Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2014

OR

 

¨ 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  x    No  ¨

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  x    No  ¨

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   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    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  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 21,061,397 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 July 31, 2014.

 

 

 


Table of Contents

DONEGAL GROUP INC.

INDEX TO FORM 10-Q REPORT

 

          Page  
PART I    FINANCIAL INFORMATION   
Item 1.    Financial Statements      1   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      19   
Item 3.    Quantitative and Qualitative Disclosures about Market Risk      28   
Item 4.    Controls and Procedures      28   
Item 4T.    Controls and Procedures      28   
PART II    OTHER INFORMATION   
Item 1.    Legal Proceedings      29   
Item 1A.    Risk Factors      29   
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds      29   
Item 3.    Defaults upon Senior Securities      29   
Item 4.    Removed and Reserved      29   
Item 5.    Other Information      29   
Item 6.    Exhibits      30   

Signatures

     31   


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

Donegal Group Inc. and Subsidiaries

Consolidated Balance Sheets

 

     June 30,
2014
    December 31,
2013
 
     (Unaudited)        

Assets

    

Investments

    

Fixed maturities

    

Held to maturity, at amortized cost

   $ 297,627,689      $ 240,370,277   

Available for sale, at fair value

     425,979,180        403,651,965   

Equity securities, available for sale, at fair value

     26,840,004        12,422,837   

Investments in affiliates

     38,352,714        35,685,433   

Short-term investments, at cost, which approximates fair value

     30,465,711        99,677,795   
  

 

 

   

 

 

 

Total investments

     819,265,298        791,808,307   

Cash

     20,566,819        27,636,416   

Accrued investment income

     5,614,616        5,423,531   

Premiums receivable

     137,198,297        123,904,629   

Reinsurance receivable

     278,563,475        244,239,113   

Deferred policy acquisition costs

     48,132,420        43,627,510   

Deferred tax asset, net

     15,957,784        20,310,558   

Prepaid reinsurance premiums

     121,200,782        112,663,942   

Property and equipment, net

     7,419,939        6,424,703   

Accounts receivable - securities

     —          1,187,866   

Federal income taxes recoverable

     756,666        420,952   

Goodwill

     5,625,354        5,625,354   

Other intangible assets

     958,010        958,010   

Other

     1,193,550        1,179,611   
  

 

 

   

 

 

 

Total assets

   $ 1,462,453,010      $ 1,385,410,502   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

    

Liabilities

    

Unpaid losses and loss expenses

   $ 526,371,272      $ 495,619,269   

Unearned premiums

     417,150,626        382,734,642   

Accrued expenses

     14,758,909        19,265,097   

Reinsurance balances payable

     14,995,181        17,948,808   

Borrowings under lines of credit

     60,000,000        58,000,000   

Cash dividends declared

     —          3,299,182   

Subordinated debentures

     5,000,000        5,000,000   

Accounts payable - securities

     8,223,433        751,641   

Due to affiliate

     4,722,598        2,170,225   

Drafts payable

     3,683,432        1,386,285   

Other

     2,068,660        2,358,242   
  

 

 

   

 

 

 

Total liabilities

     1,056,974,111        988,533,391   
  

 

 

   

 

 

 

Stockholders’ Equity

    

Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued

     —          —     

Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 21,955,646 and 21,786,765 shares and outstanding 21,013,938 and 20,845,903 shares

     219,557        217,868   

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

     192,824,908        189,116,410   

Accumulated other comprehensive income (loss)

     4,901,381        (2,312,890

Retained earnings

     220,578,243        222,888,887   

Treasury stock

     (13,101,682     (13,089,656
  

 

 

   

 

 

 

Total stockholders’ equity

     405,478,899        396,877,111   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 1,462,453,010      $ 1,385,410,502   
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

 

     Three Months Ended June 30,  
     2014      2013  

Revenues:

     

Net premiums earned

   $ 136,589,156       $ 126,963,328   

Investment income, net of investment expenses

     4,614,484         4,670,558   

Net realized investment gains (includes $2,034,172 and $1,253,982 accumulated other comprehensive income reclassifications)

     2,034,172         1,253,982   

Lease income

     213,792         210,557   

Installment payment fees

     1,681,699         1,733,642   

Equity in earnings of Donegal Financial Services Corporation

     348,625         675,568   
  

 

 

    

 

 

 

Total revenues

     145,481,928         135,507,635   
  

 

 

    

 

 

 

Expenses:

     

Net losses and loss expenses

     97,887,449         89,519,350   

Amortization of deferred policy acquisition costs

     22,025,000         19,910,000   

Other underwriting expenses

     21,546,607         21,129,407   

Policyholder dividends

     607,247         340,582   

Interest

     443,135         333,699   

Other expenses

     652,578         1,412,439   
  

 

 

    

 

 

 

Total expenses

     143,162,016         132,645,477   
  

 

 

    

 

 

 

Income before income tax expense

     2,319,912         2,862,158   

Income tax expense (includes $691,619 and $426,354 income tax expense from reclassification items)

     381,242         233,171   
  

 

 

    

 

 

 

Net income

   $ 1,938,670       $ 2,628,987   
  

 

 

    

 

 

 

Earnings per common share:

     

Class A common stock - basic

   $ 0.08       $ 0.10   
  

 

 

    

 

 

 

Class A common stock - diluted

   $ 0.07       $ 0.10   
  

 

 

    

 

 

 

Class B common stock - basic and diluted

   $ 0.07       $ 0.09   
  

 

 

    

 

 

 

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

 

     Three Months Ended June 30,  
     2014     2013  

Net income

   $ 1,938,670      $ 2,628,987   

Other comprehensive income (loss), net of tax

    

Unrealized gain (loss) on securities:

    

Unrealized holding income (loss) during the period, net of income tax (benefit) expense of $2,288,044 and ($11,419,131)

     4,307,342        (21,171,130

Reclassification adjustment for gains included in net income, net of income tax expense of $691,619 and $426,354

     (1,342,553     (827,628
  

 

 

   

 

 

 

Other comprehensive income (loss)

     2,964,789        (21,998,758
  

 

 

   

 

 

 

Comprehensive income (loss)

   $ 4,903,459      $ (19,369,771
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

 

     Six Months Ended June 30,  
     2014      2013  

Revenues:

     

Net premiums earned

   $ 270,137,417       $ 251,665,369   

Investment income, net of investment expenses

     9,230,260         9,486,001   

Net realized investment gains (includes $1,945,640 and $2,594,546 accumulated other comprehensive income reclassifications)

     1,945,640         2,594,546   

Lease income

     426,582         425,954   

Installment payment fees

     3,323,249         3,443,883   

Equity in earnings of Donegal Financial Services Corporation

     757,867         1,764,474   
  

 

 

    

 

 

 

Total revenues

     285,821,015         269,380,227   
  

 

 

    

 

 

 

Expenses:

     

Net losses and loss expenses

     195,519,841         175,052,366   

Amortization of deferred policy acquisition costs

     43,344,000         39,470,000   

Other underwriting expenses

     42,005,326         39,880,918   

Policyholder dividends

     1,001,750         815,855   

Interest

     808,617         820,848   

Other expenses

     1,614,785         2,394,793   
  

 

