 Mid-Atlantic, Midwestern, New England and Southeastern states. The personal lines products consist primarily of homeowners and private passenger automobile policies. The commercial lines products consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies.
     Our insurance subsidiaries are Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, and Sheboygan Falls Insurance Company (“Sheboygan”). We also own approximately 48% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a unitary thrift holding company that owns Province Bank FSB. Donegal Mutual owns the remaining approximately 52% of the outstanding stock of DFSC.
     At September 30, 2010, Donegal Mutual held approximately 42% of our outstanding Class A common stock and approximately 75% of our outstanding Class B common stock.
     Atlantic States and Donegal Mutual are parties to a pooling agreement under which each company places all of its direct written business in the pool and both companies share the underwriting results of the pool as provided in the pooling agreement, excluding certain reinsurance Donegal Mutual assumes from our five other insurance subsidiaries. From July 1, 2000 through February 29, 2008, Atlantic States had a 70% share of the results of the pool, and Donegal Mutual had a 30% share of the results of the pool. Donegal Mutual and Atlantic States amended the pooling agreement effective March 1, 2008 to increase Atlantic States’ share of the results of the pool to 80% and to decrease Donegal Mutual’s share of the results of the pool to 20% beginning on that date. See Note 4 — Reinsurance for more information regarding the pooling agreement.
     On February 23, 2009, our board of directors authorized a share repurchase program, pursuant to which we may purchase up to 300,000 shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable SEC rules and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the three months ended September 30, 2010 and 2009, respectively. We purchased 9,702 and no shares of our Class A common stock under this program during the nine months ended September 30, 2010 and 2009, respectively. We have purchased a total of 17,371 shares of our Class A common stock under this program through September 30, 2010.
     In October 2009, Donegal Mutual consummated an affiliation with Southern Mutual Insurance Company (“Southern Mutual”), pursuant to which Donegal Mutual purchased a surplus note of Southern Mutual in the principal amount of $2.5 million, Donegal Mutual designees became a majority of the members of Southern Mutual’s board of directors and Donegal Mutual agreed to provide quota share reinsurance to Southern Mutual for 100% of its business. Effective October 31, 2009, Donegal Mutual began to include business Donegal Mutual assumes from Southern Mutual in the pooling agreement with Atlantic States. Southern Mutual writes primarily personal lines of insurance in Georgia and South Carolina and had direct premiums written of approximately $13.3 million in 2009. Pursuant to applicable accounting standards, Southern Mutual is a variable interest entity, of which we are not the primary beneficiary.
     In April 2010, DFSC and certain of its affiliates, including Donegal Mutual and us, and Union National Financial Corporation (“UNNF”) executed an agreement pursuant to which DFSC and UNNF would merge, with DFSC as the surviving company in the merger. The merger is subject to a number of conditions, including the approval of various federal bank regulatory agencies. Under the agreement, Province Bank FSB, which DFSC owns, and Union National Community Bank, which UNNF owns, would also merge. The combined bank would have total assets of approximately $600 million and would have 13 branch locations in Lancaster County, Pennsylvania. The companies expect to complete the mergers in the fourth quarter of

6


 

2010. Following the mergers, we expect to continue using the equity method of accounting for our investment in DFSC. Under the equity method, we record our investment at cost, with adjustments for our share of DFSC’s earnings and losses as well as changes in DFSC’s equity due to unrealized gains and losses.
     In July 2010, we executed an agreement pursuant to which we will acquire all of the outstanding stock of Michigan Insurance Company (“MICO”), an 83.6%-owned subsidiary of West Bend Mutual Insurance Company (“WBM”). MICO writes various lines of property and casualty insurance exclusively in the State of Michigan. MICO had direct written premiums of $106.6 million and net written premiums of $26.7 million for the year ended December 31, 2009. The purchase price will be calculated based on the United States generally accepted accounting principles (“GAAP”) book value of MICO as of the closing date of the acquisition. We estimate that the purchase price payable to the shareholders of MICO will be approximately $39 million. The acquisition is subject to a number of conditions, including the approval of the Insurance Department of the State of Michigan. We expect to complete the acquisition in the fourth quarter of 2010.
2 — Basis of Presentation
     Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2010 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2010.
     You should read these interim financial statements in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2009.
3 — Earnings Per Share
     We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors must also declare a dividend on our Class A common stock that is payable at the same time to holders as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared the dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents for the periods indicated a reconciliation of the numerators and denominators we used to compute basic and diluted net income per share for each class of common stock:
For the Three Months Ended September 30:
                                 
    2010     2009  
    Class A     Class B     Class A     Class B  
    (in thousands, except per share data)  
Basic and diluted net income per share:
                               
Numerator:
                               
Allocation of net income
  $ 3,925     $ 985     $ 5,386     $ 1,359  
 
                       
Denominator:
                               
Weighted-average shares outstanding
    19,965,942       5,576,775       19,905,174       5,576,775  
 
                       
 
                               
Basic and diluted net income per share
  $ 0.20     $ 0.18     $ 0.27     $ 0.24  
 
                       

7


 

For the Nine Months Ended September 30:
                                 
    2010     2009  
    Class A     Class B     Class A     Class B  
    (in thousands, except per share data)  
Basic and diluted net income per share:
                               
Numerator:
                               
Allocation of net income
  $ 5,508     $ 1,376     $ 9,028     $ 2,274  
 
                       
Denominator:
                               
Weighted-average shares outstanding
    19,950,170       5,576,775       19,895,840       5,576,775  
 
                       
 
                               
Basic and diluted net income per share
  $ 0.28     $ 0.25     $ 0.45     $ 0.41  
 
                       
We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options was greater than the average market price during the period:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
Number of shares excluded
    4,005,667       3,395,264       4,005,667       3,423,432  
 
                       
4 — Reinsurance
     Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which each company places all of its direct written business into the pool, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. From July 1, 2000 through February 29, 2008, Atlantic States had a 70% share of the results of the pool, and Donegal Mutual had a 30% share of the results of the pool. Donegal Mutual and Atlantic States amended the pooling agreement effective March 1, 2008 to increase Atlantic States’ share of the results of the pool to 80% beginning on that date.
     Atlantic States, Southern and Donegal Mutual purchase third-party reinsurance on a combined basis. Le Mars, Peninsula and Sheboygan have separate third-party reinsurance programs that provide similar types of coverage and that are commensurate with their relative size and risk exposures. Our insurance subsidiaries place reinsurance with various reinsurers, all of which, consistent with Donegal Insurance Group’s requirements, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating. The following information describes the external reinsurance our insurance subsidiaries have in place during 2010 and 2009:
    excess of loss reinsurance, under which losses are automatically reinsured, through a series of reinsurance agreements, over a set retention ($750,000), and
 
    catastrophe reinsurance, under which Donegal Mutual, Atlantic States and Southern recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural disasters, over a set retention ($3.0 million).
     Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures from losses that exceed the limits provided by their reinsurance agreements with third parties.
     In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual.
     We made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2010.

