Donegal (DGICA) 10-Q 2009 Q3 Quarterly report

FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

(Mark One)

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

For the quarterly period ended September 30, 2009

OR

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

For the transition period from                    to                    .

Commission file number 0-15341

Donegal Group Inc.

(Exact name of registrant as specified in its charter)

Delaware	23-2424711
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1195 River Road, P.O. Box 302, Marietta, PA	17547
(Address of principal executive offices)	(Zip code)

(717) 426-1931

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

     Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ     Noo

     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). Yeso     Noo

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filero	Accelerated filerþ	Non-accelerated filero	Smaller reporting companyo
		(Do not check if a smaller reporting company)

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yeso     Noþ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:19,905,297 shares of Class A Common Stock, par value $0.01 per share, and 5,576,775 shares of Class B Common Stock, par value $0.01 per share, outstanding on October 31, 2009.

Part I. Financial Information

Item 1. Financial Statements.

Donegal Group Inc. and Subsidiaries
Consolidated Balance Sheets

	September 30, 2009			December 31, 2008
	(Unaudited)
Assets
Investments
Fixed maturities
Held to maturity, at amortized cost	$	78,540,210		$	99,878,156
Available for sale, at fair value		527,575,236			445,815,749
Equity securities, available for sale, at fair value		8,416,214			5,894,975
Investments in affiliates		8,946,241			8,594,177
Short-term investments, at cost, which approximates fair value		39,849,131			71,952,469
Total investments		663,327,032			632,135,526
Cash		8,816,727			1,830,954
Accrued investment income		6,317,101			6,655,506
Premiums receivable		63,508,833			55,337,270
Reinsurance receivable		85,199,902			79,952,971
Deferred policy acquisition costs		31,783,916			29,541,281
Deferred tax asset, net		—			10,994,644
Prepaid reinsurance premiums		58,261,417			51,436,487
Property and equipment, net		6,725,115			6,686,684
Accounts receivable — securities		171,377			862,790
Federal income taxes recoverable		326,197			2,590,928
Other		2,003,950			2,083,995
Total assets	$	926,441,567		$	880,109,036
Liabilities and Stockholders’ Equity
Liabilities
Unpaid losses and loss expenses	$	251,031,954		$	239,809,276
Unearned premiums		247,159,135			229,013,929
Accrued expenses		10,662,679			14,149,754
Reinsurance balances payable		3,558,394			1,566,816
Cash dividends declared to stockholders		—			2,602,104
Deferred tax liability, net		518,041			—
Subordinated debentures		15,465,000			15,465,000
Accounts payable — securities		1,502,962			1,820,574
Due to affiliate		802,380			3,148,057
Drafts payable		1,651,336			876,210
Due to Sheboygan policyholders		1,166,776			6,843,454
Other		1,393,188			1,229,997
Total liabilities		534,911,845			516,525,171
Stockholders’ Equity
Preferred stock, $1.00 par value, authorized 2,000,000 shares; none issued		—			—
Class A common stock, $.01 par value, authorized 30,000,000 shares, issued 20,544,996 and 20,494,764 shares and outstanding 19,905,297 and 19,869,065 shares		205,450			204,948
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		164,134,080			163,136,938
Accumulated other comprehensive income		23,217,277			1,713,836
Retained earnings		212,825,904			207,182,253
Treasury stock		(8,909,481	)		(8,710,602	)
Total stockholders’ equity		391,529,722			363,583,865
Total liabilities and stockholders’ equity	$	926,441,567		$	880,109,036

See accompanying notes to consolidated financial statements.

1

Donegal Group Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)

	Three Months Ended September 30,
	2009		2008
Revenues:
Net premiums earned	$	87,997,723	$	88,170,757
Investment income, net of investment expenses		5,107,356		5,801,750
Net realized investment gains (losses)		189,230		(2,811,264	)
Lease income		232,762		230,903
Installment payment fees		1,349,016		1,316,429
Total revenues		94,876,087		92,708,575
Expenses:
Net losses and loss expenses		58,609,247		54,700,316
Amortization of deferred policy acquisition costs		14,791,000		14,818,000
Other underwriting expenses		13,344,369		14,240,659
Policyholder dividends		251,573		437,470
Interest		185,315		398,855
Other expenses		329,330		314,642
Total expenses		87,510,834		84,909,942
Income before income tax expense		7,365,253		7,798,633
Income tax expense		620,402		1,528,212
Net income	$	6,744,851	$	6,270,421
Earnings per common share:
Class A common stock — basic	$	0.27	$	0.25
Class A common stock — diluted	$	0.27	$	0.25
Class B common stock — basic and diluted	$	0.24	$	0.23

Consolidated Statements of Comprehensive Income
(Unaudited)

	Three Months Ended September 30,
	2009			2008
Net income	$	6,744,851		$	6,270,421
Other comprehensive income (loss), net of tax
Unrealized income (loss) on securities:
Unrealized holding income (loss) during the period, net of income tax (benefit)		16,163,607			(9,172,698	)
Reclassification adjustment, net of income tax		(122,999	)		1,827,322
Other comprehensive income (loss)		16,040,608			(7,345,376	)
Comprehensive income (loss)	$	22,785,459		$	(1,074,955	)

See accompanying notes to consolidated financial statements.

2

Donegal Group Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)

	Nine Months Ended September 30,
	2009		2008
Revenues:
Net premiums earned	$	263,887,611	$	257,507,718
Investment income, net of investment expenses		15,731,106		17,287,476
Net realized investment gains (losses)		893,225		(2,789,535	)
Lease income		689,096		705,198
Installment payment fees		3,957,392		3,760,768
Total revenues		285,158,430		276,471,625
Expenses:
Net losses and loss expenses		186,461,543		164,849,522
Amortization of deferred policy acquisition costs		44,158,000		43,109,000
Other underwriting expenses		38,548,332		40,711,661
Policyholder dividends		586,784		924,537
Interest		1,588,560		1,545,571
Other expenses		1,104,175		1,211,480
Total expenses		272,447,394		252,351,771
Income before income tax expense		12,711,036		24,119,854
Income tax expense		1,408,757		4,972,173
Net income	$	11,302,279	$	19,147,681
Earnings per common share:
Class A common stock — basic	$	0.45	$	0.77
Class A common stock — diluted	$	0.45	$	0.76
Class B common stock — basic and diluted	$	0.41	$	0.69

Consolidated Statements of Comprehensive Income
(Unaudited)

	Nine Months Ended September 30,
	2009			2008
Net income	$	11,302,279		$	19,147,681
Other comprehensive income (loss), net of tax
Unrealized income (loss) on securities:
Unrealized holding income (loss) during the period, net of income tax (benefit)		22,084,037			(16,065,940	)
Reclassification adjustment, net of income tax		(580,596	)		1,813,198
Other comprehensive income (loss)		21,503,441			(14,252,742	)
Comprehensive income	$	32,805,720		$	4,894,939

See accompanying notes to consolidated financial statements.

3

Donegal Group Inc. and Subsidiaries
Consolidated Statement of Stockholders’ Equity
(Unaudited)
Nine Months Ended September 30, 2009

											Accumulated
									Additional		Other								Total
									Paid-In		Comprehensive		Retained			Treasury			Stockholders’
	Class A Shares		Class B Shares		Class A Amount		Class B Amount		Capital		Income		Earnings			Stock			Equity
Balance, December 31, 2008		20,494,764		5,649,240	$	204,948	$	56,492	$	163,136,938	$	1,713,836	$	207,182,253		$	(8,710,602	)	$	363,583,865
Issuance of common stock (stock compensation plans)		50,232				502				934,151										934,653
Net income														11,302,279						11,302,279
Cash dividends declared														(5,595,637	)					(5,595,637	)
Grant of stock options										62,991				(62,991	)					—
Repurchase of treasury stock																	(198,879	)		(198,879	)
Other comprehensive income												21,503,441								21,503,441
Balance, September 30, 2009		20,544,996		5,649,240	$	205,450	$	56,492	$	164,134,080	$	23,217,277	$	212,825,904		$	(8,909,481	)	$	391,529,722

See accompanying notes to consolidated financial statements.