 

    

 

 

 

Total expenses

     284,294,319         258,434,780   
  

 

 

    

 

 

 

Income before income tax expense

     1,526,696         10,945,447   

Income tax expense (includes $661,518 and $882,146 income tax expense from reclassification items)

     222,440         1,841,024   
  

 

 

    

 

 

 

Net income

   $ 1,304,256       $ 9,104,423   
  

 

 

    

 

 

 

Earnings per common share:

     

Class A common stock - basic and diluted

   $ 0.05       $ 0.35   
  

 

 

    

 

 

 

Class B common stock - basic and diluted

   $ 0.04       $ 0.32   
  

 

 

    

 

 

 

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

 

     Six Months Ended June 30,  
     2014     2013  

Net income

   $ 1,304,256      $ 9,104,423   

Other comprehensive income (loss), net of tax

    

Unrealized gain (loss) on securities:

    

Unrealized holding income (loss) during the period, net of income tax (benefit) expense of $4,546,126 and ($13,144,225)

     8,498,393        (24,336,575

Reclassification adjustment for gains included in net income, net of income tax expense of $661,518 and $882,146

     (1,284,122     (1,712,400
  

 

 

   

 

 

 

Other comprehensive income (loss)

     7,214,271        (26,048,975
  

 

 

   

 

 

 

Comprehensive income (loss)

   $ 8,518,527      $ (16,944,552
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

Donegal Group Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Equity

(Unaudited)

Six Months Ended June 30, 2014

 

    Class A
Shares
    Class B
Shares
    Class A
Amount
    Class B
Amount
    Additional
Paid-In
Capital
    Accumulated
Other
Comprehensive
Income (Loss)
    Retained
Earnings
    Treasury
Stock
    Total
Stockholders’
Equity
 

Balance, December 31, 2013

    21,786,765        5,649,240      $ 217,868      $ 56,492      $ 189,116,410      $ (2,312,890   $ 222,888,887      $ (13,089,656   $ 396,877,111   

Issuance of common stock (stock compensation plans)

    168,881        —          1,689        —          3,433,225        —          —          —          3,434,914   

Net income

    —          —          —          —          —          —          1,304,256        —          1,304,256   

Cash dividends declared

    —          —          —          —          —          —          (3,403,301     —          (3,403,301

Grant of stock options

    —          —          —          —          211,599        —          (211,599     —          —     

Tax benefit on exercise of stock options

    —          —          —          —          63,674        —          —          —          63,674   

Repurchase of treasury shares

    —          —          —          —          —          —          —          (12,026     (12,026

Other comprehensive income

    —          —          —          —          —          7,214,271        —          —          7,214,271   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, June 30, 2014

    21,955,646        5,649,240      $ 219,557      $ 56,492      $ 192,824,908      $ 4,901,381      $ 220,578,243      $ (13,101,682   $ 405,478,899   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

     Six Months Ended June 30,  
     2014     2013  

Cash Flows from Operating Activities:

    

Net income

   $ 1,304,256      $ 9,104,423   
  

 

 

   

 

 

 

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     1,690,186        1,731,939   

Net realized investment gains

     (1,945,640     (2,594,546

Equity in earnings of Donegal Financial Services Corporation

     (757,867     (1,764,474

Changes in assets and liabilities:

    

Losses and loss expenses

     30,752,003        30,822,822   

Unearned premiums

     34,415,984        29,053,529   

Premiums receivable

     (13,293,668     (14,796,642

Deferred acquisition costs

     (4,504,910     (3,186,920

Deferred income taxes

     468,165        1,462,275   

Reinsurance receivable

     (34,324,362     (24,634,256

Prepaid reinsurance premiums

     (8,536,840     (7,688,112

Accrued investment income

     (191,085     217,457   

Due to affiliate

     2,552,373        (5,195,486

Reinsurance balances payable

     (2,953,627     6,409,821   

Current income taxes

     (335,714     (2,924,912

Accrued expenses

     (4,506,188     (240,983

Other, net

     1,993,623        1,000,041   
  

 

 

   

 

 

 

Net adjustments

     522,433        7,671,553   
  

 

 

   

 

 

 

Net cash provided by operating activities

     1,826,689        16,775,976   
  

 

 

   

 

 

 

Cash Flows from Investing Activities:

    

Purchases of fixed maturities, held to maturity

     (80,370,767     —     

Purchases of fixed maturities, available for sale

     (47,084,249     (105,331,013

Purchases of equity securities, available for sale

     (14,310,274     (7,960,000

Maturity of fixed maturities:

    

Held to maturity

     24,283,903        7,594,156   

Available for sale

     16,443,132        33,013,851   

Sales of fixed maturities, available for sale

     20,772,908        51,460,696   

Sales of equity securities, available for sale

     4,858,654        7,964,080   

Net purchases of property and equipment

     (1,428,190     (334,227

Net decrease in investment in affiliates

     —          465,000   

Net sales of short-term investments

     69,212,084        8,913,405   
  

 

 

   

 

 

 

Net cash used in investing activities

     (7,622,799     (4,214,052
  

 

 

   

 

 

 

Cash Flows from Financing Activities:

    

Cash dividends paid

     (6,702,483     (6,292,981

Issuance of common stock

     3,441,022        4,889,211   

Purchase of treasury stock

     (12,026     —     

Payments on subordinated debentures

     —          (15,465,000

Payments on line of credit

     (1,000,000     (9,000,000

Borrowings under lines of credit

     3,000,000        18,500,000   
  

 

 

   

 

 

 

Net cash used in financing activities

     (1,273,487     (7,368,770
  

 

 

   

 

 

 

Net (decrease) increase in cash

     (7,069,597     5,193,154   

Cash at beginning of period

     27,636,416        19,801,290   
  

 

 

   

 

 

 

Cash at end of period

   $ 20,566,819      $ 24,994,444   
  

 

 

   

 

 

 

Cash paid during period - Interest

   $ 675,313      $ 831,215   

Net cash paid during period - Taxes

   $ —        $ 3,100,000   

See accompanying notes to consolidated financial statements.

 

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Table of Contents

DONEGAL GROUP INC. AND SUBSIDIARIES

(Unaudited)

Notes to Consolidated Financial Statements

 

1- Organization

Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, 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, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. UCB has 13 banking offices, all of which are located in Lancaster County, Pennsylvania. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC.

We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies.

At June 30, 2014, Donegal Mutual held approximately 37% of our outstanding Class A common stock and approximately 76% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 65% of the total voting power of our common stock. We believe Donegal Mutual’s voting control is beneficial to us for the reasons we describe in our Annual Report on Form 10-K. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products.

Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, the two companies pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business.

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. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the 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 versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States.

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 rules of the Securities and Exchange Commission (the “SEC”) and in privately negotiated transactions. We purchased 846 shares of our Class A common stock under this program during the six months ended June 30, 2014. We did not purchase any shares under this program during the six-month period ended June 30, 2013. We have purchased a total of 296,778 shares of our Class A common stock under this program from its inception through June 30, 2014.