8


 

5 — Investments
     The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2010 are as follows:
                                 
            Gross     Gross     Estimated  
    Amortized     Unrealized     Unrealized     Fair  
Held to Maturity   Cost     Gains     Losses     Value  
          (in thousands)          
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 1,000     $ 97     $     $ 1,097  
Obligations of states and political subdivisions
    59,949       4,095             64,044  
Corporate securities
    4,246       54             4,300  
Residential mortgage-backed securities
    810       40             850  
 
                       
Totals
  $ 66,005     $ 4,286     $     $ 70,291  
 
                       
                                 
            Gross     Gross     Estimated  
    Amortized     Unrealized     Unrealized     Fair  
Available for Sale   Cost     Gains     Losses     Value  
          (in thousands)          
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 47,957     $ 808     $     $ 48,765  
Obligations of states and political subdivisions
    359,404       21,916       235       381,085  
Corporate securities
    55,381       1,237       19       56,599  
Residential mortgage-backed securities
    74,432       2,450       54       76,828  
 
                       
Fixed maturities
    537,174       26,411       308       563,277  
Equity securities
    7,429       6,181       895       12,715  
 
                       
Totals
  $ 544,603     $ 32,592     $ 1,203     $ 575,992  
 
                       
     The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2009 are as follows:
                                 
            Gross     Gross     Estimated  
    Amortized     Unrealized     Unrealized     Fair  
Held to Maturity   Cost     Gains     Losses     Value  
          (in thousands)          
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 2,000     $ 80     $     $ 2,080  
Obligations of states and political subdivisions
    61,736       3,011       24       64,723  
Corporate securities
    6,243       72       13       6,302  
Residential mortgage-backed securities
    3,828       73             3,901  
 
                       
Totals
  $ 73,807     $ 3,236     $ 37     $ 77,006  
 
                       
                                 
            Gross     Gross     Estimated  
    Amortized     Unrealized     Unrealized     Fair  
Available for Sale   Cost     Gains     Losses     Value  
          (in thousands)          
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 41,061     $ 154     $ 585     $ 40,630  
Obligations of states and political subdivisions
    346,799       12,587       1,019       358,367  
Corporate securities
    26,972       866       72       27,766  
Residential mortgage-backed securities
    88,914       2,357       330       90,941  
 
                       
Fixed maturities
    503,746       15,964       2,006       517,704  
Equity securities
    3,804       6,339       228       9,915  
 
                       
Totals
  $ 507,550     $ 22,303     $ 2,234     $ 527,619  
 
                       

9


 

     The amortized cost and estimated fair value of our fixed maturities at September 30, 2010, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
                 
            Estimated  
    Amortized     Fair  
    Cost     Value  
    (in thousands)  
Held to maturity
               
Due in one year or less
  $ 3,996     $ 4,050  
Due after one year through five years
    13,828       14,774  
Due after five years through ten years
    45,600       48,722  
Due after ten years
    1,771       1,895  
Residential mortgage-backed securities
    810       850  
 
           
Total held to maturity
  $ 66,005     $ 70,291  
 
           
 
               
Available for sale
               
Due in one year or less
  $ 11,945     $ 12,074  
Due after one year through five years
    92,738       95,990  
Due after five years through ten years
    128,570       134,649  
Due after ten years
    229,489       243,736  
Residential mortgage-backed securities
    74,432       76,828  
 
           
Total available for sale
  $ 537,174     $ 563,277  
 
           
Gross realized gains and losses from investments before applicable income taxes are as follows:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
    (in thousands)     (in thousands)  
Gross realized gains:
                               
Fixed maturities
  $ 2,050     $     $ 3,681     $ 133  
Equity securities
    765       270       1,300       889  
 
                       
 
  $ 2,815     $ 270     $ 4,981     $ 1,022  
 
                       
 
                               
Gross realized losses:
                               
Fixed maturities
  $ 355     $ 81     $ 534     $ 82  
Equity securities
                      47  
 
                       
 
    355       81       534       129  
 
                       
Net realized gains
  $ 2,460     $ 189     $ 4,447     $ 893  
 
                       
     We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2010 as follows:
                                 
    Less than 12 months     More than 12 months  
    Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses  
            (in thousands)          
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $     $     $     $  
Obligations of states and political subdivisions
    9,150       214       2,995       21  
Corporate securities
    2,810       12       746       7  
Residential mortgage-backed securities
    2,905       54              
Equity securites
    4,486       895              
 
                       
Totals
  $ 19,351     $ 1,175     $ 3,741     $ 28  
 
                       

10


 

     We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2009 as follows:
                                 
    Less than 12 months     More than 12 months  
    Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses  
            (in thousands)          
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 26,704     $ 585     $     $  
Obligations of states and political subdivisions
    17,971       257       29,582       787  
Corporate securities
    1,284       24       667       62  
Residential mortgage-backed securities
    23,514       329       478        
Equity securites
    2,140       227              
 
                       
Totals
  $ 71,613     $ 1,422     $ 30,727     $ 849  
 
                       
     Of our total fixed maturity securities with an unrealized loss at September 30, 2010, we classified 19 securities with a fair value of $18.3 million and an unrealized loss of $308,487 as available-for-sale and carried them at fair value on our balance sheet.
     Of our total fixed maturity securities with an unrealized loss at December 31, 2009, we classified 70 securities with a fair value of $97.9 million and an unrealized loss of $2.0 million as available-for-sale and carried them at fair value on our balance sheet, while we classified three securities with a fair value of $2.3 million and an unrealized loss of $37,097 as held-to-maturity on our balance sheet and carried them at amortized cost.
     We have no direct exposure to sub-prime residential mortgage-backed securities and hold no collateralized debt obligations. Substantially all of the unrealized losses in our fixed maturity investment portfolio have resulted from general market conditions and the related impact on our fixed maturity investment valuations. We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, when we consider the decline in value of an individual investment to be other than temporary, we write the investment down to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations. We individually monitor all investments for other-than-temporary declines in value. Generally, if an individual equity security has depreciated in value by more than 20% of original cost, and has been in such an unrealized loss position for more than six months, we assume there has been an other-than-temporary decline in value. We held six equity securities that were in an unrealized loss position at September 30, 2010. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we consider these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the security prior to recovery. If it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. To determine whether a credit loss has occurred, we compare the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider a credit loss to have occurred. If we consider a credit loss to have occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including the fair value of the investment being significantly below its cost, whether the financial condition of the issuer of the security is deteriorating, the occurrence of industry, company and geographic events that have negatively impacted the value of the security and rating agency downgrades. We determined that no investments with fair values below cost had declined on an other-than-temporary basis during the first nine months of 2010 and 2009, respectively.
     We amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method.

