Donegal Group Annual Report 2013

Plain-text annual report

DONEGAL GROUP 2013 ANNUAL REPORT Our long-range strategy for growth and success Financial Highlights YEAR ENDED DECEMBER 31, 2013 2012 2011 2010 2009 INCOME STATEMENT DATA Premiums earned Investment income, net Realized investment gains Total revenues $ 515,291,944 $ 475,002,222 $ 431,470,184 $ 378,030,129 $ 355,025,477 18,795,239 20,168,919 20,858,179 19,949,714 20,630,583 2,423,442 6,859,439 12,281,267 4,395,720 4,479,558 547,110,065 514,982,585 475,017,619 408,549,446 386,733,407 Income (loss) before income taxes (beneﬁt) 32,710,265 27,858,260 (6,739,313) 9,844,149 20,676,689 Income taxes (beneﬁt) Net income 6,388,273 4,765,640 (7,192,266) 26,321,992 23,092,620 452,953 (1,623,030) 11,467,179 1,846,611 18,830,078 Basic earnings per share - Class A Diluted earnings per share - Class A Cash dividends per share - Class A Basic earnings per share - Class B Diluted earnings per share - Class B Cash dividends per share - Class B BALANCE SHEET DA TA AT YEAR END Total investments Total assets Debt obligations Stockholders’ equity Book value per share 1.04 1.02 0.51 0.94 0.94 0.46 0.92 0.91 0.49 0.83 0.83 0.44 0.02 0.02 0.48 0.01 0.01 0.43 .46 .46 .46 .41 .41 .41 .76 .76 .45 .68 .68 .40 $ 791,808,307 $ 806,429,032 $ 785,308,991 $ 728,541,814 $ 666,835,186 1,385,410,502 1,336,889,187 1,290,793,478 1,174,619,523 935,601,927 63,000,000 72,465,000 74,965,000 56,082,371 15,465,000 396,877,111 400,034,094 383,451,592 380,102,810 385,505,699 15.02 15.63 15.01 14.86 15.12 TOTAL REVENUES [ i[ i[[ n mn mmn millillionions ]s ] NET INCOME ionionionioions ]s ]s ]]] [ i[ i[ ii[ n mn mmn mn millillllili STOCKHOLDERS’ EQUITY [ i[ i[ in mn mn millillillionionions ]s ]s ] $ 550 $ 500 $ 450 $ 400 $ 30 $ 20 $ 10 $ 400 $ 350 $ 300 $ 250 $ 350 090909099 1010100010 111111111 12121212 1313 $ 0 099 10100 111111111111111111111111111111111111111111111111111 1212 1313 $ 200 0909009 1010100 111111111 121212 1313 2013 ANNUAL REPORT DONEGAL GROUP Donegal Group Inc. is an insurance holding company that offers property and casualty insurance through its wholly owned insurance subsidiaries and through a pooling agreement with Donegal Mutual Insurance Company. The insur- ance operations, rated A (Excellent) by A.M. Best Company, market full lines of personal and commercial insurance products through a network of independent insurance agencies in 22 states. As an effective acquirer of small to medium-sized “main street” property and casualty insurers, Donegal Group has grown proﬁtably for more than two decades. As reported by Forbes, Donegal Group was named to a list of 100 Most Trustworthy Companies for 2013 and 2012, ranking the company among ﬁrms that have consistently demonstrated transparent and conservative accounting practices and solid corporate governance and management. Donegal Group employs a multi-faceted strategy that includes prudent organic and acquisition growth, conservative underwriting, pricing discipline, superior tech- nological capabilities, efﬁcient operations and conservative investing. This strategy is designed to allow Donegal Group to achieve its long-standing goal to outperform the property and casualty insurance industry in terms of service, proﬁtability and book value growth. Achiev- ing that goal provides value to its insurance subsidiaries’ policyholders and to its stockholders. Our long-range strategy for growth and success 1 To Our Stockholders Since our inception in 1986, Donegal Group has followed a consistent business strategy with a steady focus on our long-term objectives of prudent premium growth, 2013 underwriting proﬁtability and book value growth. MILESTONES 6.2 PERCENT TOTAL REVENUES 14.0 PERCENT NET INCOME We compete for quality property and casualty insurance business within an industry that continues to face external and internal challenges. Those global challenges include a continuing low interest rate environment that has constricted investment returns and excess capital levels that have contributed to a competitive premium rate environment in most lines of business. In light of the continuing challenges our industry faces, we were pleased to achieve several signiﬁcant milestones in 2013. Our total revenues for 2013 increased 6.2 percent to $547.1 million, compared to $515.0 million for 2012. We achieved 2013 net income of $26.3 million, or $1.02 per share of our Class A common stock on a diluted basis, compared to $23.1 million, or $.91 per share of our Class A common stock on a diluted basis, for 2012. Our net income for 2013 represented our highest level of annual earnings in the past ﬁve years, an accomplishment that reﬂects our substantial efforts to enhance our proﬁtability over that time period. We continue to expand our product offerings, leverage existing agency relationships and appoint additional commercially-focused agents. 