On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the six-month period ended June 30, 2014.

 

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Table of Contents
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 six months ended June 30, 2014 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2014.

You should read these interim financial statements in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2013.

 

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 shall simultaneously declare a dividend on our Class A common stock that is payable to the holders of our Class A common stock at the same time and 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 a 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 our common stock:

 

     Three Months Ended June 30,  
     2014      2013  
     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

   $ 1,577       $ 362       $ 2,102       $ 527   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator:

           

Weighted-average shares outstanding

     20,961,526         5,576,775         21,202,571         5,576,775   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic net income per share

   $ 0.08       $ 0.07       $ 0.10       $ 0.09   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share:

           

Numerator:

           

Allocation of net income

   $ 1,577       $ 362       $ 2,102       $ 527   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator:

           

Number of shares used in basic computation

     20,961,526         5,576,775         21,202,571         5,576,775   

Weighted-average shares effect of dilutive securities

           

Add: Director and employee stock options

     388,838         —           401,309         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Number of shares used in per share computations

     21,350,364         5,576,775         21,603,880         5,576,775   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share

   $ 0.07       $ 0.07       $ 0.10       $ 0.09   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents
     Six Months Ended June 30,  
     2014      2013  
     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

   $ 1,067       $ 237       $ 7,304       $ 1,801   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator:

           

Weighted-average shares outstanding

     20,917,529         5,576,775         20,637,801         5,576,775   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic net income per share

   $ 0.05       $ 0.04       $ 0.35       $ 0.32   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share:

           

Numerator:

           

Allocation of net income

   $ 1,067       $ 237       $ 7,304       $ 1,801   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator:

           

Number of shares used in basic computation

     20,917,529         5,576,775         20,637,801         5,576,775   

Weighted-average shares effect of dilutive securities

           

Add: Director and employee stock options

     384,512         —           346,296         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Number of shares used in per share computations

     21,302,041         5,576,775         20,984,097         5,576,775   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share

   $ 0.05       $ 0.04       $ 0.35       $ 0.32   
  

 

 

    

 

 

    

 

 

    

 

 

 

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 of our Class A common stock during the applicable period:

 

     Three Months Ended June 30,      Six Months Ended June 30,  
     2014      2013      2014      2013  

Number of options to purchase Class A shares excluded

     2,523,500         1,199,000         2,548,500         1,199,000   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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 premiums 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. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool.

Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also purchase separate third-party reinsurance that provides coverage that we believe is commensurate with their relative size and exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with requirements of our insurance subsidiaries and Donegal Mutual, 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 from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place at June 30, 2014:

 

    excess of loss reinsurance, under which losses are automatically reinsured, through a series of reinsurance agreements, over a set retention (generally $1.0 million), 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 (generally $5.0 million) and after exceeding an annual aggregate deductible (generally $1.5 million) up to aggregate losses of $149.0 million per occurrence.

 

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Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures from losses that exceed the limits their third-party reinsurance agreements provide.

MICO maintains a quota-share reinsurance agreement with third-party reinsurers to reduce its net exposures. Effective January 1, 2014, the quota-share reinsurance percentage was 20%.

In addition to the pooling agreement and third-party reinsurance, our insurance subsidiaries have various reinsurance agreements with Donegal Mutual.

Other than the changes we discuss above, we have made no significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the six months ended June 30, 2014.

 

5- Investments

The amortized cost and estimated fair values of our fixed maturities and equity securities at June 30, 2014 were as follows:

 

     Amortized Cost      Gross Unrealized
Gains
     Gross Unrealized
Losses
     Estimated Fair
Value
 
     (in thousands)  

Held to Maturity

           

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 51,905       $ 1,052       $ 1       $ 52,956   

Obligations of states and political subdivisions

     94,992         7,744         —         $ 102,736   

Corporate securities

     52,907         1,052         25       $ 53,934   

Mortgage-backed securities

     97,824         1,434         132         99,126   
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 297,628       $ 11,282       $ 158       $ 308,752   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     Amortized Cost      Gross Unrealized
Gains
     Gross Unrealized
Losses
     Estimated Fair
Value
 
     (in thousands)  

Available for Sale

           

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 16,097       $ 184       $ 13       $ 16,268   

Obligations of states and political subdivisions

     251,191         18,001         12         269,180   

Corporate securities

     60,134         1,325         2         61,457   

Mortgage-backed securities

     77,207         1,895         28         79,074   
  

 

 

    

 

 

    

 

 

    

 

 

 

Fixed maturities

     404,629         21,405         55         425,979   

Equity securities

     25,908         958         26         26,840   
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 430,537       $ 22,363       $ 81       $ 452,819   
  

 

 

    

 

 

    

 

 

    

 

 

 

At June 30, 2014, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $277.6 million and an amortized cost of $259.4 million. Our holdings at June 30, 2014 also included special revenue bonds with an aggregate fair value of $94.3 million and an amortized cost of $86.8 million. With respect to both categories of these bonds, we held no securities of any issuer that constituted more than 10% of the category at June 30, 2014. Education bonds and water and sewer utility bonds represented 60% and 24%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at June 30, 2014. Many of the issuers of the special revenue bonds we held at June 30, 2014 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds.

 

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Table of Contents

The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2013 were as follows:

 

     Amortized Cost      Gross Unrealized
Gains
     Gross Unrealized
Losses
     Estimated Fair
Value
 
     (in thousands)  

Held to Maturity

           

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 47,946       $ —         $ 870       $ 47,076   

Obligations of states and political subdivisions

     108,435         465         446         108,454   

Corporate securities

     14,875         17         112         14,780   

Mortgage-backed securities

     69,114         33         667         68,480   
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 240,370       $ 515       $ 2,095       $ 238,790   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     Amortized Cost      Gross Unrealized
Gains
     Gross Unrealized
Losses
     Estimated Fair
Value
 
     (in thousands)  

Available for Sale

           

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 14,272       $ 118       $ 57       $ 14,333   

Obligations of states and political subdivisions

     265,783         11,779         15         277,547   

Corporate securities

     39,940         775         43         40,672   

Mortgage-backed securities

     70,259         923         82         71,100   
  

 

 

    

 

 

    

 

 

    

 

 

 

Fixed maturities

     390,254         13,595         197         403,652   

Equity securities

     12,168         348         93         12,423   
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 402,422       $ 13,943       $ 290       $ 416,075   
  

 

 

    

 

 

    

 

 

    

 

 

 

At December 31, 2013, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $294.1 million and an amortized cost of $284.9 million. Our holdings also included special revenue bonds with an aggregate fair value of $91.9 million and an amortized cost of $89.3 million. With respect to both categories, we held no securities of any issuer that constituted more than 10% of the category at December 31, 2013. Education bonds and water and sewer utility bonds represented 56% and 23%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at December 31, 2013. Many of the issuers of the special revenue bonds we held at December 31, 2013 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds.