11


 

     We amortize premiums and discounts for mortgage-backed debt securities using anticipated prepayments.
     We account for investments in our affiliates using the equity method of accounting, under which we record our investment at cost, with adjustments for our share of our affiliates’ earnings and losses as well as changes in our affiliates’ equity due to unrealized gains and losses.
6 — Segment Information
     We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles prescribed or permitted by various state insurance departments (“SAP”). Our management uses SAP to measure the performance of our insurance subsidiaries instead of GAAP. Financial data by segment is as follows:
                 
    Three Months Ended  
    September 30,  
    2010     2009  
    (in thousands)  
Revenues:
               
Premiums earned
               
Commercial lines
  $ 29,436     $ 27,520  
Personal lines
    65,513       60,546  
 
           
Net premiums earned
    94,949       88,066  
GAAP adjustments
          (62 )
 
           
GAAP premiums earned
    94,949       88,004  
Net investment income
    4,709       5,107  
Realized investment gains
    2,460       189  
Other
    1,632       1,582  
 
           
Total revenues
  $ 103,750     $ 94,882  
 
           
 
               
Income before income taxes:
               
Underwriting income (loss):
               
Commercial lines
  $ 1,819     $ 4,410  
Personal lines
    (5,906 )     (4,040 )
 
           
SAP underwriting (loss) income
    (4,087 )     370  
GAAP adjustments
    1,006       632  
 
           
GAAP underwriting (loss) income
    (3,081 )     1,002  
Net investment income
    4,709       5,107  
Realized investment gains
    2,460       189  
Other
    947       1,067  
 
           
Income before income taxes
  $ 5,035     $ 7,365  
 
           

12


 

                 
    Nine Months Ended  
    September 30,  
    2010     2009  
    (in thousands)  
Revenues:
               
Premiums earned
               
Commercial lines
  $ 86,027     $ 84,844  
Personal lines
    193,324       179,557  
 
           
Net premiums earned
    279,351       264,401  
GAAP adjustments
    (28 )     (464 )
 
           
GAAP premiums earned
    279,323       263,937  
Net investment income
    14,608       15,731  
Realized investment gains
    4,447       893  
Other
    4,749       4,646  
 
           
Total revenues
  $ 303,127     $ 285,207  
 
           
 
               
Income before income taxes:
               
Underwriting income (loss):
               
Commercial lines
  $ 1,058     $ 6,431  
Personal lines
    (18,173 )     (14,269 )
 
           
SAP underwriting loss
    (17,115 )     (7,838 )
GAAP adjustments
    2,696       1,971  
 
           
GAAP underwriting loss
    (14,419 )     (5,867 )
Net investment income
    14,608       15,731  
Realized investment gains
    4,447       893  
Other
    2,545       1,954  
 
           
Income before income taxes
  $ 7,181     $ 12,711  
 
           
7 — Subordinated Debentures
     On October 29, 2003, we received $10.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on October 29, 2033 and are callable at our option, at par. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At September 30, 2010, the interest rate on the debentures was 4.33%.
     On May 24, 2004, we received $5.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on May 24, 2034 and are callable at our option, at par. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At September 30, 2010, the interest rate on the debentures was 4.18%.
8 — Share–Based Compensation
     We measure all share-based payments to employees, including grants of stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates other than Donegal Mutual, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilized in applying the Black-Scholes option pricing model are the risk-free interest rate, expected term, dividend yield and expected volatility.
     Compensation expense related to our stock compensation plans was immaterial for the three and nine months ended September 30, 2010 and 2009. As of September 30, 2010, our total unrecognized compensation cost related to nonvested share-based compensation granted under our stock compensation plans was $303,607. We expect to recognize this cost over a weighted average period of 2.1 years.
     We account for share-based compensation to employees and directors of Donegal Mutual as share-based compensation to employees of a controlling entity. As such, we measure the fair value of the award at the grant date and recognize the fair value as a dividend to Donegal Mutual. This accounting applies to options we grant to employees and directors of Donegal Mutual, the employer of a majority of the employees

13


 

that provide services to us. We recorded implied dividends of $1.3 million and $30,068 for the three months ended September 30, 2010 and 2009, respectively. We recorded implied dividends of $1.3 million and $62,991 for the nine months ended September 30, 2010 and 2009, respectively.
     We received no cash from option exercises under all stock option compensation plans for the nine months ended September 30, 2010 and 2009. We realized no tax benefits for tax deductions from option exercises for the nine months ended September 30, 2010 and 2009.
9 — Fair Value Measurements
     We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of inputs, or assumptions, used in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories:
     Level 1 — quoted prices in active markets for identical assets and liabilities;
     Level 2 — directly or indirectly observable inputs other than Level 1 quoted prices; and
     Level 3 — unobservable inputs not corroborated by market data.
     For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or broker quotes we obtain from independent pricing services through a bank trustee. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury securities and obligations of U.S, government corporations and agencies, obligations of states and political subdivisions, corporate securities and residential mortgage-backed securities. During the first nine months of 2010, we classified one equity security as Level 3. We utilized a fair value model that incorporated significant other unobservable inputs, such as estimated volatility, to estimate the equity security’s fair value. Pursuant to terms of an initial public offering, we are restricted from selling this security for a specified period, and the fair value we determined as of September 30, 2010 reflects this restriction. During the first nine months of 2010, we recorded an unrealized loss of $171,891 related to this security in other comprehensive income.
     We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values for our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements using proprietary pricing applications, which include available relevant market information, benchmark yields, sector curves and matrix pricing. The pricing services do not use broker quotes in determining the fair values of our investments. We review the estimates of fair value the pricing services provide to determine if the estimates obtained are representative of fair values based upon our general knowledge of the market, our research findings related to unusual fluctuations in value and our comparison of such values to execution prices for similar securities. As of September 30, 2010 and December 31, 2009, we received one estimate per security from one of the pricing services, and we priced all but an insignificant amount of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided as of September 30, 2010 and December 31, 2009, we did not identify any discrepancies, and we did not make any adjustments to the estimates the pricing services provided.
     We present our cash and short-term investments at cost, which approximates fair value. The carrying values in the balance sheet for premium and reinsurance receivables and payables approximate their fair values. The carrying amounts reported in the balance sheet for our subordinated debentures approximate their fair values due to their variable rate nature, and there has been no change in our creditworthiness.