4

Donegal Group Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)

	Nine Months Ended September 30,
	2009			2008
Cash Flows from Operating Activities:
Net income	$	11,302,279		$	19,147,681
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,961,738			1,786,722
Net realized investment (gains) losses		(893,225	)		2,789,535
Changes in assets and liabilities:
Losses and loss expenses		11,222,678			18,321,092
Unearned premiums		18,145,206			36,449,339
Premiums receivable		(8,171,563	)		(8,221,167	)
Deferred acquisition costs		(2,242,635	)		(4,636,597	)
Deferred income taxes		(66,092	)		(1,534,983	)
Reinsurance receivable		(5,246,931	)		(7,612,143	)
Prepaid reinsurance premiums		(6,824,930	)		(7,616,205	)
Accrued investment income		338,405			(23,675	)
Due to affiliate		(2,345,677	)		216,870
Reinsurance balances payable		1,991,578			(112,419	)
Current income taxes		2,264,731			(300,535	)
Accrued expenses		(3,487,075	)		(1,065,974	)
Other, net		1,018,363			873,144
Net adjustments		7,664,571			29,313,004
Net cash provided by operating activities		18,966,850			48,460,685
Cash Flows from Investing Activities:
Purchases of fixed maturities:
Available for sale		(93,510,595	)		(149,742,022	)
Purchases of equity securities, available for sale		(25,815,019	)		(12,890,734	)
Maturity of fixed maturities:
Held to maturity		20,981,616			49,698,926
Available for sale		30,353,892			43,899,947
Sales of fixed maturities:
Available for sale		12,121,541			25,215,920
Sales of equity securities, available for sale		25,847,613			31,922,932
Payments to Sheboygan policyholders		(5,676,678	)		—
Net (increase) decrease in investment in affiliates		(98,771	)		401,828
Net purchases of property and equipment		(826,047	)		(932,986	)
Net sales (purchases) of short-term investments		32,103,338			(12,561,772	)
Net cash used in investing activities		(4,519,110	)		(24,987,961	)
Cash Flows from Financing Activities:
Cash dividends paid		(8,197,741	)		(7,417,380	)
Redemption of subordinated debentures		—			(15,464,000	)
Issuance of common stock		934,653			3,352,100
Purchase of treasury stock		(198,879	)		(2,449,448	)
Tax benefit on exercise of stock options		—			683,216
Net cash used in financing activities		(7,461,967	)		(21,295,512	)
Net increase in cash		6,985,773			2,177,212
Cash at beginning of period		1,830,954			4,289,365
Cash at end of period	$	8,816,727		$	6,466,577
Cash paid during period — Interest	$	675,193		$	1,772,648
Net cash (recovered) paid during period — Taxes	$	(792,582	)	$	6,125,000

See accompanying notes to consolidated financial statements.

5

DONEGAL GROUP INC. AND SUBSIDIARIES
(Unaudited)
Notes to Consolidated Financial Statements

1 — Organization

     Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as a downstream insurance holding company on August 26, 1986. Our six insurance subsidiaries and Donegal Mutual conduct business as the Donegal Insurance Group. The Donegal Insurance Group writes personal and commercial lines of property and casualty insurance exclusively through a network of independent insurance agents in 18 Mid-Atlantic, Midwestern and Southeastern states. The personal lines products consist primarily of homeowners and private passenger automobile policies. The commercial lines products consist primarily of commercial automobile, commercial multi-peril and workers’ compensation policies.

     Our insurance subsidiaries are Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”) which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, and Sheboygan Falls Insurance Company (“Sheboygan”). We also own approximately 48% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a unitary thrift holding company that owns Province Bank FSB. Donegal Mutual owns the remaining approximately 52% of the outstanding stock of DFSC.

     At September 30, 2009, Donegal Mutual held approximately 42% of our outstanding Class A common stock and approximately 75% of our outstanding Class B common stock.

     Atlantic States and Donegal Mutual are parties to a pooling agreement under which each company places all of its direct written business in the pool and both companies share proportionately the underwriting results of the pool, excluding certain reinsurance assumed by Donegal Mutual from our five other insurance subsidiaries. From July 1, 2000 through February 29, 2008, Atlantic States had a 70% share of the results of the pool, and Donegal Mutual had a 30% share of the results of the pool. Effective March 1, 2008, Donegal Mutual and Atlantic States amended the pooling agreement to increase Atlantic States’ share of the results of the pool to 80% and to decrease Donegal Mutual’s share of the pool to 20%. In connection with this amendment to the pooling agreement, Donegal Mutual transferred approximately $11.9 million in cash and net liabilities to Atlantic States. See Note 4 — Reinsurance for more information regarding the pooling agreement.

     On March 7, 2007, our board of directors authorized a share repurchase program, pursuant to which we may purchase up to 500,000 shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of Securities and Exchange Commission (“SEC”) Rule 10b-18 and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the three months ended September 30, 2009. We purchased 4,000 shares of our Class A common stock under this program during the three months ended September 30, 2008. We purchased 14,000 and 144,243 shares of our Class A common stock under this program during the nine months ended September 30, 2009 and 2008, respectively. We have purchased a total of 494,769 shares of our Class A common stock under this program through September 30, 2009.

     In June 2007, Donegal Mutual consummated an affiliation with Sheboygan. As part of the affiliation, Donegal Mutual made a $3.5 million contribution note investment in Sheboygan. During 2008, Sheboygan’s board of directors adopted a plan of conversion to convert to a stock insurance company. Following policyholder and regulatory approval of the plan of conversion, we acquired Sheboygan as of December 1, 2008 for approximately $12.0 million in cash, including payment of the contribution note and accrued interest to Donegal Mutual. Sheboygan’s results of operations have been included in our consolidated results since December 1, 2008.

     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 SEC Rule 10b-18 and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the nine months ended September 30, 2009.

6

     In October 2009, Donegal Mutual consummated an agreement with Southern Mutual Insurance Company (“Southern Mutual”), under which Donegal Mutual purchased a surplus note of Southern Mutual in the principal amount of $2,500,000, Donegal Mutual designees became a majority of the members of Southern Mutual’s board of directors and Donegal Mutual agreed to provide quota share reinsurance to Southern Mutual for 100% of its business. Effective October 31, 2009, Donegal Mutual began to include business assumed from Southern Mutual in its pooling agreement with Atlantic States. Southern Mutual writes primarily personal lines of insurance in Georgia and South Carolina and had net written premiums of approximately $12 million in 2008.

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 the interim periods included in this Form 10-Q Report. Our results of operations for the nine months ended September 30, 2009 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2009.

     You should read these interim financial statements in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2008. As indicated in Note 22 to our financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2008, we discovered an immaterial error in the amount recorded for net losses and loss expenses incurred for the third quarter of 2008. We adjusted our 2008 financial information included in this Form 10-Q Report to correct this error.

3 — Earnings Per Share

     We have two classes of common stock, which we refer to as our Class A common stock and our Class B common stock. Our certificate of incorporation provides that whenever our board of directors declares a dividend on our Class B common stock, our board of directors must also declare a dividend on our Class A common stock that is payable at the same time to holders as of the same record date at a rate that is at least 10% greater than the rate at which our board of directors declared the dividend on our Class B common stock. Accordingly, we use the two-class method to compute our earnings per common share. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on dividends we have declared and an allocation of our remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. The table below presents a reconciliation of the numerators and denominators we use to compute basic and diluted net income per share for each class of common stock:

For the Three Months Ended September 30:

	(in thousands, except per share data)
	2009				2008
	Class A		Class B		Class A		Class B
Basic net income per share:
Numerator:
Allocation of net income	$	5,386	$	1,359	$	5,009	$	1,261
Denominator:
Weighted-average shares outstanding		19,905,174		5,576,775		19,882,405		5,576,775
Basic net income per share	$	0.27	$	0.24	$	0.25	$	0.23
Diluted net income per share:
Numerator:
Allocation of net income	$	5,386	$	1,359	$	5,009	$	1,261
Denominator:
Number of shares used in basic computations		19,905,174		5,576,775		19,882,405		5,576,775
Weighted-average effect of dilutive securities
Director and employee stock options		—		—		132,787		—
Number of shares used in per share computations		19,905,174		5,576,775		20,015,192		5,576,775
Diluted net income per share	$	0.27	$	0.24	$	0.25	$	0.23