We made reclassifications from available for sale to held to maturity of fixed maturities at fair value on November 30, 2013. The following table summarizes the reclassifications by type of securities at November 30, 2013:

 

     Amortized Cost      Estimated Fair
Value
 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 50,627,225       $ 47,914,311   

Obligations of states and political subdivisions

     88,456,842         79,866,801   

Corporate securities

     15,745,976         14,879,294   

Mortgage-backed securities

     72,465,250         69,567,883   
  

 

 

    

 

 

 

Totals

   $ 227,295,293       $ 212,228,289   
  

 

 

    

 

 

 

We have segregated within accumulated other comprehensive income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities reclassified from available for sale to held to maturity. We will amortize this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent

 

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Table of Contents

with the accretion of discount on the same fixed maturities. During the six months ended June 30, 2014, amortization of $617,325 was recorded in accumulated other comprehensive income. At June 30, 2014 and December 31, 2013, net unrealized losses of $14.4 million and $15.0 million, respectively, remained within accumulated other comprehensive income.

We show below the amortized cost and estimated fair value of our fixed maturities at June 30, 2014 by contractual maturity. 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.

 

     Amortized Cost      Estimated Fair
Value
 
     (in thousands)  

Held to maturity

     

Due in one year or less

   $ 3,640       $ 3,665   

Due after one year through five years

     32,539         32,902   

Due after five years through ten years

     82,712         84,777   

Due after ten years

     80,913         88,282   

Mortgage-backed securities

     97,824         99,126   
  

 

 

    

 

 

 

Total held to maturity

   $ 297,628       $ 308,752   
  

 

 

    

 

 

 

Available for sale

     

Due in one year or less

   $ 12,000       $ 12,084   

Due after one year through five years

     67,977         69,662   

Due after five years through ten years

     119,264         126,695   

Due after ten years

     128,181         138,464   

Mortgage-backed securities

     77,207         79,074   
  

 

 

    

 

 

 

Total available for sale

   $ 404,629       $ 425,979   
  

 

 

    

 

 

 

Gross realized gains and losses from investments before applicable income taxes were as follows:

 

     Three Months Ended June 30,      Six Months Ended June 30,  
     2014      2013      2014      2013  
     (in thousands)      (in thousands)  

Gross realized gains:

           

Fixed maturities

   $ 1,325       $ 1,389       $ 1,348       $ 2,340   

Equity securities

     709         267         652         741   
  

 

 

    

 

 

    

 

 

    

 

 

 
     2,034         1,656         2,000         3,081   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross realized losses:

           

Fixed maturities

     —           10         1         24   

Equity securities

     —           392         53         462   
  

 

 

    

 

 

    

 

 

    

 

 

 
     —           402         54         486   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net realized gains

   $ 2,034       $ 1,254       $ 1,946       $ 2,595   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at June 30, 2014 as follows:

 

     Less Than 12 Months      More Than 12 Months  
     Fair Value      Unrealized Losses      Fair Value      Unrealized Losses  
     (in thousands)  

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 2,663       $ 13       $ 264       $ 1   

Obligations of states and political subdivisions

     —           —           1,572         12   

Corporate securities

     6,919         27         —           —     

Mortgage-backed securities

     9,966         50         13,083         110   

Equity securities

     4,028         26         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 23,576       $ 116       $ 14,919       $ 123   
  

 

 

    

 

 

    

 

 

    

 

 

 

We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2013 as follows:

 

     Less Than 12 Months      More Than 12 Months  
     Fair Value      Unrealized Losses      Fair Value      Unrealized Losses  
     (in thousands)  

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 50,803       $ 822       $ 4,642       $ 104   

Obligations of states and political subdivisions

     65,171         363         13,405         99   

Corporate securities

     16,694         84         6,852         72   

Mortgage-backed securities

     72,878         536         19,014         213   

Equity securities

     1,629         93         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 207,175       $ 1,898       $ 43,913       $ 488   
  

 

 

    

 

 

    

 

 

    

 

 

 

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, 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 when we consider the decline in value of an individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value 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 held six equity securities that were in an unrealized loss position at June 30, 2014. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered 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 determine 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 debt security prior to recovery. If we determine 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 we determine 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. We determine whether a credit loss has occurred by comparing 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 that a credit loss has occurred. If we determine 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 applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 30 debt securities that were in an unrealized loss position at June 30, 2014. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary.

 

12


Table of Contents

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.

We amortize premiums and discounts on mortgage-backed debt securities using anticipated prepayments.

We account for investments in our affiliates using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliates’ earnings and losses as well as changes in the equity of our affiliates due to unrealized gains and losses. Our investments in affiliates include our 48.2% ownership interest in DFSC. We include our share of DFSC’s net income in our results of operations. We have compiled the following summary financial information for DFSC at June 30, 2014 and December 31, 2013 and for the three months and six months ended June 30, 2014 and 2013, respectively, from the financial statements of DFSC. The financial information of DFSC at June 30, 2014 and for the three and six months then ended is unaudited.

 

Balance sheets:    June 30,
2014
     December 31,
2013
 
     (in thousands)  

Total assets

   $ 519,366       $ 512,578   
  

 

 

    

 

 

 

Total liabilities

   $ 439,906       $ 438,649   

Stockholders’ equity

     79,460         73,929   
  

 

 

    

 

 

 

Total liabilities and stockholders’ equity

   $ 519,366       $ 512,578   
  

 

 

    

 

 

 

 

     Three Months Ended June 30,      Six Months Ended June 30,  
Income statements:    2014      2013      2014      2013  
     (in thousands)      (in thousands)  

Net income

   $ 723       $ 1,401       $ 1,572       $ 3,659   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents
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 (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment is as follows:

 

                                 
     Three Months Ended June 30,  
     2014     2013  
     (in thousands)  

Revenues:

    

Premiums earned

    

Commercial lines

   $ 56,696      $ 49,612   

Personal lines

     79,893        77,351   
  

 

 

   

 

 

 

GAAP premiums earned

     136,589        126,963   

Net investment income

     4,614        4,671   

Realized investment gains

     2,034        1,254   

Equity in earnings of DFSC

     349        676   

Other

     1,896        1,944   
  

 

 

   

 

 

 

Total revenues

   $ 145,482      $ 135,508   
  

 

 

   

 

 

 

Income before income taxes:

    

Underwriting loss:

    

Commercial lines

   $ (5,827   $ (3,079

Personal lines

     (3,125     (3,448
  

 

 

   

 

 

 

SAP underwriting loss

     (8,952     (6,527

GAAP adjustments

     3,475        2,591   
  

 

 

   

 

 

 

GAAP underwriting loss

     (5,477     (3,936

Net investment income

     4,614        4,671   

Realized investment gains

     2,034        1,254   

Equity in earnings of DFSC

     349        676   

Other

     800        197   
  

 

 

   

 

 

 

Income before income taxes

   $ 2,320      $ 2,862   
  

 

 

   

 

 

 

 

14


Table of Contents
     Six Months Ended June 30,  
     2014     2013  
     (in thousands)  

Revenues:

    

Premiums earned

    

Commercial lines

   $ 111,042      $ 97,243   

Personal lines

     159,095        154,422   
  

 

 

   

 

 

 