8.5 PERCENT 14.1 PERCENT NET PREMIUMS EARNED COMMERCIAL PREMIUMS Our net premiums earned increased by a healthy 8.5 percent, representing a combination of solid organic growth in our commercial lines of insurance and the beneﬁts of the premium rate increases we have implemented in the past two years. Our strategic efforts led to a 14.1 percent increase in net premiums written within our commercial insurance segment in 2013. We achieved this organic growth through a combination of renewal premium increases and new com- mercial lines accounts throughout our operating regions. We will continue to seek to strengthen our relationships with our independent agents by providing excellent service, competitive compensation and state-of-the-art technology to facilitate efﬁcient communications with them. 2 DONEGAL GROUP We also continue to pursue acquisitions as a core element of our forward strategy, searching for suitable acquisitions and afﬁliations to build on the ten transactions we have completed over the past 25 years. Our 2013 premium growth reﬂected continuing beneﬁts from our December 2010 acquisition of Michigan Insurance Company. At the time of our acquisi- tion, Michigan reinsured 50 percent of its premiums through a quota-share reinsurance agreement with third parties. Since our acquisition, Michigan has gradually reduced the amount of its premiums it reinsures as we have integrated Michigan into our operations. For 2012 and 2013, Michigan reduced its external reinsurance to 40 percent and 30 percent, respectively. For 2014, Michigan has reduced further the level of its external quota-share reinsurance from 30 percent to 20 percent, which we estimate will add another $10 million to our net premiums written, not counting any growth from new business or rate increases. This strategy has continued to provide us acquisition-driven premium growth over a multi-year time horizon. $10 MILLION ESTIMATED ACQUISITION NET PREMIUM INCREASE IN 2014 Increased premium revenue from strategic growth initiatives and higher premium rates was a key component of our improved underwriting results. Our statutory combined ratio for 2013 improved to 97.4 percent, comparing favorably to our statutory combined ratio of 99.8 percent for 2012 and A.M. Best Company’s projected industry statutory combined ratio of 97.6 percent for 2013. Fewer weather losses and a lower frequency of casualty losses also contributed to the improvement in our underwriting proﬁtability. 97.4 PERCENT STATUTORY COMBINED RATIO We continue to view underwriting proﬁtability as our primary revenue source, but we also strive to supplement that income with stable investment income. As a result of increases in market interest rates during 2013, we experienced a decrease in the market value of our ﬁxed-maturity investment portfolio. That decrease led to a modest decrease in our book value to $15.02 per share of our common stock at December 31, 2013, compared to $15.63 at December 31, 2012. 2013 ANNUAL REPORT 3 Our afﬁliation with Donegal Mutual Insurance Company provides our insurance subsidiaries 2013 access to state-of-the-art technology tools. MILESTONES These technology tools allow our insurance subsidiaries to improve operational efﬁciency and to provide excellent service to their agents and customers. During 2013, we fully integrated Michigan Insurance Company’s systems into those of Donegal Mutual. This integration reduced Michigan’s operating costs and enhanced its service levels to agents and customers. We also introduced a new mobile application during 2013 that allows our insurance subsidiaries’ customers to access their policy information, pay their premiums and report claims from their mobile phones. During 2014, Donegal Mutual has begun to develop a new policy billing system and a new personal lines rating system that will replace its legacy systems and signiﬁcantly enhance our combined insurance operations when fully implemented. CUSTOMER MOBILE APP We reafﬁrm our long-held belief that substantial opportunity exists for a well-capitalized regional insurance group with a solid business strategy to grow proﬁtably and compete effectively with national property and casualty insurance companies. OUR LONG-RANGE STRATEGY We remain focused on expanding our insurance operations within our regional insurance markets. We believe we can continue to excel as a regional provider of quality property and casualty insurance products. We believe we have established a successful track record of growth and proﬁtability, and we remain committed to achieving our long-standing goals to outperform the property and casualty insurance industry in terms of service, proﬁtability and book value growth. We are executing our long-range strategy for growth and success that we believe will enhance the value of our stockholders’ investment. We appreciate your conﬁdence as we manage operations to achieve our long-term objectives. Donald H. Nikolaus PRESIDENT 4 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2013 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________________ to _________________ Commission file number 0-15341 DONEGAL GROUP INC. (Exact name of registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 1195 River Road, Marietta, Pennsylvania (Address of principal executive offices) 23-2424711 (I.R.S. Employer Identification No.) 17547 (Zip code) Securities registered pursuant to Section 12(b) of the Act: Registrant’s telephone number, including area code: (888) 877-0600 Title of Each Class Name of Each Exchange on Which Registered Class A Common Stock, $.01 par value The NASDAQ Global Select Market Class B Common Stock, $.01 par value The NASDAQ Global Select Market Securities registered pursuant to Section 12(g) of the Act: None. Indicate by check mark whether the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act: Yes . No . Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. Yes . No . Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes . No . Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes . No . Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements we incorporate by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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 definition of “large accelerated filer,” “accelerated filer” or “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one): Large accelerated filer Accelerated filer Non-accelerated filer (Do not check if a smaller reporting company) Smaller reporting company Indicate by check mark whether the registrant is a shell company. Yes . No . State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $191,025,187. Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 20,870,231 shares of Class A common stock and 5,576,775 shares of Class B common stock outstanding on March 1, 2014. The registrant incorporates by reference portions of the registrant’s definitive proxy statement relating to registrant’s annual meeting of stockholders to be held April 17, 2014 into Part III of this report. Documents Incorporated by Reference DONEGAL GROUP INC. INDEX TO FORM 10-K REPORT PART I Item 1. Business Item 1A. Risk Factors Item 1B. Unresolved Staff Comments Item 2. Item 3. Item 4. Properties Legal Proceedings Reserved Executive Officers of the Company PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7. Management’s Discussion and Analysis of Results of Operations and Financial Condition Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Item 9. Financial Statements and Supplementary Data Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 9B. Other Information PART III Item 10. Directors, Executive Officers and Corporate Governance of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions and Director Independence Item 14. Principal Accountant Fees and Services PART IV Item 15. Exhibits and Financial Statement Schedules Page 1 22 33 33 33 33 34 35 38 39 54 56 92 92 92 94 94 94 94 94 95 (i) [THIS PAGE INTENTIONALLY LEFT BLANK] Item 1. Business. Introduction PART I Donegal Group Inc., or DGI, is an insurance holding company whose insurance subsidiaries offer personal and commercial lines of property and casualty insurance to businesses and individuals in 22 Mid-Atlantic, Midwestern, New England and Southern states. As used herein, the terms “we,” “us” and “our” refer to Donegal Group Inc. and its subsidiaries. Donegal Mutual Insurance Company, or Donegal Mutual, organized us as an insurance holding company on August 26, 1986. At December 31, 2013, Donegal Mutual held approximately 37% of our outstanding Class A common stock and approximately 76% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 65% of the aggregate voting power of our outstanding shares of Class A common stock and our outstanding shares of Class B common stock. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions we describe in Note 3 of the Notes to Consolidated Financial Statements. While maintaining the separate corporate existence of each company, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. We have been an effective consolidator of smaller “main street” property and casualty insurance companies, and we expect to continue to acquire other insurance companies to expand our business in a given region or to commence operations in a new region. Since 1995, we have completed six acquisitions of property and casualty insurance companies or began to participate in their business through Donegal Mutual's entry into quota-share reinsurance agreements with them. Our insurance subsidiaries and Donegal Mutual provide their policyholders with a selection of insurance products at competitive rates, while pursuing profitability by adhering to a strict underwriting discipline. Our insurance subsidiaries derive a substantial portion of their insurance business from smaller to mid-sized regional communities. We believe this focus provides our insurance subsidiaries with competitive advantages in terms of local market knowledge, marketing, underwriting, claims servicing and policyholder service. At the same time, we believe our insurance subsidiaries have cost advantages over many smaller regional insurers that result from economies of scale they realize through centralized accounting, administrative, data processing, investment and other services. We believe we have a substantial opportunity, as a well-capitalized regional insurance holding company with a solid business strategy, to grow profitably and compete effectively with national property and