7

For the Nine Months Ended September 30:

	(in thousands, except per share data)
	2009				2008
	Class A		Class B		Class A		Class B
Basic net income per share:
Numerator:
Allocation of net income	$	9,028	$	2,274	$	15,280	$	3,868
Denominator:
Weighted-average shares outstanding		19,895,840		5,576,775		19,849,971		5,576,775
Basic net income per share	$	0.45	$	0.41	$	0.77	$	0.69
Diluted net income per share:
Numerator:
Allocation of net income	$	9,028	$	2,274	$	15,280	$	3,868
Denominator:
Number of shares used in basic computations		19,895,840		5,576,775		19,849,971		5,576,775
Weighted-average effect of dilutive securities
Director and employee stock options		—		—		176,458		—
Number of shares used in per share computations		19,895,840		5,576,775		20,026,429		5,576,775
Diluted net income per share	$	0.45	$	0.41	$	0.76	$	0.69

     We did not include outstanding options to purchase the following number of shares of Class A common stock in our computation of diluted earnings per share because the exercise price of the options was greater than the average market price during the relevant period:

	Three Months Ended				Nine months Ended
	September 30,				September 30,
	2009		2008		2009		2008
Number of shares		3,395,264		1,031,500		3,423,432		1,028,500

4 — Reinsurance

     Atlantic States has participated in a pooling agreement with Donegal Mutual since 1986 under which each company places all of its direct written business into the pool, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. From July 1, 2000 through February 29, 2008, Atlantic States had a 70% share of the results of the pool, and Donegal Mutual had a 30% share of the results of the pool. Effective March 1, 2008, Donegal Mutual and Atlantic States amended the pooling agreement to increase Atlantic States’ share of the results of the pool to 80%. Donegal Mutual transferred approximately $11.9 million of cash and net liabilities to Atlantic States in connection with this amendment to the pooling agreement as of March 1, 2008 as follows:

	(in thousands)
Unearned premiums (net of reinsurance)	$	13,626
Less: Ceding commissions		(1,709	)
Net liabilities transferred	$	11,917

     Atlantic States, Southern and Donegal Mutual purchase third-party reinsurance on a combined basis. Le Mars, Peninsula and Sheboygan have separate third-party reinsurance programs that provide similar types of coverage and that are commensurate with their relative size and risk exposures. Our insurance subsidiaries place reinsurance with various reinsurers, all of which, consistent with Donegal Insurance Group’s requirements, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating. The following information describes the external reinsurance Atlantic States, Southern and Donegal Mutual have in place during 2009 and 2008:

8

• excess of loss reinsurance, under which losses are automatically reinsured, through a series of reinsurance agreements, over a set retention ($750,000 and $600,000 for 2009 and 2008, respectively), and

• catastrophe reinsurance, under which Donegal Mutual, Atlantic States and Southern recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural disasters, over a set retention ($3.0 million for 2009 and 2008).

     Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures from losses that exceed the limits provided by their reinsurance agreements with third parties.

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

     We renewed our 2009 reinsurance program at rates comparable to 2008, largely attributable to our decision to increase our excess of loss reinsurance retention from $600,000 to $750,000 effective January 1, 2009. We made no other significant changes to our third-party reinsurance or other reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2009.

5 — Investments

     The amortized cost and estimated fair values of our fixed maturities and equity securities at September 30, 2009 are as follows:

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(in thousands)
Held to Maturity
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	2,000	$	98	$	—	$	2,098
Obligations of states and political subdivisions		63,831		3,879		—		67,710
Corporate securities		8,343		73		16		8,400
Residential mortgage-backed securities		4,366		90		—		4,456
Totals	$	78,540	$	4,140	$	16	$	82,664

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(in thousands)
Available for Sale
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	23,899	$	180	$	270	$	23,809
Obligations of states and political subdivisions		366,766		24,036		111		390,691
Corporate securities		31,169		787		99		31,857
Residential mortgage-backed securities		77,988		3,230		—		81,218
Fixed maturities		499,822		28,233		480		527,575
Equity securities		3,579		5,099		262		8,416
Totals	$	503,401	$	33,332	$	742	$	535,991

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The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2008 are as follows:

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(in thousands)
Held to Maturity
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	8,517	$	176	$	—	$	8,693
Obligations of states and political subdivisions		76,451		1,955		231		78,175
Corporate securities		8,342		57		392		8,007
Residential mortgage-backed securities		6,568		35		29		6,574
Totals	$	99,878	$	2,223	$	652	$	101,449

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(in thousands)
Available for Sale
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	6,526	$	105	$	—	$	6,631
Obligations of states and political subdivisions		341,663		5,321		9,981		337,003
Corporate securities		24,518		208		790		23,936
Residential mortgage-backed securities		76,304		1,960		18		78,246
Fixed maturities		449,011		7,594		10,789		445,816
Equity securities		2,939		3,015		59		5,895
Totals	$	451,950	$	10,609	$	10,848	$	451,711

     The amortized cost and estimated fair value of our fixed maturities at September 30, 2009, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

			Estimated
	Amortized		Fair
	Cost		Value
	(in thousands)
Held to maturity
Due in one year or less	$	6,601	$	6,659
Due after one year through five years		6,016		6,198
Due after five years through ten years		58,204		61,850
Due after ten years		3,353		3,501
Residential mortgage-backed securities		4,366		4,456
Total held to maturity	$	78,540	$	82,664
Available for sale
Due in one year or less	$	13,644	$	13,912
Due after one year through five years		86,589		90,011
Due after five years through ten years		113,204		120,103
Due after ten years		208,397		222,331
Residential mortgage-backed securities		77,988		81,218
Total available for sale	$	499,822	$	527,575

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

	Nine Months Ended
	September 30,
	2009		2008
	(in thousands)
Gross realized gains:
Fixed maturities	$	133	$	670
Equity securities		889		1,521
	$	1,022	$	2,191
Gross realized losses:
Fixed maturities	$	82	$	308
Equity securities		47		4,673
		129		4,981
Net realized gains (losses)	$	893	$	(2,790	)

     We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at September 30, 2009 as follows:

	Less than 12 months				12 months or longer
	Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses
	(in thousands)
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	9,308	$	270	$	—	$	—
Obligations of states and political subdivisions		5,456		36		5,809		76
Corporate securities		1,811		26		1,673		88
Residential mortgage-backed securities		—		—		—		—
Equity securities		1,815		262		—		—
Total	$	18,390	$	594	$	7,482	$	164

     We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2008 as follows:

	Less than 12 months				12 months or longer
	Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses
	(in thousands)
Obligations of states and political subdivisions	$	117,360	$	6,881	$	65,627	$	3,331
Corporate securities		16,781		449		2,536		733
Residential mortgage-backed securities		2,925		24		2,929		23
Equity securities		484		59		—		—
Total	$	137,550	$	7,413	$	71,092	$	4,087

     Of our total fixed maturity securities with an unrealized loss at September 30, 2009, we classified 19 securities with a fair value of $22.8 million and an unrealized loss of $479,570 as available-for-sale and carried them at fair value on our balance sheet, while we classified three securities with a fair value of $1.2 million and an unrealized loss of $15,951 as held-to-maturity on our balance sheet and carried them at amortized cost.

     Of our total fixed maturity securities with an unrealized loss at December 31, 2008, we classified 179 securities with a fair value of $184.1 million and an unrealized loss of $10.8 million as available-for-sale and carried them at fair value on our balance sheet, while we classified 23 securities with a fair value of $24.1 million and an unrealized loss of $652,450 as held-to-maturity on our balance sheet and carried them at amortized cost.