14


 

     We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities as of September 30, 2010:
                                 
            Fair Value Measurements Using
            Quoted              
            Prices in Active Markets     Significant Other     Significant  
            for Identical Assets     Observable Inputs     Unobservable Inputs  
    Fair Value     (Level 1)     (Level 2)     (Level 3)  
    (in thousands)  
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 48,765     $     $ 48,765     $  
Obligations of states and political subdivisions
    381,085             381,085        
Corporate securities
    56,599             56,599        
Residential mortgage-backed securities
    76,828             76,828        
Equity securities
    12,715       5,363       1,292       6,060  
     
Totals
  $ 575,992     $ 5,363     $ 564,569     $ 6,060  
     
     We did not have any transfers between Levels 1 and 2 during the quarter ended September 30, 2010.
     The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities as of December 31, 2009:
                                 
            Fair Value Measurements Using
            Quoted              
            Prices in Active Markets     Significant Other     Significant  
            for Identical Assets     Observable Inputs     Unobservable Inputs  
    Fair Value     (Level 1)     (Level 2)     (Level 3)  
    (in thousands)  
U.S. Treasury securities and obligations of U.S. government corporations and agencies
  $ 40,630     $     $ 40,630     $  
Obligations of states and political subdivisions
    358,367             358,367        
Corporate securities
    27,766             27,766        
Residential mortgage-backed securities
    90,941             90,941        
Equity securities
    9,915       2,426       1,257       6,232  
     
Totals
  $ 527,619     $ 2,426     $ 518,961     $ 6,232  
     
          The following table presents a roll forward of the significant unobservable inputs for our Level 3 securities for the three months ended September 30, 2010 and 2009, respectively:
                 
    2010     2009  
    (in thousands)  
Balance, June 30
  $ 6,326     $  
Transfer to Level 3
          4,960  
Net unrealized loss
    (266 )      
 
           
Balance, September 30
  $ 6,060     $ 4,960  
 
           

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     The following table presents a roll forward of the significant unobservable inputs for our Level 3 securities for the nine months ended September 30, 2010 and 2009, respectively:
                 
    2010     2009  
    (in thousands)  
Balance, January 1
  $ 6,232     $  
Transfer to Level 3
          4,960  
Net unrealized loss
    (172 )      
 
           
Balance, September 30
  $ 6,060     $ 4,960  
 
           
10 — Income Taxes
     As of September 30, 2010 and December 31, 2009, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. The Internal Revenue Service examined our 2006 federal tax return and made no adjustments to the taxes we had reported. Tax years 2007, 2008 and 2009 remained open for examination as of September 30, 2010.
11 — Impact of New Accounting Standards
          In June 2009, the FASB issued FAS 166, “Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140,” codified in ASC subtopic 860-20. ASC subtopic 860-20 amends the derecognition guidance in Statement 140 and eliminates the concept of qualifying special-purpose entities. ASC subtopic 860-20 is effective for fiscal years and interim periods beginning after November 15, 2009. We adopted ASC subtopic 860-20 on January 1, 2010. The adoption did not impact our financial position or results of operations.
          In June 2009, the FASB issued FAS 167, “Amendments to FASB Interpretation No. 46(R),” which amends the consolidation guidance applicable to variable interest entities (“VIEs”) and is codified in ASC subtopic 810-10. An entity would consolidate a VIE, as the primary beneficiary, when the entity has both of the following characteristics: (a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (b) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. ASC subtopic 810-10 requires ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE. ASC subtopic 810-10 amends interpretation 46(R) to eliminate the quantitative approach previously required for determining the primary beneficiary of a VIE. ASC subtopic 810-10 is effective for fiscal years and interim periods beginning after November 15, 2009. We adopted ASC subtopic 810-10 on January 1, 2010. The adoption did not impact our financial position or results of operations.
          In January 2010, the FASB issued Accounting Standards Update (ASU) 2010-06, “Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends ASC subtopic 820-10 by requiring new, and clarifying existing, fair value disclosures. ASU 2010-06 is effective for the interim period ended March 31, 2010, except for certain new Level 3 roll forward disclosures, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. We have included herein the disclosures ASU 2010-06 requires for the first nine months of 2010, and we will include the Level 3 roll forward disclosures ASU 2010-06 requires for fiscal years and interim periods beginning after December 31, 2010.
          In October 2010, the FASB issued updated guidance to address the diversity in practice for the accounting for costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost must be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. If application of this guidance would result in the capitalization of acquisition costs that a reporting entity had not previously capitalized, the entity may elect not to capitalize those costs. The updated guidance is effective for periods ending after December 15, 2011. We do not expect the adoption of this guidance to have a material impact on our financial position or results of operations.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
     You should read the following information in conjunction with the historical financial information and the notes thereto included in this Quarterly Report on Form 10-Q and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2009.
Critical Accounting Policies and Estimates
     We combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.
     Our insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures that we report in our financial statements. The most significant estimates relate to our insurance subsidiaries’ reserves for property and casualty insurance unpaid losses and loss expenses, valuation of investments and determination of other-than-temporary impairment in the value of investments and policy acquisition costs. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts may differ from the amounts estimated. We regularly review these estimates and reflect any adjustment we consider necessary in our current results of operations.
Liability for Unpaid Losses and Loss Expenses
     Liabilities for unpaid losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to policyholder claims based on facts and circumstances the insurer then knows. An insurer recognizes at the time it establishes its estimates that its ultimate liability for unpaid losses and loss expenses will exceed or be less than those estimates. Our insurance subsidiaries base their estimates of liabilities for unpaid losses and loss expenses on assumptions as to future loss trends and expected claims severity, judicial theories of liability and other factors, including prevailing economic conditions. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to adjust their estimates of liability. Our insurance subsidiaries reflect any adjustments to their liabilities for unpaid losses and loss expenses in their results of operations for the period in which our insurance subsidiaries change their estimates.
     Our insurance subsidiaries maintain liabilities for the payment of unpaid losses and loss expenses with respect to both reported and unreported claims. It is the intent of our insurance subsidiaries that their liabilities for loss expenses will cover the ultimate costs of settling all losses, including investigation and litigation costs from those losses. Our insurance subsidiaries base the amount of their liabilities for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the provisions of our insurance policies relating to the type of loss. Our insurance subsidiaries determine the amount of their liabilities for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries closely monitor their liabilities and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for unpaid losses and loss expenses.
     Our liability estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions as to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while claims severity has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on bodily injury claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include accurate measurement of the impact of rate changes and changes in policy provisions and consistency in the quality and characteristics of business written within a given line of business among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments they consider appropriate for those changes in their liabilities.