casualty insurers. Our downstream holding company structure, with Donegal Mutual holding approximately 65% of the aggregate voting power of our common stock, has proven its effectiveness and success over the past 28 years of our existence. Over that time frame, we have grown significantly in terms of revenue and financial strength, and the Donegal Insurance Group has developed an excellent reputation as a regional group of property and casualty insurers. We own 48.2% of Donegal Financial Services Corporation, or DFSC. DFSC is a grandfathered unitary savings and loan holding company that owns all of the outstanding capital stock of Union Community Bank, a state savings bank, or UCB. UCB has 13 banking offices, all of which are located in Lancaster County, Pennsylvania. Donegal Mutual owns the remaining 51.8% of DFSC. For further information regarding DFSC, we refer to "Business - Donegal Financial Services Corporation" in this Form 10-K Annual Report. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. We set forth financial information about these segments in Note 19 of the Notes to Consolidated Financial Statements. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers' compensation policies. Available Information You may obtain our Annual Reports on Form 10-K, including this Form 10-K Annual Report, our quarterly reports on Form 10-Q, our current reports on Form 8-K, our proxy statement and our other filings pursuant to the Securities Exchange Act of 1934, or the Exchange Act, without charge by viewing our website at www.donegalgroup.com. You may also view our Code of Business Conduct and Ethics and the charters of our executive committee, our audit committee, our compensation committee -1- and our nominating committee on our website. Upon request to our corporate secretary, we will also provide printed copies of any of these documents to you without charge. We have provided the address of our website solely for the information of investors. We do not intend the reference to our website address to be an active link or to otherwise incorporate the contents of our website into this Form 10-K Annual Report. History and Organizational Structure In the mid-1980's, Donegal Mutual recognized the desirability, as a mutual insurance company, of developing additional sources of capital and surplus so it could remain competitive and have the surplus to expand its business and ensure its long- term viability. Donegal Mutual determined to implement a downstream holding company structure as one of its business strategies. Accordingly, in 1986, Donegal Mutual formed us as a downstream holding company. Initially, Donegal Mutual owned all of our outstanding common stock. After Donegal Mutual formed us, we in turn formed Atlantic States as our wholly owned property and casualty insurance company subsidiary. In connection with the establishment of Atlantic States and our downstream insurance holding company system, Donegal Mutual and DGI entered into a proportional reinsurance agreement, or pooling agreement, that became effective October 1, 1986. Under the pooling agreement, Donegal Mutual and Atlantic States pool substantially all of their respective premiums, losses and loss expenses to the reinsurance pool, and the reinsurance pool, acting through Donegal Mutual, then cedes a portion of the pooled business, currently 80%, to our subsidiary, Atlantic States. Since we established Atlantic States in 1986, Donegal Mutual and our insurance subsidiaries have conducted business together as the Donegal Insurance Group, while retaining their separate legal and corporate existences. Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the underwriting pool. As the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to enhance market penetration and underwriting profitability objectives. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophies, the same management, the same employees and the same facilities and offer the same types of insurance products. We believe Donegal Mutual's majority interest in the combined voting power of our Class A common stock and of our Class B common stock fosters our ability to implement our business philosophies, enjoy management continuity, maintain superior employee relations and provide a stable environment within which we can grow our businesses. The products Donegal Mutual and our insurance subsidiaries offer are generally complementary, which permits the Donegal Insurance Group to offer a broad range of products in a given market and to expand the Donegal Insurance Group's ability to service an entire personal lines or commercial lines account. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer generally relate to specific risk profiles within similar classes of business, such as preferred tier products versus standard tier products. Donegal Mutual and we do not allocate all of the standard risk gradients to one company. As a result, the underwriting profitability of the business the individual companies write directly will vary. However, the underwriting pool homogenizes the risk characteristics of all business Donegal Mutual and Atlantic States write directly. We receive 80% of the results of the underwriting pool because Atlantic States has an 80% participation in the pool. The business Atlantic States derives from the underwriting pool represents a significant percentage of our total consolidated revenues. However, that percentage has gradually decreased over the past few years as we have acquired a number of other property and casualty insurance companies in other jurisdictions that do not participate in the underwriting pool. As the capital of Atlantic States and our other insurance subsidiaries has increased, the underwriting capacity of our insurance subsidiaries, including Atlantic States, has proportionately increased. The size of the underwriting pool has increased substantially. Therefore, as we originally planned in the mid-1980s, Atlantic States has successfully raised the capital necessary to support the growth of its direct business as well as to accept increases in its allocation of business from the underwriting pool. In addition, the portion of the underwriting pool allocated to Atlantic States has increased from an initial allocation of 35% in 1986 to an 80% allocation since March 1, 2008. We do not anticipate any further change in the pooling agreement between Atlantic States and Donegal Mutual in the foreseeable future, including any change in the percentage participation of Atlantic States in the underwriting pool. In addition to Atlantic States, our insurance subsidiaries include Southern Insurance Company of Virginia, or Southern, Le Mars Insurance Company, or Le Mars, The Peninsula Insurance Company and its wholly owned subsidiary, Peninsula Indemnity Company, or collectively, Peninsula, Sheboygan Falls Insurance Company, or Sheboygan, and Michigan Insurance Company, or MICO. We also benefit from Donegal Mutual’s 100% quota-share reinsurance agreement with Southern Mutual Insurance Company, or Southern Mutual, and Donegal Mutual’s placement of its assumed business from Southern Mutual into the pooling agreement. -2- The following chart depicts our organizational structure. The chart depicts all of our property and casualty insurance subsidiaries, Southern Mutual and our interest in DFSC: Because of the different relative voting power of our Class A common stock and Class B common stock, our public stockholders (1) hold approximately 34.6% of the aggregate voting power of our Class A common stock and Class B common stock and Donegal Mutual holds approximately 65.4% of the aggregate voting power of our Class A common stock and Class B common stock. Relationship with Donegal Mutual Donegal Mutual provides facilities, personnel and other services to us and our insurance subsidiaries. Donegal Mutual allocates certain related expenses to Atlantic States in relation to the relative participation of Donegal Mutual and Atlantic States in the underwriting pool. Our insurance subsidiaries other than Atlantic States reimburse Donegal Mutual for their respective personnel costs and bear their proportionate share of information services costs based on their respective percentage of the total written premiums of the Donegal Insurance Group. Charges for these services totaled $94.0 million, $78.8 million and $64.7 million for 2013, 2012 and 2011, respectively. Our insurance subsidiaries have various reinsurance arrangements with Donegal Mutual. These agreements include: • • • • • excess of loss reinsurance agreements with Le Mars, Peninsula, Sheboygan and Southern; catastrophe reinsurance agreements with Atlantic States, Le Mars and Southern; a quota-share reinsurance agreement with Le Mars; a quota-share reinsurance agreement with Peninsula; and a quota-share reinsurance agreement with MICO. The purpose of the excess of loss and catastrophe reinsurance agreements is to lessen the effects of a single large loss, or an accumulation of smaller losses arising from one event, to levels that are appropriate given each subsidiary's size, underwriting profile and surplus position. The purpose of the quota-share reinsurance agreement with Le Mars is to transfer to Le Mars 100% of the premiums and losses related to certain products Donegal Mutual offers in certain Midwest states, which provide the availability of complementary products to Le Mars' commercial accounts. The purpose of the quota-share reinsurance agreement with Peninsula is to transfer to Donegal Mutual 100% of the premiums and losses related to the workers' compensation product line of Peninsula in certain states, which provides the -3- availability of an additional workers' compensation tier to Donegal Mutual's commercial accounts. Donegal Mutual places its assumed business from Peninsula into the underwriting pool. The purpose of the quota-share reinsurance agreement with MICO is to transfer to Donegal Mutual 25% of the premiums and losses related to MICO's business. Donegal Mutual places its assumed business from MICO into the underwriting pool. Effective November 1, 2012, Donegal Mutual and Southern terminated their quota-share reinsurance agreement on a run- off basis. The intent of the quota-share