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     We have no direct exposure to sub-prime residential mortgage-backed securities and hold no collateralized debt obligations. Substantially all of the unrealized losses in our fixed maturity investment portfolio have resulted from general market conditions and the related impact on our fixed maturity investment valuations. We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, when we consider the decline in value of an individual investment to be other than temporary, we write the investment down to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations. We individually monitor all investments for other-than-temporary declines in value. Generally, if an individual equity security has depreciated in value by more than 20% of original cost, and has been in such an unrealized loss position for more than six months, we assume there has been an other-than-temporary decline in value. We held three equity securities that were in an unrealized loss position at September 30, 2009. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we consider these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the security prior to recovery. If it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. To determine whether a credit loss has occurred, we compare the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider a credit loss to have occurred. If we consider a credit loss to have occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including the fair value of the investment being significantly below its cost, whether the financial condition of the issuer of a security is deteriorating, the occurrence of industry, company and geographic events that have negatively impacted the value of a security and rating agency downgrades. We determined that no investments with fair values below cost had declined on an other-than-temporary basis during the first nine months of 2009. We determined that certain investments with fair values below cost had declined on an other-than-temporary basis and included losses of $1.2 million in our results of operations for these investments during the first nine months of 2008.

     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 for mortgage-backed debt securities using anticipated prepayments.

     We account for investments in affiliates using the equity method of accounting. Under the equity method, we record our investment at cost, with adjustments for our share of affiliate earnings and losses as well as changes in affiliate equity due to unrealized gains and losses.

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6 — Segment Information

     We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries as determined under statutory accounting principles prescribed or permitted by various state insurance departments (“SAP”). Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). Financial data by segment is as follows:

	Three Months Ended
	September 30,
	2009			2008
	(in thousands)
Revenues:
Premiums earned:
Commercial lines	$	27,520		$	30,781
Personal lines		60,546			57,390
Net premiums earned		88,066			88,171
GAAP adjustments		(68	)		—
GAAP premiums earned		87,998			88,171
Net investment income		5,107			5,802
Realized investment gains (losses)		189			(2,811	)
Other		1,582			1,547
Total revenues	$	94,876		$	92,709
Income before income taxes:
Underwriting income (loss):
Commercial lines	$	4,410		$	3,194
Personal lines		(4,040	)		202
SAP underwriting income		370			3,396
GAAP adjustments		632			578
GAAP underwriting income		1,002			3,974
Net investment income		5,107			5,802
Realized investment gains (losses)		189			(2,811	)
Other		1,067			834
Income before income taxes	$	7,365		$	7,799

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	Nine Months Ended
	September 30,
	2009			2008
	(in thousands)
Revenues:
Premiums earned:
Commercial lines	$	84,844		$	90,617
Personal lines		179,557			166,891
Net premiums earned		264,401			257,508
GAAP adjustments		(513	)		—
GAAP premiums earned		263,888			257,508
Net investment income		15,731			17,287
Realized investment gains (losses)		893			(2,790	)
Other		4,646			4,467
Total revenues	$	285,158		$	276,472
Income before income taxes:
Underwriting income (loss):
Commercial lines	$	6,431		$	9,653
Personal lines		(14,269	)		(6,863	)
SAP underwriting income (loss)		(7,838	)		2,790
GAAP adjustments (1)		1,971			5,124
GAAP underwriting income (loss)		(5,867	)		7,914
Net investment income		15,731			17,287
Realized investment gains (losses)		893			(2,790	)
Other		1,954			1,709
Income before income taxes	$	12,711		$	24,120

(1) GAAP adjustments for the nine months ended September 30, 2008 include an increase in deferred acquisition costs, which offset the ceding commissions that we included in the transfer of net liabilities from Donegal Mutual discussed in Note 4 — Reinsurance.

7 — Subordinated Debentures

     On October 29, 2003, we received $10.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on October 29, 2033 and are callable at our option, at par, after October 29, 2008. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At September 30, 2009, the interest rate on the debentures was 4.35%.

     On May 24, 2004, we received $5.0 million in net proceeds from the issuance of subordinated debentures. The debentures mature on May 24, 2034 and are callable at our option, at par, after May 24, 2009. The debentures carry an interest rate equal to the three-month LIBOR rate plus 3.85%, which is adjustable quarterly. At September 30, 2009, the interest rate on the debentures was 4.26%.

8 — Share-Based Compensation

     We measure all share-based payments to employees, including grants of stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates other than Donegal Mutual, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilized in applying the Black-Scholes option pricing model are the risk-free interest rate, expected term, dividend yield and expected volatility.

     We charged compensation expense for our stock compensation plans against income before income taxes of $61,614 and $55,518 for the three months ended September 30, 2009 and 2008, respectively, with a corresponding income tax benefit of $21,565 and $19,431, respectively. We charged compensation expense for our stock compensation plans against income before income taxes of $172,005 and $142,214 for the nine months ended September 30, 2009 and 2008, respectively, with a corresponding income tax

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benefit of $60,202 and $49,775, respectively. As of September 30, 2009, our total unrecognized compensation cost related to nonvested share-based compensation granted under our stock compensation plans was $114,442. We expect to recognize this cost over a weighted average period of 2.6 years.

     We account for share-based compensation to employees and directors of Donegal Mutual as share-based compensation to employees of a controlling entity. As such, we measure the fair value of the award at the grant date and recognize the fair value as a dividend to the controlling entity. This accounting applies to options we grant to employees and directors of Donegal Mutual, the employer of a majority of the employees that provide services to us. We recorded implied dividends of $30,068 and $1,709,099 for the three months ended September 30, 2009 and 2008, respectively. We recorded implied dividends of $62,991 and $1,749,063 for the nine months ended September 30, 2009 and 2008, respectively.

     We received cash from option exercises under all stock compensation plans for the three months ended September 30, 2009 and 2008 of $0 and $877,773, respectively. We realized tax benefits for the tax deductions from option exercises of $0 and $51,459 for the three months ended September 30, 2009 and 2008, respectively. We received cash from option exercises under all stock compensation plans for the nine months ended September 30, 2009 and 2008 of $0 and $2.3 million, respectively. We realized tax benefits for the tax deductions from option exercises of $0 and $683,216 for the nine months ended September 30, 2009 and 2008, respectively.

9 — Fair Value Measurements

     We account for financial assets using a framework that establishes a hierarchy that ranks the quality and reliability of inputs, or assumptions, used in the determination of fair value, and we classify financial assets and liabilities carried at fair value in one of the following three categories:

     Level 1 — quoted prices in active markets for identical assets and liabilities;

     Level 2 — directly or indirectly observable inputs other than Level 1 quoted prices; and

     Level 3 — unobservable inputs not corroborated by market data.

     For investments that have quoted market prices in active markets, we use the quoted market price as fair value and include these investments in Level 1 of the fair value hierarchy. We classify publicly traded equity securities as Level 1. When quoted market prices in active markets are not available, we base fair values on quoted market prices of comparable instruments or broker quotes we obtain from independent pricing services through a bank trustee. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury securities and obligations of U.S, government corporations and agencies, obligations of states and political subdivisions, corporate securities and residential mortgage-backed securities. During the third quarter, we reclassified one equity security to Level 3. The fair value of this security was difficult to determine due to the announcement by the issuer that it intended to offer securities as a result of an initial public offering in October 2009. We utilized a fair value model that incorporated significant other unobservable inputs, such as estimated volatility, to estimate the equity security’s fair value. We are restricted from selling certain shares we obtained in the initial public offering for a period of 18 months, and the fair value we determined as of September 30, 2009 reflects this selling restriction. During the third quarter and first nine months of 2009, we recorded an unrealized gain of $2.1 million related to this security in other comprehensive income.

     We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if the security was sold in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values for our fixed maturity and equity investments. We generally obtain one price per security. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements using proprietary pricing applications, which include available relevant market information, benchmark yields, sector curves and matrix pricing. The pricing services do not use broker quotes in determining the fair values of our investments. We review the estimates of fair value provided by the pricing services to determine if the estimates obtained are representative of fair values based upon our general knowledge of the market, our research findings related to unusual fluctuations in value and our comparison of such values to execution prices for similar securities.

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     As of September 30, 2009 and December 31, 2008, we received one estimate per security from one of the pricing services and we priced all but an insignificant amount of our Level 1 and Level 2 investments using those prices. In our review of the estimates provided by the pricing services as of September 30, 2009 and December 31, 2008, we did not identify any discrepancies and we did not make any adjustments to the estimates the pricing services provided.

     We present our cash and short-term investments at estimated fair value. The carrying values in the balance sheet for premium and reinsurance receivables and payables approximate their fair values. The carrying amounts reported in the balance sheet for our subordinated debentures approximate their fair values due to their variable rate nature.