GAAP premiums earned

     270,137        251,665   

Net investment income

     9,230        9,486   

Realized investment gains

     1,946        2,595   

Equity in earnings of DFSC

     758        1,764   

Other

     3,750        3,870   
  

 

 

   

 

 

 

Total revenues

   $ 285,821      $ 269,380   
  

 

 

   

 

 

 

Income before income taxes:

    

Underwriting loss:

    

Commercial lines

   $ (11,175   $ (4,670

Personal lines

     (6,959     (3,224
  

 

 

   

 

 

 

SAP underwriting loss

     (18,134     (7,894

GAAP adjustments

     6,400        4,340   
  

 

 

   

 

 

 

GAAP underwriting loss

     (11,734     (3,554

Net investment income

     9,230        9,486   

Realized investment gains

     1,946        2,595   

Equity in earnings of DFSC

     758        1,764   

Other

     1,327        654   
  

 

 

   

 

 

 

Income before income taxes

   $ 1,527      $ 10,945   
  

 

 

   

 

 

 

 

7- Borrowings

Lines of Credit

In June 2014, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit expires in July 2017. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the agreement. At June 30, 2014, we had $45.0 million in outstanding borrowings and had the ability to borrow an additional $15.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings is adjustable quarterly. At June 30, 2014, the interest rate on our outstanding borrowings was 2.41%. 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. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We were in compliance with all requirements of the credit agreement during the six months ended June 30, 2014.

MICO is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. MICO had no outstanding borrowings with the FHLB of Indianapolis at December 31, 2013 or June 30, 2014. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO’s membership at June 30, 2014.

 

FHLB stock purchased and owned as part of the agreement

   $ 252,100   

Collateral pledged, at par (carrying value $2,673,959)

     3,700,000   

Borrowing capacity currently available

     2,301,231   

 

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Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. In the first quarter of 2013, Atlantic States issued secured debt in the principal amount of $15.0 million to the FHLB of Pittsburgh in exchange for cash advances in the amount of $15.0 million. The interest rate on the advances was .31% at June 30, 2014. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at June 30, 2014.

 

FHLB stock purchased and owned as part of the agreement

   $ 941,700   

Collateral pledged, at par (carrying value $17,089,256)

     20,500,000   

Borrowing capacity currently available

     1,305,523   

Subordinated Debentures

In January 2002, West Bend Mutual Insurance Company (“West Bend”), the prior owner of MICO, purchased a $5.0 million surplus note from MICO at face value to increase MICO’s statutory surplus. On December 1, 2010, Donegal Mutual purchased the surplus note from West Bend at face value. The surplus note carries an interest rate of 5.00%, and any repayment of principal or payment of interest on the surplus note requires prior approval of the Michigan Department of Insurance and Financial Services.

 

8- Share–Based Compensation

We measure all share-based payments to employees, including grants of stock options, and use a fair-value-based method for the recording of related compensation 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, 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 utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, the expected term, the dividend yield and the expected volatility.

We charged compensation expense related to our stock compensation plans against income before income taxes of $497,614 and $155,523 for the three months ended June 30, 2014 and 2013, respectively, with a corresponding income tax benefit of $174,165 and $54,433, respectively. We charged compensation expense related to our stock compensation plans against income before income taxes of $1.0 million and $327,828 for the six months ended June 30, 2014 and 2013, respectively, with a corresponding income tax benefit of $363,484 and $114,740, respectively. At June 30, 2014, we had $3.6 million of unrecognized compensation expense related to nonvested share-based compensation granted under our stock compensation plans. We expect to recognize this cost over a weighted average period of 1.9 years.

We received cash from option exercises under all stock compensation plans for the three months ended June 30, 2014 and 2013 of $1.2 million and $1.9 million, respectively. We received cash from option exercises under all stock compensation plans for the six months ended June 30, 2014 and 2013 of $1.4 million and $3.6 million, respectively. We realized actual tax benefits for the tax deductions from option exercises of share-based compensation of $52,159 and $87,952 for the three months ended June 30, 2014 and 2013, respectively. We realized actual tax benefits for the tax deductions from option exercises of share-based compensation of $63,674 and $186,881 for the six months ended June 30, 2014 and 2013, respectively.

 

9- Fair Value Measurements

We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of the inputs, or assumptions, we use 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

 

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quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or price estimates we obtain from independent pricing services and include these investments in Level 2 of the fair value hierarchy. 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 mortgage-backed securities.

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 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 or obtain market quotations for substantially all of our fixed maturity and equity investments. These 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 based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain are representative of fair values based upon our investment personnel’s general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel regularly monitor the market, current trading ranges for similar securities and the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At December 31, 2013, we received one estimate per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. At June 30, 2014, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at June 30, 2014 and December 31, 2013, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided.

We present our cash and short-term investments at estimated fair value. We classify these items as Level 1.

The carrying values in the balance sheet for premium receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts we report in the balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3.

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 at June 30, 2014:

 

            Fair Value Measurements Using  
     Fair Value      Quoted
Prices in Active

Markets for
Identical Assets
(Level 1)
     Significant Other
Observable Inputs
(Level 2)
     Significant
Unobservable

Inputs (Level 3)
 
     (in thousands)  

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 16,268       $ —         $ 16,268       $ —     

Obligations of states and political subdivisions

     269,180         —           269,180         —     

Corporate securities

     61,457         —           61,457         —     

Mortgage-backed securities

     79,074         —           79,074         —     

Equity securities

     26,840         17,539         9,301         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 452,819       $ 17,539       $ 435,280       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

We did not transfer any investments between Levels 1 and 2 during the six months ended June 30, 2014.

 

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The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2013:

 

            Fair Value Measurements Using  
     Fair Value      Quoted
Prices in Active
Markets for
Identical Assets
(Level 1)
     Significant Other
Observable Inputs
(Level 2)
     Significant
Unobservable

Inputs (Level 3)
 
     (in thousands)  

U.S. Treasury securities and obligations of U.S. government corporations and agencies

   $ 14,333       $ —         $ 14,333       $ —     

Obligations of states and political subdivisions

     277,547         —           277,547         —     

Corporate securities

     40,672         —           40,672         —     

Mortgage-backed securities

     71,100         —           71,100         —     

Equity securities

     12,423         6,468         5,955         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Totals

   $ 416,075       $ 6,468       $ 409,607       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

 

10- Income Taxes

At June 30, 2014 and December 31, 2013, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. Tax years 2010 through 2013 remained open for examination at June 30, 2014. We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of our tax asset. We established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars at January 1, 2004. We have determined that we are not required to establish a valuation allowance for the other net deferred tax assets of $40.2 million and $39.6 million at June 30, 2014 and December 31, 2013, respectively, because it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax planning strategies. We also have a net operating loss carryforward of $4.7 million related to Le Mars, which will begin to expire in 2020 if not previously utilized. This carryforward is subject to an annual limitation in the amount that we can use in any one year of approximately $376,000.We also have an alternative minimum tax credit carryforward of $10.0 million with an indefinite life.