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Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded at September 30, 2010. For every 1% change in our estimate of our insurance subsidiaries’ liability for unpaid losses and loss expenses, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $1.9 million.
     The establishment of appropriate liabilities is an inherently uncertain process. There can be no assurance that the ultimate liability of our insurance subsidiaries will not exceed our insurance subsidiaries’ unpaid loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, since the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for unpaid losses and loss expenses in certain periods, and in other periods their estimates have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimate of their liabilities for unpaid losses and loss expenses generally reflect actual payments and the evaluation of information received since the prior reporting date.
     Excluding the impact of severe weather events, our insurance subsidiaries have noted slight downward trends in the number of claims incurred and the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the property and casualty insurance industry has experienced increased litigation trends, periods in which economic conditions have extended the estimated length of disabilities, increased medical loss cost trends and a general slowing of settlement rates in litigated claims. We may make adjustments in the future to reflect subsequent developments. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liabilities for unpaid losses and loss expenses as of September 30, 2010.
     Atlantic States’ participation in the pool with Donegal Mutual exposes it to adverse loss development on the business of Donegal Mutual that is included in the pool. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share any adverse risk development of the pooled business according to their respective participation in the pool. The business in the pool is homogeneous, and the pooling agreement provides that each company has a percentage share of the entire pool. Since Atlantic States and Donegal Mutual pool substantially all their business and each company shares the results according to its respective participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than they would experience individually and to spread the risk of loss between Atlantic States and Donegal Mutual.
     The risk profiles of the business Atlantic States and Donegal Mutual write have historically been, and continue to be, substantially similar. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries.

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     In addition, Donegal Mutual and our insurance subsidiaries, operating together as the Donegal Insurance Group, share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business directly written by the individual companies will vary. However, because the pool homogenizes the risk characteristics of all business written directly by Donegal Mutual and Atlantic States and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool. Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business as of September 30, 2010 and December 31, 2009 consisted of the following:
                 
    September 30,     December 31,  
    2010     2009  
    (in thousands)  
Commercial lines:
               
Automobile
  $ 20,437     $ 21,465  
Workers’ compensation
    40,835       38,092  
Commercial mult-peril
    32,234       30,640  
Other
    2,235       1,886  
 
           
Total commercial lines
    95,741       92,083  
 
           
 
               
Personal lines:
               
Automobile
  $ 72,537     $ 70,019  
Homeowners
    15,034       16,312  
Other
    1,721       1,848  
 
           
Total personal lines
    89,292       88,179  
 
           
 
               
Total commercial and personal lines
    185,033       180,262  
Plus reinsurance recoverable
    93,603       83,337  
 
           
Total liability for unpaid losses and loss expenses
  $ 278,636     $ 263,599  
 
           

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     We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing loss and loss expense reserves:
                                     
        Adjusted Loss and                
Percentage   Loss Expense           Adjusted Loss and    
Change in Loss   Reserves Net of   Percentage Change   Loss Expense   Percentage Change
and Loss Expense   Reinsurance as of   in Stockholders’ Equity as of   Reserves Net of   in Stockholders’ Equity as of
Reserves Net of   September 30,   September 30,   Reinsurance as of   December 31,
Reinsurance   2010   2010(1)   December 31, 2009   2009(1)
(dollars in thousands)
  (10.0 )%   $ 166,530       3.0 %   $ 162,236       3.0 %
  (7.5 )     171,156       2.3       166,742       2.3  
  (5.0 )     175,781       1.5       171,249       1.5  
  (2.5 )     180,407       0.8       175,755       0.8  
Base     185,033             180,262        
  2.5       189,659       -0.8       184,769       -0.8  
  5.0       194,285       -1.5       189,275       -1.5  
  7.5       198,910       -2.3       193,782       -2.3  
  10.0       203,536       -3.0       198,288       -3.0  
 
(1)   Net of income tax effect.

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Statutory Combined Ratios
     We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting (loss) income, combined ratio and net premiums written. An insurance company’s statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to premium written and the ratio of dividends to policyholders to premiums earned. The combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, installment payment fees are not deducted from incurred expenses, and the expense ratio is based on premiums earned instead of premiums written. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and nine months ended September 30, 2010 and 2009:
                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
    2010     2009     2010     2009  
Commercial lines:
                               
Automobile
    88.2 %     89.4 %     89.4 %     89.5 %
Workers’ compensation
    108.4       76.1       99.6       94.3  
Commercial multi-peril
    85.2       83.6       101.1       92.3  
Other
    51.0       38.3       37.4       31.5  
Total commercial lines
    91.3       81.9       95.1       90.0  
 
                               
Personal lines:
                               
Automobile
    101.2       103.7       100.5       101.9  
Homeowners
    111.8       101.9       118.5       114.8  
Other
    105.0       90.5       104.6       89.4  
Total personal lines
    104.8       102.6       106.3       105.1  
 
                               
Total commercial and personal lines
    100.7       96.2       102.8       100.3  
Investments
     We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, when we consider the decline in value of an individual investment to be other than temporary, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations. We individually monitor all investments for other-than-temporary declines in value. Generally, if an individual equity security has depreciated in value by more than 20% of original cost, and has been in such an unrealized loss position for more than six months, we assume there has been an other-than-temporary decline in value. We held six equity securities that were in an unrealized loss position at September 30, 2010. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we consider these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the security prior to recovery. If it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. To determine whether a credit loss has occurred, we compare the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider a credit loss to have occurred. If we consider that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of