     We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities as of September 30, 2009:

			Fair Value Measurements Using
			Quoted
			Prices in
			Active		Significant
			Markets for		Other			Significant
			Identical		Observable			Unobservable
			Assets		Inputs			Inputs
	Fair Value		(Level 1)		(Level 2)			(Level 3)
			(in thousands)
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	23,809	$	—	$	23,809		$	—
Obligations of states and political subdivisions		390,691		—		390,691			—
Corporate securities		31,857				31,857	��
Residential mortgage-backed securities		81,218		—		81,218			—
Equity securities		8,416		2,266		1,190			4,960
Total	$	535,991	$	2,266	$	528,765		$	4,960

     The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities as of December 31, 2008:

			Fair Value Measurements Using
			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)
			(in thousands)
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	6,630	$	—	$	6,630	$	—
Obligations of states and political subdivisions		337,003		—		337,003		—
Corporate securities		23,936		—		23,936		—
Residential mortgage-backed securities		78,247		—		78,247		—
Equity securities		5,895		4,971		924		—
Total	$	451,711	$	4,971	$	446,740	$	—

10 — Income Taxes

     As of September 30, 2009 and December 31, 2008, respectively, we had no material unrecognized tax benefits or accrued interest and penalties. The Internal Revenue Service examined our 2006 federal tax return and made no adjustments to the reported tax. Tax years 2006, 2007 and 2008 remained open for examination as of September 30, 2009.

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11 — Impact of New Accounting Standards

     In April 2009, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) FAS 115-2 and Financial Accounting Standard (FAS) 124-2, Recognition and Presentation of Other-Than- Temporary Impairments, codified in FASB Accounting Standards Codification (ASC) section 320-10-65. ASC section 320-10-65 provides guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on debt and equity securities. ASC section 320-10-65 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for interim and annual periods ending after March 15, 2009. Effective April 1, 2009, we adopted ASC section 320-10-65. For the interim period ended September 30, 2009, we had no cumulative effect adjustment because we had sold in previous periods all securities determined to be other-than-temporary-impaired. Beginning on April 1, 2009, we analyzed our debt securities for other-than-temporary-impairment adjustments using the guidance in ASC section 320-10-65.

     In April 2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” codified in ASC section 820-10-35. ASC section 820-10-35 provides guidelines for making fair value measurements that are more consistent with the principles presented in FAS 157, “Fair Value Measurements,” codified in ASC subtopic 820-10. ASC section 820-10-35 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for interim and annual periods ending after March 15, 2009. Effective April 1, 2009, we adopted ASC section 820-10-35. The adoption of ASC section 820-10-35 expanded certain fair value disclosures in our financial statements but had no effect on our results of operations, financial condition or liquidity.

     In April 2009, the FASB issued FSP FAS 107-1 and Accounting Principles Board (APB) 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” codified in ASC section 825-10-65. ASC section 825-10-65 amends FAS 107, “Disclosures about Fair Value of Financial Instruments,” codified in ASC subtopic 825-10, to require disclosures about fair value of financial instruments for interim periods as well as in annual financial statements. ASC section 825-10-65 is effective for interim and annual periods ending after June 30, 2009, with early adoption permitted for interim and annual periods ending after March 15, 2009. Effective June 30, 2009, we adopted ASC section 825-10-65. Footnote 9 includes the disclosures ASC section 825-10-65 require.

     In May 2009, the FASB issued FAS 165, “Subsequent Events,” codified in ASC section 855-10-50. ASC section 855-10-50 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. ASC section 855-10-50 is effective for interim and annual periods ending after June 15, 2009. Effective June 30, 2009, we adopted ASC section 855-10-50. We have evaluated subsequent events for potential recognition or disclosure through November 6, 2009, the date we issued the consolidated financial statements included in this Quarterly Report on Form 10-Q.

     In June 2009, the FASB issued FAS 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162.” On the effective date of this Standard, ASC became the source of authoritative U.S. accounting and reporting standards for nongovernmental entities, in addition to guidance issued by the SEC. ASC significantly changes the way financial statement preparers, auditors and academic personnel perform accounting research. This statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The new standard flattens the GAAP hierarchy to two levels: one that is authoritative (in ASC) and one that is non-authoritative (not in ASC). We began to use the new guidelines and numbering system prescribed by the Codification referring to GAAP in the third quarter of 2009. As the intent of Codification was not to change or alter existing GAAP, the adoption did not impact our financial position or results of operations.

12 — Future Adoption of New Accounting Standards

     In June 2009, the FASB issued FAS 166, “Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140.” FAS 166 amends the derecognition guidance in Statement 140 and eliminates the concept of qualifying special-purpose entities (“QSPEs”). FAS 166 is effective for fiscal years and interim periods beginning after November 15, 2009. Early adoption of FAS 166 is prohibited. We will adopt FAS 166 on January 1, 2010 and have not yet determined the effect of its adoption on our consolidated financial statements.

     In June 2009, the FASB issued FAS 167, “Amendments to FASB Interpretation No. 46(R),” which amends the consolidation guidance applicable to variable interest entities (“VIEs”). An entity would

17

consolidate a VIE, as the primary beneficiary, when the entity has both of the following characteristics: (a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (b) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. FAS 167 requires ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE. FAS 167 amends interpretation 46(R) to eliminate the quantitative approach previously required for determining the primary beneficiary of a VIE. FAS 167 is effective for fiscal years and interim periods beginning after November 15, 2009. We will adopt FAS 167 on January 1, 2010 and have not yet determined the effect of its adoption on our consolidated financial statements.

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

     You should read the following information in conjunction with the historical financial information and the notes thereto included in this Quarterly Report on Form 10-Q and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2008.

Critical Accounting Policies and Estimates

     We combine our financial statements with those of our insurance subsidiaries and present our financial statements on a consolidated basis in accordance with GAAP.

     Our insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures that we report in our financial statements. The most significant estimates relate to our insurance subsidiaries’ reserves for property and casualty insurance unpaid losses and loss expenses, valuation of investments and determination of other-than-temporary impairment in the value of investments and policy acquisition costs. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts may differ from the amounts estimated. We regularly review these estimates and reflect any adjustment considered necessary in our current results of operations.

Liability for Unpaid Losses and Loss Expenses

     Liabilities for unpaid losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to policyholder claims based on facts and circumstances then known. An insurer recognizes at the time of establishing its estimates that its ultimate liability for unpaid losses and loss expenses will exceed or be less than those estimates. Our insurance subsidiaries base their estimates of liabilities for unpaid losses and loss expenses on assumptions as to future loss trends and expected claims severity, judicial theories of liability and other factors, including prevailing economic conditions. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to adjust their estimates of liability. Our insurance subsidiaries reflect any adjustments to their liabilities for unpaid losses and loss expenses in their results of operations for the period in which our insurance subsidiaries change their estimates.

     Our insurance subsidiaries maintain liabilities for the payment of unpaid losses and loss expenses with respect to both reported and unreported claims. It is the intent of our insurance subsidiaries that their liabilities for loss expenses will cover the ultimate costs of settling all losses, including investigation and litigation costs from those losses. Our insurance subsidiaries base the amount of their liabilities for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the provisions of our insurance policies relating to the type of loss. Our insurance subsidiaries determine the amount of their liabilities for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries closely monitor their liabilities and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for unpaid losses and loss expenses.

     Our liability estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions as to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while claims severity has

18

gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on bodily injury claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include accurate measurement of the impact of rate changes and changes in policy provisions and consistency in the quality and characteristics of business written within a given line of business among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries make adjustments they consider appropriate for those changes in their liabilities. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded at September 30, 2009. For every 1% change in our estimate of our insurance subsidiaries’ liability for unpaid losses and loss expenses, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $1.7 million.

     The establishment of appropriate liabilities is an inherently uncertain process. There can be no assurance that the ultimate liability of our insurance subsidiaries will not exceed our insurance subsidiaries’ unpaid loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, since the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for unpaid losses and loss expenses in certain periods, and in other periods their estimates have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimate of their liability for unpaid losses and loss expenses generally reflect actual payments and the evaluation of information received since the prior reporting date.