 

11- Impact of New Accounting Standards

In February 2013, the Financial Accounting Standards Board (“FASB”) issued guidance that requires an entity to provide information about amounts it reclassifies out of accumulated other comprehensive income. If GAAP requires an entity to reclassify amounts out of accumulated other comprehensive income to net income in their entirety in the same reporting period, the guidance requires an entity to present significant amounts it reclassifies out of accumulated other comprehensive income by the respective line items of net income, either on the face of the statement where the entity presents net income or in the notes to the entity’s financial statements,. For other amounts that GAAP does not require an entity to reclassify to net income in their entirety, the guidance requires an entity to cross-reference such amounts to other disclosures GAAP requires that provide additional detail about those amounts. The guidance was effective for interim and annual reporting periods after December 15, 2012. We adopted this new guidance as of January 1, 2013. Our adoption of this new guidance did not impact our financial position, results of operations or cash flows.

In July 2013, the FASB issued a new standard that requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss carryforward or similar tax loss or tax credit carryforward, rather than as a liability, when the uncertain tax position would reduce the net operating loss or other carryforward under the tax law of the applicable jurisdiction and when the entity intends to use the deferred tax asset for that purpose. The new standard was effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. We adopted this new guidance as of January 1, 2014. Our adoption of this new standard did not impact our financial position, results of operations or cash flows.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

We recommend that you read the following information in conjunction with the historical financial information and the footnotes to that financial information we include in this Quarterly Report on Form 10-Q. We also recommend you read Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2013.

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 we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, the valuation of investments and determination of other-than-temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts of these liabilities may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current results of operations.

Liability for Unpaid Losses and Loss Expenses

Liabilities for 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. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. 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 refine and adjust their estimates for these liabilities. We reflect any adjustments to our insurance subsidiaries’ liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates.

Our insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability 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 insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability 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 losses.

Reserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions related 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 workers’ compensation 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 consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries attempt to make appropriate adjustments for such changes in their reserves. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded at June 30, 2014. For every 1% change in our insurance subsidiaries’ estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $2.8 million.

 

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The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ 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 losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimate of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date.

Excluding the impact of severe weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in 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 United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. 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 liability for losses and loss expenses.

Atlantic States’ participation in the pool with Donegal Mutual exposes it to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States proportionately share any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its 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 either would experience individually and to spread the risk of loss between the companies.

 

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Donegal Mutual and our insurance subsidiaries operate together as the Donegal Insurance Group and share a combined business plan designed 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 the individual companies write directly will vary. However, because the pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly 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 at June 30, 2014 and December 31, 2013 consisted of the following:

 

     June 30,
2014
     December 31,
2013
 
     (in thousands)  

Commercial lines:

     

Automobile

   $ 40,648       $ 36,017   

Workers’ compensation

     84,019         79,932   

Commercial multi-peril

     46,271         39,822   

Other

     2,796         2,716   
  

 

 

    

 

 

 

Total commercial lines

     173,734         158,487   
  

 

 

    

 

 

 

Personal lines:

     

Automobile

     86,918         92,280   

Homeowners

     12,882         13,367   

Other

     2,818         1,471   
  

 

 

    

 

 

 

Total personal lines

     102,618         107,118   
  

 

 

    

 

 

 

Total commercial and personal lines

     276,352         265,605   

Plus reinsurance recoverable

     250,019         230,014   
  

 

 

    

 

 

 

Total liability for unpaid losses and loss expenses

   $ 526,371       $ 495,619   
  

 

 

    

 

 

 

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 consider 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 the loss and loss expense reserves of our insurance subsidiaries:

 

Percentage Change in Loss
and Loss Expense
Reserves Net of
Reinsurance
    Adjusted Loss and Loss
Expense Reserves Net of
Reinsurance at

June 30, 2014
    Percentage Change
in Stockholders’ Equity at
June 30, 2014(1)
    Adjusted Loss and Loss
Expense Reserves Net of
Reinsurance at
December 31, 2013
    Percentage Change
in Stockholders’ Equity at
December 31, 2013(1)
 
(dollars in thousands)  
  (10.0 )%    $ 248,717        4.4   $ 239,045        4.4
  (7.5     255,626        3.3        245,685        3.3   
  (5.0     262,534        2.2        252,325        2.2   
  (2.5     269,443        1.1        258,965        1.1   
  Base        276,352        —          265,605          
  2.5        283,261        (1.1     272,245        (1.1
  5.0        290,170        (2.2     278,885        (2.2
  7.5        297,078        (3.3     285,525        (3.3
  10.0        303,987        (4.4     292,166        (4.4

 

(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 net premiums 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 combined 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, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio on premiums earned instead of premiums written. Differences between our GAAP loss ratios reported in our financial statements and our insurance subsidiaries’ statutory loss ratios result from anticipating salvage and subrogation recoveries for the GAAP loss ratios but not for the statutory loss ratios. The following table sets forth our insurance subsidiaries’ statutory combined ratios by major line of business for the three and six months ended June 30, 2014 and 2013:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2014     2013     2014     2013  

Commercial lines:

        

Automobile

     128.4     99.8     114.5     101.2

Workers’ compensation

     90.6        108.1        94.1        104.9   

Commercial multi-peril

     109.7        103.1        114.4        100.8   

Total commercial lines

     105.8        101.4        105.1        99.9   

Personal lines:

        

Automobile

     103.3        100.2        100.6        102.2   

Homeowners

     90.9        101.6        100.3        95.3   

Other

     105.9        88.3        113.4        85.6   

Total personal lines

     99.5        100.2        101.1        99.2   

Total commercial and personal lines

     102.1        100.6        102.7        99.3   

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, we write down an individual investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of the individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of its original cost and has been in such an unrealized loss position for more than six months. We held six equity securities that were in an unrealized loss position at June 30, 2014. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered 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 determine 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 debt security prior to recovery. If we determine 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 we determine 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. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect on the debt security. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine 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 applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security or rating agency downgrades. We held 30 debt

 

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securities that were in an unrealized loss position at June 30, 2014. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in the first six months of 2014 or 2013.

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 or obtain market quotations for substantially all of 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 based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain are representative of fair values based upon the general market knowledge of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At December 31, 2013, we received one estimate per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. At June 30, 2014, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at June 30, 2014 and December 31, 2013, we did not identify any material discrepancies and we did not make any adjustments to the estimates the pricing services provided.

Policy Acquisition Costs

Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that relate directly to the successful acquisition of insurance policies. 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. This method 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 June 30, 2014 Compared to Three Months Ended June 30, 2013

Net Premiums Written. Our insurance subsidiaries’ net premiums written for the three months ended June 30, 2014 were $151.4 million, an increase of $10.8 million, or 7.7%, from the $140.6 million of net premiums written for the second quarter of 2013. We primarily attribute the increase to a reduction in MICO’s external quota-share reinsurance, the impact of premium rate increases and an increase in the writing of commercial lines of business. Effective January 1, 2014, MICO reduced its external quota-share reinsurance percentage from 30% to 20%. Personal lines net premiums written increased $4.2 million, or 5.0%, for the second quarter of 2014 compared to the second quarter of 2013. The increase included $1.1 million related to the MICO reinsurance change, with the remainder of the increase attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2013. Commercial lines net premiums written increased $6.7 million, or 11.8%, for the second quarter of 2014 compared to the second quarter of 2013. The increase included $1.5 million related to the MICO reinsurance change, with the remainder of the increase attributable to premium rate increases and increased writings of new accounts in the commercial automobile, commercial multi-peril and workers’ compensation lines of business.

Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the second quarter of 2014 were $136.6 million, an increase of $9.6 million, or 7.6%, compared to $127.0 million for the second quarter of 2013, reflecting increases in net premiums written during 2014 and 2013. 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. Our net investment income was $4.6 million for the second quarter of 2014, compared to $4.7 million for the second quarter of 2013. We attribute the decrease primarily to lower average investment yields on our invested assets.

 

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Net Realized Investment Gains. Net realized investment gains for the second quarter of 2014 were $2.0 million, compared to net realized investment gains of $1.3 million for the second quarter of 2013. The net realized investment gains for the second quarters of 2014 and 2013 resulted primarily from strategic sales of fixed maturities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the second quarters of 2014 or 2013.

Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $348,625 for the second quarter of 2014, compared to $675,568 for the second quarter of 2013. The decrease in DFSC’s earnings resulted from a lesser benefit from acquisition accounting adjustments during the second quarter of 2014 compared to the second quarter of 2013.

Losses and Loss Expenses. Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the second quarter of 2014 was 71.7%, an increase from our insurance subsidiaries’ 70.5% loss ratio for the second quarter of 2013. We attribute the increased loss ratio primarily to an increase in weather-related losses to $11.6 million for the second quarter of 2014, compared to $9.4 million for the second quarter of 2013 and an increase in large fire losses to $9.3 million for the second quarter of 2014, compared to $5.7 million for the second quarter of 2013. Our insurance subsidiaries’ commercial lines loss ratio increased to 76.8% for the second quarter of 2014 compared to 73.1% for the second quarter of 2013, primarily due to increases in the commercial multi-peril and commercial automobile loss ratios. The personal lines loss ratio decreased to 68.7% for the second quarter of 2014 compared to 69.4% for the second quarter of 2013, primarily due to a decrease in the homeowners loss ratios. Due largely to our emphasis on increasing premium rates in recent years, our homeowners loss ratios declined despite the weather-related losses. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $6.0 million during the second quarter of 2014 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $4.7 million during the second quarter of 2013. The change in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial automobile, personal automobile and commercial multi-peril reserves.

Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 31.9% for the second quarter of 2014, relatively comparable to 32.3% for the second quarter of 2013.

Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratio was 104.0% and 103.1% for the three months ended June 30, 2014 and 2013, respectively.

Interest Expense. Our interest expense for the second quarter of 2014 was $443,135, compared to $333,699 for the second quarter of 2013. The increase was related to the timing of the payment of renewal fees offset by a lower average interest rate on borrowings during the second quarter of 2014 compared to the second quarter of 2013.

Income Taxes. Income tax expense was $381,242 for the second quarter of 2014, representing an effective tax rate of 16.4%, compared to income tax expense of $233,171 for the second quarter of 2013, representing an effective tax rate of 8.1%. The effective tax rate in both periods represented an estimate based on projected annual taxable income.

Net Income and Earnings Per Share. Our net income for the second quarter of 2014 was $1.9 million, or $.07 per share of Class A common stock on a diluted basis and $.07 per share of Class B common stock, compared to net income of $2.6 million, or $.10 per share of Class A common stock on a diluted basis and $.09 per share of Class B common stock, for the second quarter of 2013. We had 21.0 million and 20.4 million Class A shares outstanding at June 30, 2014 and 2013, respectively. We had 5.6 million Class B shares outstanding at the end of both periods.

Results of Operations - Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013

Net Premiums Written. Our insurance subsidiaries’ net premiums written for the six months ended June 30, 2014 were $296.0 million, an increase of $23.0 million, or 8.4%, from the $273.0 million of net premiums written for the comparable period of 2013. We primarily attribute the increase to a reduction in MICO’s external quota-share reinsurance, the impact of premium rate increases and an increase in the writing of commercial lines of business. Effective January 1, 2014, MICO reduced its external quota-share reinsurance percentage from 30% to 20%. Personal lines net premiums written increased $7.6 million, or 4.8%, for the first half of 2014 compared to the first half of 2013. The increase included $2.2 million related to the MICO reinsurance change, with the remainder of the increase attributable primarily to premium rate increases our insurance subsidiaries implemented throughout 2013. Commercial lines net premiums written increased $15.4 million, or 13.4%, for the first half of 2014 compared to the first half of 2013. The increase included $3.2 million related to the MICO reinsurance change, with the remainder of the increase attributable to premium rate increases and increased writings of new accounts in the commercial automobile, commercial multi-peril and workers’ compensation lines of business.

 

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Net Premiums Earned. Our insurance subsidiaries’ net premiums earned for the first half of 2014 were $270.1 million, an increase of $18.4 million, or 7.3%, compared to $251.7 million for the first half of 2013, reflecting increases in net premiums written during 2014 and 2013. 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. Our net investment income was $9.2 million for the first half of 2014, compared to $9.5 million for the first half of 2013. We attribute the decrease primarily to lower average investment yields on our invested assets.

Net Realized Investment Gains. Net realized investment gains for the first half of 2014 were $1.9 million, compared to net realized investment gains of $2.6 million for the first half of 2013. The net realized investment gains for the first half of 2014 and 2013 resulted primarily from strategic sales of fixed maturities within our investment portfolio. We did not recognize any impairment losses in our investment portfolio during the first six months of 2014 or 2013.

Equity in Earnings of DFSC. Our equity in the earnings of DFSC was $757,867 for the first half of 2014, compared to $1.8 million for the first half of 2013. The decrease in DFSC’s earnings resulted from a reduced benefit of acquisition accounting adjustments during the first half of 2014 compared to the first half of 2013.

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 half of 2014 was 72.4%, an increase from our insurance subsidiaries’ 69.6% loss ratio for the first half of 2013. Our insurance subsidiaries’ commercial lines loss ratio increased to 76.2% for the first half of 2014 compared to 71.9% for the first half of 2013 primarily due to an increase in the commercial automobile and commercial multi-peril loss ratios. The personal lines loss ratio increased to 70.5% for the first half of 2014 compared to 68.7% for the first half of 2013 primarily due to a increase in the homeowners loss ratios. We primarily attribute the increased loss ratios to an increase in weather-related losses to $26.9 million for the first half of 2014, compared to $15.0 million for the first half of 2013. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $5.6 million during the first half of 2014 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $6.5 million during the first half of 2013. The change in loss reserve development patterns occurred primarily within our insurance subsidiaries’ commercial automobile, personal automobile and commercial multi-peril reserves.

Underwriting Expenses. The expense ratio for an insurance company is the ratio of policy acquisition costs and other underwriting expenses to premiums earned. The expense ratio of our insurance subsidiaries was 31.6% for the first half of 2014, relatively comparable to 31.5% for the first half of 2013.