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applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including the fair value of the investment being significantly below its cost, whether the financial condition of the issuer of a security is deteriorating, the occurrence of industry, company and geographic events that have negatively impacted the value of a security and rating agency downgrades. We determined that no investments with a fair value below cost had declined on an other-than-temporary basis during the first nine months of 2010 and 2009, respectively.
     We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if the security was sold in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values for our fixed maturity and equity investments. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements using proprietary pricing applications, which include available relevant market information, benchmark yields, sector curves and matrix pricing. The pricing services do not use broker quotes in determining the fair values of our investments. We review the estimates of fair value the pricing services provide to determine if the estimates obtained are representative of market prices based upon our general knowledge of the market, our research findings related to unusual fluctuations in value and our comparison of such values to execution prices for similar securities. As of September 30, 2010 and December 31, 2009, we received one estimate per security from one of the pricing services, and we priced all but an insignificant amount of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided as of September 30, 2010 and December 31, 2009, we did not identify any discrepancies, and we did not make any adjustments to the fair value estimates the pricing services provided. We classified one equity security as Level 3 as of September 30, 2010, as described in Footnote 9 to the Notes to Consolidated Financial Statements. We utilized a fair value model that incorporated significant other unobservable inputs, such as estimated volatility, to estimate the equity security’s fair value. Pursuant to terms of an initial public offering, we are restricted from selling this security for a specified period, and the fair value we determined as of September 30, 2010 reflects this restriction.
Policy Acquisition Costs
     Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that vary with and relate primarily to the production of business. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums.
Results of Operations — Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009
          Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended September 30, 2010 were $101.9 million, an increase of $8.3 million, or 8.8%, from the $93.6 million of net premiums written for the comparable period in 2009. Personal lines net premiums written increased $5.6 million, or 8.4%, for the third quarter of 2010 compared to the comparable period in 2009. The increase was attributable to $2.2 million of additional personal lines premiums received from the pooling agreement as a result of Donegal Mutual’s affiliation with Southern Mutual, as well as increased writings in the personal automobile and homeowners lines of business. Commercial lines net premiums written increased $2.7 million, or 10.1%, for the third quarter of 2010 compared to the comparable period in 2009 due to increased writings in the commercial automobile, commercial multi-peril and workers’ compensation lines of business.
          Net Premiums Earned. Our insurance subsidiaries’ net premiums earned were $94.9 million, an increase of $6.9 million, or 7.8%, compared to $88.0 million for the third quarter of 2009. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12 month period compared to the comparable period one year earlier.

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          Investment Income. For the three months ended September 30, 2010, our net investment income decreased to $4.7 million, compared to $5.1 million for the comparable period one year ago. An increase in our average invested assets from $647.0 million for the third quarter of 2009 to $676.0 million for the third quarter of 2010 was offset by a decrease in our annualized average rate of return to 2.8% in 2010, compared to 3.2% in 2009. Our annualized average rate of return on investments decreased primarily due to lower market interest rates over the past year.
          Net Realized Investment Gains. Net realized investment gains for the third quarter of 2010 were $2.5 million, compared to $189,230 for the comparable period in 2009. The increase in net realized investment gains arose primarily from strategic sales of fixed maturity and equity investments during the third quarter of 2010. We did not recognize any impairment losses during the third quarter of 2010 or 2009.
          Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2010 was 71.0%, an increase from our 66.6% loss ratio for the third quarter of 2009. Our insurance subsidiaries incurred weather-related losses of approximately $9.9 million after reinsurance during the third quarter of 2010, primarily related to a number of wind and hail events in the Mid-Atlantic and Midwestern regions, compared to approximately $5.9 million during the third quarter of 2009. Our insurance subsidiaries incurred fire losses of approximately $4.5 million during the third quarter of 2010, compared to approximately $2.0 million during the third quarter of 2009. Our insurance subsidiaries’ loss ratio was also impacted by an increase in casualty claim severity during the third quarter of 2010 compared to the third quarter of 2009. Our insurance subsidiaries recognized a decrease in their liability for losses and loss expenses of prior years of approximately $800,000 in the third quarter of 2010, compared to an increase of approximately $1.6 million in the third quarter of 2009. Our insurance subsidiaries’ commercial lines loss ratio increased to 63.2% for the third quarter of 2010, compared to 52.7% for the third quarter of 2009, primarily due to increases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines loss ratio increased to 74.5% for the third quarter of 2010, compared to 72.0% for the third quarter of 2009, primarily due to increases in the homeowners loss ratio.
          Underwriting Expenses. Our insurance subsidiaries’ expense ratio, which is the ratio of policy acquisition costs and other underwriting expenses to premiums earned, for the third quarters of 2010 and 2009 was 32.0%. The expense ratio for both periods reflected decreased expenses incurred for underwriting-based incentive compensation costs as a result of our higher loss ratios.
          Combined Ratio. Our insurance subsidiaries’ combined ratio was 103.2% and 98.9% for the three months ended September 30, 2010 and 2009, respectively. The combined ratio represents the sum of the loss ratio, expense ratio and dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned. The increase in the combined ratio was attributable to an increase in the loss ratio.
          Interest Expense. Interest expense for the third quarter of 2010 was $183,616, compared to $185,315 for the third quarter of 2009. The slightly lower interest expense in the 2010 period reflected a decrease in average interest rates on our subordinated debentures for the third quarter of 2010 compared to the comparable period in 2009.
          Income Taxes. Income tax expense was $125,032 for the third quarter of 2010, representing an effective tax rate of 2.5%, compared to $620,402 for the third quarter of 2009, representing an effective tax rate of 8.4%. Effective tax rates in both periods represented estimates based on projected annual taxable income, with the decrease in 2010 attributable to tax-exempt interest representing a larger proportion of our income before taxes.
          Net Income and Earnings Per Share. Our net income for the third quarter of 2010 was $4.9 million, or $.20 per share of Class A common stock and $.18 per share of Class B common stock, compared to net income of $6.7 million, or $.27 per share of Class A common stock and $.24 per share of Class B common stock, for the third quarter of 2009. We had 20.0 million and 19.9 million shares of our Class A shares outstanding for the third quarters of 2010 and 2009, respectively. We had 5.6 million Class B shares outstanding for both periods.