     Excluding the impact of severe weather events, our insurance subsidiaries have noted slight downward trends in the number of claims incurred and the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the property and casualty insurance industry has experienced increased litigation trends, periods in which economic conditions have extended the estimated length of disabilities, increased medical loss cost trends and a general slowing of settlement rates in litigated claims. We may make adjustments in the future to reflect subsequent developments. However, on the basis of our insurance subsidiaries’ internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for unpaid losses and loss expenses as of September 30, 2009.

     Atlantic States’ participation in the pool with Donegal Mutual exposes it to adverse loss development on the business of Donegal Mutual that is included in the pool. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States share any adverse risk development of the pooled business according to their respective participation in the pool. The business in the pool is homogeneous and each company has a percentage share of the entire pool as provided in the pooling agreement. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its respective participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than they would experience individually and to spread the risk of loss between Atlantic States and Donegal Mutual.

     The risk profiles of the business Atlantic States and Donegal Mutual write have historically been, and continue to be, substantially similar. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries.

     In addition, Donegal Mutual and our insurance subsidiaries, operating together as the Donegal Insurance Group, share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual offer are generally complementary, thereby allowing Donegal Insurance Group to offer a broader range of products to a given market and to expand Donegal Insurance Group’s ability to service an entire personal lines or commercial

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lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier products compared to standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business directly written by the individual companies will vary. However, as the risk characteristics of all business written directly by Donegal Mutual and Atlantic States are homogenized within the pool and each company shares the results according to each company’s participation percentage, each company realizes its percentage share of the underwriting results of the pool.

     Our insurance subsidiaries’ unpaid liability for losses and loss expenses by major line of business as of September 30, 2009 and December 31, 2008 consisted of the following:

	September 30,		December 31,
	2009		2008
	(in thousands)
Commercial lines:
Automobile	$	22,049	$	19,758
Workers’ compensation		36,394		36,667
Commercial multi-peril		27,757		27,808
Other		1,732		1,893
Total commercial lines		87,932		86,126
Personal lines:
Automobile		66,879		60,939
Homeowners		10,557		11,796
Other		1,837		2,445
Total personal lines		79,273		75,180
Total commercial and personal lines		167,205		161,306
Plus reinsurance recoverable		83,827		78,503
Total liability for unpaid losses and loss expenses	$	251,032	$	239,809

     We have evaluated the effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables we considered in establishing the loss and loss expense reserves of our insurance subsidiaries. We established the range of reasonably likely changes based on a review of changes in accident year development by line of business and applied those changes to our insurance subsidiaries’ loss reserves as a whole. The selected range does not necessarily indicate what could be the potential best or worst case or the most likely scenario. The following table sets forth the estimated effect on our insurance subsidiaries’ unpaid loss and loss expense reserves and our stockholders’ equity in the event of reasonably likely changes in the variables considered in establishing loss and loss expense reserves:

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			Adjusted Loss and		Percentage			Adjusted Loss and		Percentage
Percentage			Loss Expense		Change			Loss Expense		Change
Change in Loss			Reserves Net of		in Stockholders’			Reserves Net of		in Stockholders’
and Loss Expense			Reinsurance as of		Equity as of			Reinsurance as of		Equity as of
Reserves Net of			September 30,		September 30,			December 31,		December 31,
Reinsurance			2009		2009(1)			2008		2008(1)
(dollars in thousands)
	(10.0	)%	$	150,485		2.8	%	$	145,175		2.9	%
	(7.5	)		154,665		2.1			149,208		2.2
	(5.0	)		158,845		1.4			153,241		1.4
	(2.5	)		163,025		0.7			157,273		0.7
Base				167,205		—			161,306		—
	2.5			171,385		-0.7			165,339		-0.7
	5.0			175,565		-1.4			169,371		-1.4
	7.5			179,745		-2.1			173,404		-2.2
	10.0			183,926		-2.8			177,437		-2.9

(1) Net of income tax effect.

Investments

     We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, when we consider the decline in value of an individual investment to be other than temporary, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations. We individually monitor all investments for other-than-temporary declines in value. Generally, if an individual equity security has depreciated in value by more than 20% of original cost, and has been in such an unrealized loss position for more than six months, we assume there has been an other-than-temporary decline in value. We held three equity securities that were in an unrealized loss position at September 30, 2009. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we consider these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the security prior to recovery. If it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. To determine whether a credit loss has occurred, we compare the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider a credit loss to have occurred. If we consider a credit loss to have occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including the fair value of the investment being significantly below its cost, whether the financial condition of the issuer of a security is deteriorating, the occurrence of industry, company and geographic events that have negatively impacted the value of a security and rating agency downgrades. We determined that no investments with a fair value below cost had declined on an other-than-temporary basis during the first nine months of 2009. We determined that certain investments with a fair value below cost had declined on an other-than-temporary basis and included losses of $1.2 million in our results of operations for these investments during the first nine months of 2008.

     We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if the security was sold in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values for our fixed maturity and equity investments. We generally obtain one price per

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security. The pricing services utilize market quotations for fixed maturity and equity securities that have quoted prices in active markets. For fixed maturity securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements using proprietary pricing applications, which include available relevant market information, benchmark yields, sector curves and matrix pricing. The pricing services do not use broker quotes in determining the fair values of our investments. We review the estimates of fair value provided by the pricing services to determine if the estimates obtained are representative of market prices based upon our general knowledge of the market, our research findings related to unusual fluctuations in value and our comparison of such values to execution prices for similar securities. As of September 30, 2009 and December 31, 2008, we received one estimate per security from one of the pricing services and we priced all but an insignificant amount of our Level 1 and Level 2 investments using those prices. In our review of the estimates provided by the pricing services as of September 30, 2009 and December 31, 2008, we did not identify any discrepancies and we did not make any adjustments to the fair value estimates the pricing services provided. We classified one equity security as Level 3 as of September 30, 2009, as described in Footnote 9. The fair value of this security was difficult to determine due to the announcement by the issuer that it intended to offer securities in an initial public offering in October 2009. We utilized a fair value model that incorporated significant other unobservable inputs, such as estimated volatility, to estimate the equity security’s fair value. We are restricted from selling certain shares we obtained as a result of the initial public offering for a period of 18 months, and the fair value we determined as of September 30, 2009 reflects this selling restriction.

Policy Acquisition Costs

     Our insurance subsidiaries defer their policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that vary with and are primarily related to the production of business. We amortize these costs over the period in which our insurance subsidiaries earn the related premiums. The method we follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premiums to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premiums.

Results of Operations — Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

     Net Premiums Written. Net premiums written for the three months ended September 30, 2009 were $93.6 million, an increase of $1.4 million, or 1.6%, from the $92.2 million of net premiums written for the comparable period in 2008. Personal lines net premiums written increased $3.7 million, or 5.9%, for the third quarter of 2009 compared to the comparable period in 2008, due to increased writings in our personal automobile and homeowners lines of business . Commercial lines net premiums written decreased $2.3 million, or 7.9%, for the third quarter of 2009 compared to the comparable period in 2008 primarily because of competitive conditions in this market during an uncertain economy.

     Net Premiums Earned. Net premiums earned decreased slightly to $88.0 million for the third quarter of 2009, compared to $88.2 million for the third quarter of 2008. 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 twelve-month period compared to the comparable period one year earlier.

     Investment Income. For the three months ended September 30, 2009, our net investment income decreased to $5.1 million, compared to $5.8 million for the comparable period one year ago. An increase in our average invested assets from $621.2 million for the third quarter of 2008 to $647.0 million for the third quarter of 2009 was offset by a decrease in our annualized average rate of return to 3.2% in 2009, compared to 3.7% in 2008. The decrease in our annualized average rate of return on investments was primarily due to increased holdings of lower-yielding tax-exempt municipal bonds and short-term U.S. Treasury securities during the third quarter of 2009.

     Net Realized Investment Gains (Losses). Net realized investment gains for the third quarter of 2009 were $189,230, compared to net realized investment losses of $2.8 million for the comparable period in 2008. We did not recognize any impairment losses during the third quarter of 2009. During the third quarter of 2008, we included impairment losses of $328,716 in net realized investment gains (losses).