reinsurance agreement with Southern was to transfer to Southern 100% of the premiums and losses related to certain personal lines products Donegal Mutual offered in Virginia through the use of its automated policy quoting and issuance system. We and Donegal Mutual have maintained a coordinating committee since our formation in 1986. The coordinating committee consists of two members of our board of directors, neither of whom is a member of Donegal Mutual’s board of directors, and two members of Donegal Mutual’s board of directors, neither of whom is a member of our board of directors. The purpose of the coordinating committee is to establish and maintain a process for an annual evaluation of the transactions between Donegal Mutual, our insurance subsidiaries and us. The coordinating committee considers the fairness of each intercompany transaction to Donegal Mutual and its policyholders and to us and our stockholders. A new agreement or any change to a previously approved agreement must receive coordinating committee approval. The coordinating committee approval process for a new agreement between Donegal Mutual and us or one of our insurance subsidiaries or a change in such an agreement is as follows: • • • • both of our members on the coordinating committee must determine that the new agreement or the change in an existing agreement is fair and equitable to us and in the best interests of our stockholders; both of Donegal Mutual’s members on the coordinating committee must determine that the new agreement or the change in an existing agreement is fair and equitable to Donegal Mutual and in the best interests of its policyholders; the new agreement or the change in an existing agreement must be approved by our board of directors; and the new agreement or the change in an existing agreement must be approved by Donegal Mutual's board of directors. The coordinating committee also meets annually to review each existing agreement between Donegal Mutual and us or our insurance subsidiaries, including all reinsurance agreements between Donegal Mutual and our insurance subsidiaries. The purpose of this annual review is to examine the results of the agreements over the past year and, in the case of reinsurance agreements, over a five-year period and to determine if the results of the existing agreements remain fair and equitable to us and our stockholders and fair and equitable to Donegal Mutual and its policyholders or if Donegal Mutual and we should mutually agree to certain adjustments. In the case of these reinsurance agreements, the annual adjustments typically relate to the reinsurance premiums, losses and reinstatement premiums. These agreements are ongoing in nature and will continue in effect throughout 2014 in the ordinary course of business. Our members on the coordinating committee, as of the date of this Form 10-K Annual Report, are Robert S. Bolinger and John J. Lyons. Donegal Mutual’s members on the coordinating committee as of such date are Dennis J. Bixenman and John E. Hiestand. We refer to our proxy statement for our annual meeting of stockholders on April 17, 2014 for further information about the members of the coordinating committee. We believe our relationships with Donegal Mutual offer us and our insurance subsidiaries a number of competitive advantages, including the following: • • • enabling our stable management, the consistent underwriting discipline of our insurance subsidiaries, external growth, long-term profitability and financial strength; creating operational and expense synergies from the combination of resources and integrated operations of Donegal Mutual and our insurance subsidiaries; enhancing our opportunities to expand by acquisition because of the ability of Donegal Mutual to affiliate with and acquire control of other mutual insurance companies and, thereafter, demutualize them and combine them with us; -4- • • • producing more stable and uniform underwriting results for our insurance subsidiaries over extended periods of time than we could achieve without our relationship with Donegal Mutual; providing opportunities for growth because of the ability of Donegal Mutual to enter into reinsurance agreements with other mutual insurance companies and place the business it assumes into the pooling agreement; and providing Atlantic States with a significantly larger underwriting capacity because of the underwriting pool Donegal Mutual and Atlantic States have maintained since 1986. In the latter portion of the fourth quarter of 2013 and the first quarter of 2014, our board of directors and the board of directors of Donegal Mutual each undertook a review of the relationships of Donegal Mutual and DGI and determined that continuing the current relationships and the current corporate structure of Donegal Mutual and DGI is in the best interests of DGI and its various constituencies. Business Strategy Our strategy is designed to allow our insurance subsidiaries to achieve their longstanding goal of outperforming the United States property and casualty insurance industry in terms of profitability and service, thereby providing