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Results of Operations — Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009
          Net Premiums Written. Our insurance subsidiaries’ net premiums written for the nine months ended September 30, 2010 were $297.2 million, an increase of $22.0 million, or 8.0%, from the $275.2 million of net premiums written for the comparable period in 2009. Personal lines net premiums written increased $14.0 million, or 7.4%, for the first nine months of 2010 compared to the comparable period in 2009. We attribute the increase to $7.0 million of additional personal lines premiums received from the pooling agreement as a result of Donegal Mutual’s affiliation with Southern Mutual, as well as increased writings in the personal automobile and homeowners lines of business. Commercial lines net premiums written increased $8.0 million, or 9.2%, for the first nine months of 2010 compared to the comparable period in 2009 due to increased writings in the commercial automobile, commercial multi-peril and workers’ compensation lines of business.
          Net Premiums Earned. Our insurance subsidiaries’ net premiums earned were $279.3 million, an increase of $15.4 million, or 5.8%, compared to $263.9 million for the first nine months of 2009. Our insurance subsidiaries earn premiums and recognize them as revenue over the terms of their policies, which are one year or less in duration. Therefore, increases or decreases in net premiums earned generally reflect increases or decreases in net premiums written in the preceding 12 month period compared to the comparable period one year earlier.
          Investment Income. For the nine months ended September 30, 2010, our net investment income decreased to $14.6 million, compared to $15.7 million for the comparable period one year ago. An increase in our average invested assets from $647.7 million for the first nine months of 2009 to $673.3 million for the first nine months of 2010 was offset by a decrease in our annualized average rate of return to 2.9% in 2010, compared to 3.2% in 2009. Our annualized average rate of return on investments decreased primarily due to lower market interest rates over the past year.
          Net Realized Investment Gains. Net realized investment gains for the first nine months of 2010 were $4.4 million, compared to $893,225 for the comparable period in 2009. The increase in net realized gains was primarily attributable to strategic sales of fixed maturity and equity investments during the first nine months of 2010. We did not recognize any impairment losses during the first nine months of 2010 or 2009.
          Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the first nine months of 2010 was 73.0%, an increase from the 70.7% loss ratio for the first nine months of 2009. Our insurance subsidiaries incurred weather-related losses of approximately $29.0 million after reinsurance during the first nine months of 2010, primarily related to a number of wind and hail events in the Mid-Atlantic and Midwestern regions and two major winter storms in the Mid-Atlantic region, compared to approximately $21.5 million during the first nine months of 2009. Our insurance subsidiaries incurred fire losses of approximately $18.5 million during the first nine months of 2010, compared to approximately $12.5 million during the first nine months of 2009. Our insurance subsidiaries recognized a decrease in their liability for losses and loss expenses of prior years of approximately $700,000 in the first nine months of 2010, compared to an increase of approximately $8.4 million in the first nine months of 2009. Our insurance subsidiaries’ commercial lines loss ratio increased to 67.3% for the first nine months of 2010, compared to 61.5% for the first nine months of 2009, primarily due to increases in the commercial multi-peril and workers’ compensation loss ratios. The personal lines loss ratio increased to 75.7% for the first nine months of 2010, compared to 74.8% for the first nine months of 2009, primarily due to increases in the homeowners loss ratios.
          Underwriting Expenses. Our insurance subsidiaries’ expense ratio, which is the ratio of policy acquisition costs and other underwriting expenses to premiums earned, for the first nine months of 2010 was 32.0%, compared to 31.3% for the first nine months of 2009. The expense ratio for both periods reflected decreased expenses incurred for underwriting-based incentive compensation costs as a result of higher loss ratios.
          Combined Ratio. Our insurance subsidiaries’ combined ratio was 105.2% and 102.2% for the nine months ended September 30, 2010 and 2009, respectively. The combined ratio represents the sum of the loss ratio, expense ratio and dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned. The increase in the combined ratio is primarily due to an increase in the loss ratio.
          Interest Expense. Interest expense for the first nine months of 2010 was $537,309, compared to $1.6 million for the first nine months of 2009. The lower interest expense in the 2010 period reflected a decrease in average interest rates on our subordinated debentures for the first nine months of 2010

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compared to the comparable period in 2009. Interest expense for the first nine months of 2009 included $974,000 related to interest and penalties on contested premium tax litigation paid during that period.
          Income Taxes. Income tax expense was $296,960 for the first nine months of 2010, representing an effective tax rate of 4.1%, compared to $1.4 million for the first nine months of 2009, representing an effective tax rate of 11.1%. Effective tax rates in both periods represented estimates based on projected annual taxable income, with the decrease in 2010 attributable to tax-exempt interest representing a larger proportion of income before taxes.
          Net Income and Earnings Per Share. Our net income for the first nine months of 2010 was $6.9 million, or $.28 per share of Class A common stock and $.25 per share of Class B common stock, compared to net income of $11.3 million, or $.45 per share of Class A common stock and $.41 per share of Class B common stock, reported for the first nine months of 2009. We had 20.0 million Class A shares outstanding for both periods. We had 5.6 million Class B shares outstanding for both periods.
Liquidity and Capital Resources
          Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as they arise. Our major sources of funds from operations are the net cash flows generated from our insurance subsidiaries’ underwriting results, investment income and maturing investments.
          We have historically generated sufficient net positive cash flow from our operations to fund our commitments and add to our investment portfolio, thereby increasing future investment returns. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash flow positive because of the consistent underwriting profitability of the pool. We settle the pool monthly, thereby resulting in cash flows substantially similar to cash flows that would result from the underwriting of direct business. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach, so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Net cash flows provided by operating activities in the first nine months of 2010 and 2009 were $11.8 million and $18.9 million, respectively, with the change in cash flows due primarily to increased claim payments during the first nine months of 2010.
          In June 2010, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $35.0 million unsecured, revolving line of credit that will expire in September 2013. We may request a one-year extension of the credit agreement as of each anniversary date of the agreement. As of September 30, 2010, we had the ability to borrow $35.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus between 1.75% and 2.25%, depending on our leverage ratio. In October 2010, we requested and received approval of an increase in the credit amount to $60.0 million. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants, which include minimum levels of our net worth, leverage ratio and statutory surplus and the A.M. Best ratings of our insurance subsidiaries. During the nine months ended September 30, 2010, we had no borrowings outstanding under the credit agreement, and we were in compliance with all requirements of the credit agreement.
          The following table shows our expected payments for significant contractual obligations as of September 30, 2010.
                                         
            Less than 1                    
    Total     year     1-3 years     4-5 years     After 5 years  
    (in thousands)  
Net liability for unpaid losses and loss expenses of our insurance subsidiaries
  $ 185,033     $ 84,308     $ 83,365     $ 7,722     $ 9,638  
Subordinated debentures
    15,465                         15,465  
 
                             
 
                                       
Total contractual obligations
  $ 200,498     $ 84,308     $ 83,365     $ 7,722     $ 25,103  
 
                             