Combined Ratio. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned. Our insurance subsidiaries’ combined ratio was 104.3% and 101.4% for the six months ended June 30, 2014 and 2013, respectively.

Interest Expense. Our interest expense for the first half of 2014 was $808,617, relatively comparable to $820,848 for the first half of 2013.

Income Taxes. Income tax expense was $222,440 for the first half of 2014, representing an effective tax rate of 14.6%, compared to income tax expense of $1.8 million for the first half of 2013, representing an effective tax rate of 16.8%. The effective tax rate in both periods represented an estimate based on projected annual taxable income.

Net Income and Earnings Per Share. Our net income for the first half of 2014 was $1.3 million, or $.05 per share of Class A common stock and $.04 per share of Class B common stock, compared to net income of $9.1 million, or $.35 per share of Class A common stock and $.32 per share of Class B common stock, for the first half of 2013. We had 21.0 million and 20.4 million Class A shares outstanding at June 30, 2014 and 2013, respectively. We had 5.6 million Class B shares outstanding at the end of both periods.

 

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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 such obligations and needs arise. Our major sources of funds from operations are the net cash flows we generate from our insurance subsidiaries’ underwriting results, investment income and investment maturities.

Our operations have historically generated sufficient net positive cash flow to fund our commitments and add to our investment portfolio, thereby increasing future investment returns and enhancing our liquidity. 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. Donegal Mutual and Atlantic States settle their respective obligations to each other under the pool monthly, thereby resulting in cash flows substantially similar to the cash flows that would result from each company writing 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. The net cash flows our operating activities provided in the first six months of 2014 and 2013 were $1.8 million and $16.8 million, respectively, with the change in cash flows due primarily to our insurance subsidiaries’ increased claim payments during the first six months of 2014 compared to the prior-year period.

At June 30, 2014, we had $45.0 million in outstanding borrowings under our line of credit with M&T and had the ability to borrow an additional $15.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. At June 30, 2014, Atlantic States had $15.0 million in outstanding advances with the FHLB of Pittsburgh. The interest rate on these advances was .31% at June 30, 2014.

The following table shows our expected payments for significant contractual obligations at June 30, 2014:

 

     Total      Less than 1 year      1-3 years      4-5 years      After 5 years  
     (in thousands)  

Net liability for unpaid losses and loss expenses of our insurance subsidiaries

   $ 276,352       $ 126,398       $ 126,074       $ 11,100       $ 12,780   

Subordinated debentures

     5,000         —           —           —           5,000   

Borrowings under lines of credit

     60,000         15,000         45,000         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations

   $ 341,352       $ 141,398       $ 171,074       $ 11,100       $ 17,780   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

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. We show the liability 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 timing of the amounts for the borrowings under our lines of credit based on their contractual maturities that we discuss in Note 7 – Borrowings. The borrowings under our lines of credit carry interest rates that vary as we discuss in Note 7 – Borrowings. Based upon the interest rates in effect at June 30, 2014, our annual interest cost associated with the borrowings under our lines of credit is approximately $1.1 million. For every 1% change in the interest rate associated with the borrowings under our lines of credit, the effect on our annual interest cost would be approximately $600,000.

We estimate the timing of the amounts for the subordinated debentures based on their contractual maturity we discuss in Note 7 – Borrowings. The subordinated debentures carry an interest rate of 5%, and any repayment of principal or payment of interest on the subordinated debentures requires prior regulatory approval of the Michigan Department of Insurance and Financial Services. Our annual interest cost associated with the subordinated debentures is approximately $250,000.

 

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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 rules of the SEC and in privately negotiated transactions. We purchased 846 shares of our Class A common stock under this program during the six months ended June 30, 2014. We did not purchase any shares under this program during the six-month period ended June 30, 2013. We have purchased a total of 296,778 shares of our Class A common stock under this program from its inception through June 30, 2014.

On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of applicable rules of the SEC and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the six-month period ended June 30, 2014.

On July 17, 2014, our board of directors declared quarterly cash dividends of 13.15 cents per share of our Class A common stock and 11.60 cents per share of our Class B common stock, payable on August 15, 2014 to our stockholders of record as of the close of business on August 1, 2014. We are not subject to any restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends by our insurance subsidiaries to us. Dividends from our insurance subsidiaries are our principal source of cash for payment of dividends to our stockholders. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital (“RBC”) requirements that limit their ability to pay dividends to us. Our insurance subsidiaries’ statutory capital and surplus at December 31, 2013 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Our insurance subsidiaries paid $4.0 million in dividends to us during the first six months of 2014. Amounts remaining available for distribution to us as dividends from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities in 2014 are $18.7 million from Atlantic States, $2.2 million from Southern, $2.8 million from Le Mars, $2.2 million from Peninsula, $1.1 million from Sheboygan and $4.1 million from MICO, or a total of approximately $31.1 million.

At June 30, 2014, we had no material commitments for capital expenditures.

Equity Price Risk

Our portfolio of marketable equity securities, which we carry 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.

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 its 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 licensed insurance 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.

 

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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 the securities we hold in 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 our debt obligations.

Our investment mix shifted slightly during the first six months of 2014. We reinvested funds we held in short-term investments at year-end 2013 into fixed maturities. The duration of our investment portfolio increased slightly due to this reinvestment activity.

There have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2013 through June 30, 2014.

 

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, at the end of the period this Quarterly Report on Form 10-Q covers. 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 Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.

Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

We base all statements contained in this Quarterly Report on Form 10-Q that are not historic facts on our 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. Forward-looking statements we make may be identified by our use of words such as “will,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “seeks,” “estimates” and similar expressions. Actual results could vary materially. The factors that could cause our actual results to vary materially from forward-looking statements we have previously made, include, but are not limited to, our ability to maintain profitable operations, the adequacy of the loss and loss expense reserves of our insurance subsidiaries, business and economic conditions in the areas in which we operate, interest rates, competition from various insurance and other financial businesses, terrorism, the availability and cost of reinsurance, adverse and catastrophic weather events, legal and judicial developments, changes in regulatory requirements, our ability to integrate and manage successfully the companies we may acquire from time to time and the 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 we may make 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 2013 Annual Report on Form 10-K filed with the SEC on March 14, 2014. There have been no material changes in the risk factors disclosed in that Form 10-K Report during the six months ended June 30, 2014.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

 

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
Exhibit 101.INS   XBRL Instance Document
Exhibit 101.SCH   XBRL Taxonomy Extension Schema Document
Exhibit 101.PRE   XBRL Taxonomy Presentation Linkbase Document
Exhibit 101.CAL   XBRL Taxonomy Calculation Linkbase Document
Exhibit 101.LAB   XBRL Taxonomy Label Linkbase Document
Exhibit 101.DEF   XBRL Taxonomy Extension Definition Linkbase Document

 

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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.
August 7, 2014     By:  

/s/ Donald H. Nikolaus

     

Donald H. Nikolaus, President
and Chief Executive Officer

August 7, 2014     By:  

/s/ Jeffrey D. Miller

     

Jeffrey D. Miller, Executive Vice President
and Chief Financial Officer