     Losses and Loss Expenses. Our loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, for the third quarter of 2009 was 66.6%, an increase from our 62.0% loss ratio for the

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third quarter of 2008. We experienced weather-related losses of $5.9 million after reinsurance and adverse prior-accident-year loss reserve development of approximately $1.6 million in the third quarter of 2009. Our commercial lines loss ratio decreased to 52.7% for the third quarter of 2009, compared to 57.3% for the third quarter of 2008, primarily due to decreases in our commercial multi-peril and workers’ compensation loss ratios. Our personal lines loss ratio increased to 72.0% for the third quarter of 2009, compared to 64.3% for the third quarter of 2008, primarily due to increases in our personal automobile loss ratio.

     Underwriting Expenses. Our expense ratio, which is the ratio of policy acquisition costs and other underwriting expenses to premiums earned, for the third quarters of 2009 and 2008 were 32.0% and 33.0%, respectively. Our expense ratio for the third quarter of 2009 reflected decreased expenses incurred for underwriting-based incentive compensation costs as a result of our higher loss ratio compared to the comparable period in 2008 and the cost reduction initiatives we began in 2008.

     Combined Ratio. Our combined ratio was 98.9% and 95.5% for the three months ended September 30, 2009 and 2008, respectively. Our combined ratio represents the sum of our loss ratio, expense ratio and dividend ratio, which is the ratio of workers’ compensation policy dividends incurred to premiums earned.

     Interest Expense. Interest expense for the third quarter of 2009 was $185,315, compared to $398,855 for the third quarter of 2008. The lower interest expense in the 2009 period reflected a decrease in average interest rates on our subordinated debentures for the third quarter of 2009 compared to the comparable period in 2008 and the redemption of $15 million of subordinated debentures in August 2008.

     Income Taxes.Income tax expense was $620,402 for the third quarter of 2009, representing an effective tax rate of 8.4%, compared to $1.5 million for the third quarter of 2008, representing an effective tax rate of 19.5%. The change in effective tax rates is due to tax-exempt interest income representing a greater proportion of net income before taxes for the third quarter of 2009 compared to the comparable period in 2008 and an adjustment to income taxes for the third quarter of 2009 to reflect a decrease in our projected annual taxable income for the full year 2009.

     Net Income and Earnings Per Share. Our net income for the third quarter of 2009 was $6.7 million, or $.27 per share of Class A common stock and $.24 per share of Class B common stock, compared to net income of $6.3 million, or $.25 per share of Class A common stock and $.23 per share of Class B common stock, reported for the third quarter of 2008. Our fully diluted Class A shares outstanding for the third quarter of 2009 decreased slightly to 19.9 million, compared to 20.0 million for the third quarter of 2008, as a result of our repurchase of treasury stock. We had 5.6 million Class B shares outstanding for both periods.

Results of Operations — Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008

     Net Premiums Written. Net premiums written for the nine months ended September 30, 2009 were $275.2 million, a decrease of $11.1 million, or 3.9%, over the comparable period in 2008. Net premiums written for the nine months of 2008 included a $13.6 million transfer of unearned premiums related to the change in the pooling agreement between Atlantic States and Donegal Mutual effective March 1, 2008. Commercial lines net premiums written decreased $14.6 million, or 14.4%, for the first nine months of 2009 compared to the comparable period in 2008 primarily because of competitive conditions in this market during an uncertain economy. Personal lines net premiums written increased $3.4 million, or 1.9%, for the first nine months of 2009 compared to the comparable period in 2008, due to increased writings in our personal automobile and homeowners lines of business.

     Net Premiums Earned. Net premiums earned were $263.9 million for the first nine months of 2009, an increase of $6.4 million, or 2.5%, over the first nine months of 2008. Premiums are earned, or recognized as revenue, over the terms of our 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 twelve-month period compared to the comparable period one year earlier.

     Investment Income. For the nine months ended September 30, 2009, our net investment income decreased to $15.7 million, compared to $17.3 million for the comparable period one year ago. An increase in average invested assets from $615.0 million for the first nine months of 2008 to $647.7 million for the first nine months of 2009 was offset by a decrease in the annualized average rate of return on investments from 3.7% for the first nine months of 2008 to 3.2% for the first nine months of 2009. The decrease in our annualized average rate of return on investments was primarily due to increased holdings of lower-yielding tax-exempt municipal bonds and short-term U.S. Treasury securities during the first nine months of 2009.

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     Net Realized Investment Gains (Losses). Net realized investment gains for the first nine months of 2009 were $893,225, compared to net realized investment losses of $2.8 million for the comparable period in 2008. We recognized no impairment charges in the first nine months of 2009, compared to impairment charges of $1.2 million recognized in the first nine months of 2008. The impairment charges for 2008 were the result of declines in the fair value of equity securities that we deemed to be other than temporary. The remaining net realized investment gains in both periods resulted from normal sales from our investment portfolio.

     Losses and Loss Expenses. Our loss ratio for the first nine months of 2009 was 70.7%, compared to 64.0% for the first nine months of 2008. Losses and loss expenses increased for the first nine months of 2009, as we experienced significant weather-related claim activity and unfavorable prior-accident-year loss reserve development largely attributable to weather-related property claims compared to the first nine months of 2008. The commercial lines loss ratio increased to 61.5% for the first nine months of 2009, compared to 55.6% for the first nine months of 2008, primarily due to increases in the commercial automobile, workers’ compensation and commercial multi-peril loss ratios. The personal lines loss ratio increased from 68.7% for the first nine months of 2008 to 74.8% for the first nine months of 2009, primarily due to increases in our homeowners loss ratio.

     Underwriting Expenses. Our expense ratio for the first nine months of 2009 was 31.3%, compared to 32.6% for the first nine months of 2008. The expense ratio reflected decreased expenses incurred for underwriting-based incentive compensation costs as a result of higher loss ratios compared to the comparable period in 2008 and the cost reduction initiatives we began in 2008.

     Combined Ratio. Our combined ratio was 102.2% and 96.9% for the nine months ended September 30, 2009 and 2008, respectively. The combined ratio represents the sum of the loss ratio, expense ratio and dividend ratio. The increase in the combined ratio was largely attributable to the increase in the loss ratio for the 2009 period compared to the 2008 period.

     Interest Expense. Interest expense for the first nine months of 2009 was $1.6 million, compared to $1.5 million for the first nine months of 2008. The higher interest expense for the 2009 period reflected approximately $974,000 related to interest and penalties on contested premium tax litigation, which was offset by a decrease in average interest rates on our subordinated debentures in the first nine months of 2009 compared to the comparable period in 2008 and the redemption of $15 million of subordinated debentures in August 2008.

     Income Taxes.Income tax expense was $1.4 million for the first nine months of 2009, representing an effective tax rate of 11.1%, compared to $5.0 million for the first nine months of 2008, representing an effective tax rate of 20.6%. The change in effective tax rates is primarily due to tax-exempt interest income representing a greater proportion of net income before taxes in the 2009 period compared to the 2008 period.

     Net Income and Earnings Per Share.Our net income for the first nine months of 2009 was $11.3 million, or $.45 per share of Class A common stock and $.41 per share of Class B common stock, compared to our net income of $19.1 million, or $.76 per share of Class A common stock on a diluted basis and $.69 per share of Class B common stock, for the first nine months of 2008. We had 20.0 million diluted Class A shares and 5.6 million Class B shares outstanding for both periods.

Liquidity and Capital Resources

     Liquidity is a measure of an entity’s ability to secure enough cash to meet its contractual obligations and operating needs as they arise. Our major sources of funds from operations are the net cash flows generated from our insurance subsidiaries’ underwriting results, investment income and maturing investments.