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          We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. The liability is shown net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes pursuant to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. We include cash settlement of Atlantic States’ assumed liability from the pool in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States’ for its percentage share of pooled losses occurring in periods prior to the effective date of such change.
          We estimate the date of payment for the subordinated debentures based on their contractual maturities. The debentures are redeemable at our option, at par, as discussed in Note 7 — Subordinated Debentures. The subordinated debentures carry interest rates that vary based upon the three-month LIBOR rate and adjust quarterly. Based upon the interest rates in effect as of September 30, 2010, our annual interest cost associated with the subordinated debentures is approximately $642,000. For every 1% change in the three-month LIBOR rate, the effect on our annual interest cost would be approximately $150,000.
          On February 23, 2009, our board of directors authorized a share repurchase program, pursuant to which we may purchase up to 300,000 shares of our Class A common stock at prices prevailing from time to time in the open market subject to the applicable SEC rules and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the three months ended September 30, 2010 and 2009, respectively. We purchased 9,702 and no shares of our Class A common stock under this program during the nine months ended September 30, 2010 and 2009, respectively. We have purchased a total of 17,371 shares of our Class A common stock under this program through September 30, 2010.
          On October 21, 2010, our board of directors declared quarterly cash dividends of 11.5 cents per share for our Class A common stock and 10.25 cents per share for our Class B common stock, payable November 15, 2010 to stockholders of record as of the close of business on November 1, 2010. There are no regulatory restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of annual dividends greater than 10% of statutory surplus by our insurance subsidiaries to us. Our insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis and require prior approval of the applicable domiciliary insurance regulatory authorities for dividends in excess of 10% of statutory surplus. Our insurance subsidiaries are subject to risk-based capital (“RBC”) requirements. At December 31, 2009, our insurance subsidiaries’ capital levels were each substantially above the applicable RBC requirements. At January 1, 2010, amounts available for distribution as dividends to us from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities were $19.0 million from Atlantic States, $0 from Southern, $2.8 million from Le Mars, $3.9 million from Peninsula, and $584,431 from Sheboygan, all of which remained available at September 30, 2010.
          As of September 30, 2010, we had no material commitments for capital expenditures. We anticipate that our pending acquisitions of UNNF and MICO will close in the fourth quarter of 2010. We currently estimate that the cash purchase price of these acquisitions will total approximately $51 million, which we will derive from our existing internally generated funds, dividends from our insurance subsidiaries and draws under our line of credit.
Equity Price Risk
          Our portfolio of marketable equity securities, which is carried on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by performing an analysis of prospective investments and through regular reviews of our portfolio by our investment staff.

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Credit Risk
          Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay the debt. We manage this risk by performing an analysis of prospective investments and through regular reviews of our portfolio by our investment staff. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer.
          Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although we bill a portion of our commercial business through agents to whom our insurance subsidiaries extend credit in the normal course of business.
          Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from business ceded to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers.
Impact of Inflation
          We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
          Our market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and debt obligations.
          Our investment mix has shifted slightly due to a shift from lower-yielding short-term investments to fixed maturity investments during 2010. We have maintained approximately the same duration of our investment portfolio to our liabilities from December 31, 2009 to September 30, 2010.
          There have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2009 through September 30, 2010.
Item 4. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
          We conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to SEC Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information we, including our consolidated subsidiaries, are required to disclose in our periodic filings with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Control Over Financial Reporting
          There has been no change in our internal control over financial reporting during the quarter covered by this report that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.

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Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
          All statements contained in this report that are not historic facts are based on current expectations. Such statements are forward-looking in nature (as defined in the Private Securities Litigation Reform Act of 1995) and necessarily involve risks and uncertainties. Actual results could vary materially. The factors that could cause actual results to vary materially include, but are not limited to, our ability to maintain profitable operations, the adequacy of our reserves for unpaid losses and loss adjustment expenses, business and economic conditions in the areas in which we operate, conditions resulting from the ongoing recession in the United States, severe weather events, competition from various insurance and non-insurance businesses, terrorism, the availability and cost of reinsurance, legal and judicial developments, changes in regulatory requirements and other risks that we describe from time to time in our filings with the SEC. We disclaim any obligation to update such statements or to announce publicly the results of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
Item 4T. Controls and Procedures.
          Not applicable.

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Part II. Other Information
Item 1. Legal Proceedings.
          None.
Item 1A. Risk Factors.
     Our business, results of operations and financial condition, and, therefore, the value of our Class A common stock and Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2009 Annual Report on Form 10-K filed with the SEC on March 11, 2010. There have been no material changes in the risk factors disclosed in that Form 10-K Report during the nine months ended September 30, 2010.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
                     
                (d) Maximum Number
            (c) Total Number of   (or Approximate
            Shares (or Units)   Dollar Value) of
            Purchased as Part   Shares (or Units)
    (a) Total Number of   (b) Average   of Publicly   that May Yet Be
    Shares (or Units)   Price Paid per   Announced Plans or   Purchased Under the
Period   Purchased   Share (or Unit)   Programs   Plans or Programs
Month #1
  Class A – None   Class A – None   Class A – None        
July 1-31, 2010
  Class B – None   Class B – None   Class B – None        
 
                   
Month #2
  Class A – None   Class A – None   Class B – None        
August 1-31, 2010
  Class B – 9,738   Class B – $20.00   Class B – 9,738     (1 )
 
                   
Month #3
  Class A – None   Class A – None   Class A – None        
September 1-30, 2010
  Class B – None   Class B – None   Class B – None        
 
                   
 
  Class A – None   Class A – None   Class B – None        
Total
  Class B – 9,738   Class B – $20.00   Class B – 9,738        
 
(1)   Donegal Mutual purchased these shares pursuant to its announcement on August 17, 2004 that it will, at its discretion, purchase shares of our Class A common stock and Class B common stock at market prices prevailing from time to time in the open market subject to the provisions of SEC Rule 10b-18 and in privately negotiated transactions. Such announcement did not stipulate a maximum number of shares that may be purchased under this stock repurchase program.
Item 3. Defaults upon Senior Securities.
          None.
Item 4. Removed and Reserved.
Item 5. Other Information.
          None.

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Item 6. Exhibits.
     
Exhibit No.   Description
Exhibit 31.1
  Certification of Chief Executive Officer
 
   
Exhibit 31.2
  Certification of Chief Financial Officer
 
   
Exhibit 32.1
  Statement of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code
 
   
Exhibit 32.2
  Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 of Title 18 of the United States Code

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Signatures
     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  DONEGAL GROUP INC.
 
 
November 9, 2010  By:   /s/ Donald H. Nikolaus    
    Donald H. Nikolaus, President   
    and Chief Executive Officer   
 
     
November 9, 2010  By:   /s/ Jeffrey D. Miller    
    Jeffrey D. Miller, Senior Vice President   
    and Chief Financial Officer   
 

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