     We have historically generated sufficient net positive cash flow from our operations to fund our commitments and build our investment portfolio, thereby increasing future investment returns. The impact of the pooling agreement between Donegal Mutual and Atlantic States has historically been cash flow positive because of the consistent underwriting profitability of the pool. The pool is settled monthly, thereby resulting in cash flows substantially similar to cash flows that would result from the underwriting of direct business. We have not experienced any unusual variations in the timing of claim payments associated with the loss reserves of our insurance subsidiaries. We maintain significant liquidity in our investment portfolio in the form of readily marketable fixed maturities, equity securities and short-term investments. Our fixed-maturity investment portfolio is structured following a “laddering” approach, so that projected cash flows from

24

investment income and principal maturities are evenly distributed from a timing perspective, thereby providing an additional measure of liquidity to meet our obligations should an unexpected variation occur in the future. Net cash flows provided by operating activities in the first nine months of 2009 and 2008 were $19.0 million and $48.5 million, respectively. The net cash flows provided by operating activities in the first nine months of 2008 included an $11.9 million transfer of cash from Donegal Mutual discussed in Note 4 — Reinsurance.

     We maintain a credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $35.0 million unsecured, revolving line of credit that will expire in July 2010. As of September 30, 2009, we have the ability to borrow $35.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus between 1.50% and 1.75%, depending on our leverage ratio. In addition, we pay a fee of 0.15% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants, which include minimum levels of our net worth, leverage ratio and statutory surplus and the A.M. Best ratings of our insurance subsidiaries. During the nine months ended September 30, 2009, we had no borrowings outstanding under the credit agreement, and we were in compliance with all requirements of the credit agreement.

     The following table shows our expected payments for significant contractual obligations as of September 30, 2009.

			Less
			than 1		1-3		4-5		After 5
	Total		year		years		years		years
	(in thousands)
Net liability for unpaid losses and loss expenses of our insurance subsidiaries	$	167,205	$	78,558	$	74,013	$	7,011	$	7,623
Due to Sheboygan policyholders		1,167		1,167		—		—		—
Subordinated debentures		15,465		—		—		—		15,465
Total contractual obligations	$	183,837	$	79,725	$	74,013	$	7,011	$	23,088

     We estimate the date of payment for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. The liability is shown net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Amounts Atlantic States assumes pursuant to the pooling agreement with Donegal Mutual represent a substantial portion of our insurance subsidiaries’ gross liability for unpaid losses and loss expenses, and amounts Atlantic States cedes to the pooling agreement represent a substantial portion of our insurance subsidiaries’ reinsurance recoverable on unpaid losses and loss expenses. Cash settlement of Atlantic States’ assumed liability from the pool is included in monthly settlements of pooled activity, as we net amounts ceded to and assumed from the pool. Although Donegal Mutual and we do not anticipate any changes in the pool participation levels in the foreseeable future, any such change would be prospective in nature and therefore would not impact the timing of expected payments by Atlantic States’ for its percentage share of pooled losses occurring in periods prior to the effective date of such change.

     We estimate the date of payment for the subordinated debentures based on their contractual maturities. The debentures are redeemable at our option, at par, after five years from their issuance dates as discussed in Note 7 — Subordinated Debentures. The subordinated debentures carry interest rates that vary based upon the three-month LIBOR rate and adjust quarterly. Based upon the interest rates in effect as of September 30, 2009, our annual interest cost associated with the subordinated debentures is approximately $647,000. For every 1% change in the three-month LIBOR rate, the effect on our annual interest cost would be approximately $150,000.

     On March 7, 2007, our board of directors authorized a share repurchase program pursuant to which we may purchase up to 500,000 shares of our Class A common stock at market prices prevailing from time to time in the open market subject to the provisions of SEC Rule 10b-18 and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program during the three months ended September 30, 2009. We purchased 4,000 shares of our Class A common stock under this program during the three months ended September 30, 2008. We purchased 14,000 and 144,243

25

shares of our Class A common stock under this program during the nine months ended September 30, 2009 and 2008, respectively. We have purchased a total of 494,769 shares of our Class A common stock under this program through September 30, 2009.

     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 SEC Rule 10b-18 and in privately negotiated transactions. We did not purchase any shares of our Class A common stock under this program through September 30, 2009.

     On October 15, 2009, our board of directors declared quarterly cash dividends of 11.25 cents per share for our Class A common stock and 10.0 cents per share for our Class B common stock, payable November 16, 2009 to stockholders of record as of the close of business on November 2, 2009. There are no regulatory restrictions on the payment of dividends to our stockholders, although there are state law restrictions on the payment of annual dividends greater than 10% of statutory surplus by our insurance subsidiaries to us. Our insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis and require prior approval of the applicable domiciliary insurance regulatory authorities for dividends in excess of 10% of statutory surplus. Our insurance subsidiaries are subject to risk-based capital (“RBC”) requirements. At December 31, 2008, our insurance subsidiaries’ capital levels were each substantially above the applicable RBC requirements. At January 1, 2009, amounts available for distribution as dividends to us from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities were $18.4 million from Atlantic States, $1.6 million from Southern, $2.8 million from Le Mars, $3.9 million from Peninsula, and $0 from Sheboygan, all of which remained available at September 30, 2009.

     As of September 30, 2009, we had no material commitments for capital expenditures.

Equity Price Risk

     Our portfolio of marketable equity securities, which is carried on our consolidated balance sheets at estimated fair value, has exposure to the risk of loss resulting from an adverse change in prices. We manage this risk by performing an analysis of prospective investments and through regular reviews of our portfolio by our investment staff.

Credit Risk

     Our portfolio of fixed-maturity securities and, to a lesser extent, our portfolio of short-term investments is subject to credit risk, which we define as the potential loss in market value resulting from adverse changes in the borrower’s ability to repay the debt. We manage this risk by performing an analysis of prospective investments and through regular reviews of our portfolio by our investment staff. We also limit the percentage and amount of our total investment portfolio that we invest in the securities of any one issuer.

     Our insurance subsidiaries provide property and casualty insurance coverages through independent insurance agencies. We bill the majority of this business directly to the insured, although a portion of the commercial business is billed through agents to whom our insurance subsidiaries extend credit in the normal course of business.

     Because the pooling agreement does not relieve Atlantic States of primary liability as the originating insurer, Atlantic States is subject to a concentration of credit risk arising from business ceded to Donegal Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal Mutual and with a number of other major unaffiliated authorized reinsurers.

Impact of Inflation

     We establish property and casualty insurance premium rates before we know the amount of unpaid losses and loss expenses or the extent to which inflation may impact such expenses. Consequently, our insurance subsidiaries attempt, in establishing rates, to anticipate the potential impact of inflation.

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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 our investment portfolio as a result of fluctuations in prices and interest rates and, to a lesser extent, our debt obligations. We attempt to manage our interest rate risk by maintaining an appropriate relationship between the average duration of our investment portfolio and the approximate duration of our liabilities, i.e., policy claims of our insurance subsidiaries and debt obligations.

     Our investment mix has shifted slightly due to our continuing shift from taxable to tax-exempt fixed maturity investments during 2009. We have maintained approximately the same duration of our investment portfolio to our liabilities from December 31, 2008 to September 30, 2009.

     There have been no material changes to our quantitative or qualitative market risk exposure from December 31, 2008 through September 30, 2009.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

     We conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to SEC Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information we, including our consolidated subsidiaries, are required to disclose in our periodic filings with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control Over Financial Reporting

     There has been no change in our internal control over financial reporting during the quarter covered by this report that has materially affected, or is reasonably likely to affect materially, our internal control over financial reporting.

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

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

Item 4T. Controls and Procedures.

     Not applicable.

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Part II. Other Information

Item 1. Legal Proceedings.

     None.

Item 1A. Risk Factors.

Our business, results of operations and financial condition, and, therefore, the value of our Class A common stock and Class B common stock, are subject to a number of risks. For a description of certain risks, we refer to “Risk Factors” in our 2008 Annual Report on Form 10-K filed with the SEC on March 12, 2009. There have been no material changes during the nine months ended September 30, 2009 in the risk factors disclosed in that Form 10-K Report.

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

     None.

Item 3. Defaults upon Senior Securities.

     None.

Item 4. Submission of Matters to a Vote of Security Holders.

     None.

Item 5. Other Information.

None.

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Item 6. Exhibits.

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

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Signatures

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	DONEGAL GROUP INC.
November 6, 2009	By:	/s/ Donald H. Nikolaus
		Donald H. Nikolaus, President
		and Chief Executive Officer
November 6, 2009	By:	/s/ Jeffrey D. Miller
		Jeffrey D. Miller, Senior Vice President
		and Chief Financial Officer

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