value to the policyholders of our insurance subsidiaries and, ultimately, providing value to our stockholders. The annual net premiums earned of our insurance subsidiaries have increased from $265.8 million in 2004 to $515.3 million in 2013, a compound annual growth rate of 7.6%. Over the same time period, our insurance subsidiaries have generally achieved a statutory combined ratio more favorable than that of the United States property and casualty insurance industry as a whole. The combined ratio of our insurance subsidiaries and that of the United States property and casualty insurance industry as computed using United States generally accepted accounting principles, or GAAP, and statutory accounting principles, or SAP, for the years 2009 through 2013 are shown in the following table: Our GAAP combined ratio (1) Our SAP combined ratio Industry SAP combined ratio (2) 2013 98.8% 97.4 97.6 2012 101.6% 99.8 102.2 2011 110.6% 107.9 106.7 2010 104.7% 102.9 101.2 2009 102.2% 101.1 99.5 (1) Our GAAP combined ratio for 2011 was adversely affected by accounting adjustments related to the acquisition of MICO. (2) As reported or projected by A.M. Best Company. We and Donegal Mutual believe we can continue to expand our insurance operations over time through organic growth and acquisitions of, or affiliations with, other insurance companies. We and Donegal Mutual have enhanced the performance of companies we have acquired, while leveraging the acquired companies' core strengths and local market knowledge to expand their operations. Our insurance subsidiaries and Donegal Mutual also seek to increase their premium base by making quality independent agency appointments, enhancing their competitive position within each agency, introducing new and enhanced insurance products and developing and maintaining automated systems to improve service, communications and efficiency. We translate these initiatives into our book value growth in a number of ways, including the following: • maintaining a conservative underwriting culture and pricing discipline to sustain our record of underwriting profitability; • continuing our investment in technology to achieve operating efficiencies that lower expenses, enhance the service we provide to agencies and policyholders and increase the speed of our communications with agencies and policyholders; and • maintaining a conservative investment approach. -5- A detailed review of our business strategies follows: • Achieving underwriting profitability. Our insurance subsidiaries focus on achieving a combined ratio of less than 100%. Our insurance subsidiaries achieved that objective in 2013, and we remain committed to achieving consistent underwriting profitability. We believe that underwriting profitability is a fundamental component of our long-term financial strength because it allows our insurance subsidiaries to generate profits without relying exclusively on their investment income. Our insurance subsidiaries seek to enhance their underwriting results by: • • carefully selecting the product lines they underwrite; carefully selecting the individual risks they underwrite; • minimizing their individual exposure to catastrophe-prone areas; and • evaluating their claims history on a regular basis to ensure the adequacy of their underwriting guidelines and product pricing. Our insurance subsidiaries have no material exposures to asbestos and environmental liabilities. Our insurance subsidiaries seek to provide more than one policy to a given personal lines or commercial lines customer because this “account selling” strategy diversifies their risk and has historically improved their underwriting results. Our insurance subsidiaries also use reinsurance to manage their exposure and limit their maximum net loss from large single risks or risks in concentrated areas. Our insurance subsidiaries believe these practices are key factors in their ability to maintain a statutory combined ratio that has generally been more favorable than the combined ratio of the United States property and casualty insurance industry. • Pursuing profitable growth by organic expansion within the traditional operating territories of our insurance subsidiaries through developing and maintaining quality agency representation. We believe that continued expansion of our insurance subsidiaries within their existing markets will be a key source of their continued premium growth and that maintaining an effective and growing network of independent agencies is integral to their expansion. Our insurance subsidiaries seek to be among the top three insurers within each of the independent agencies for the lines of business our insurance subsidiaries write by providing a consistent, competitive and stable market for their products. We believe that the consistency of their product offerings enables our insurance subsidiaries to compete effectively for agents with other insurers whose product offerings fluctuate based on industry conditions. Our insurance subsidiaries offer a competitive compensation program to their independent agents that rewards them for producing profitable growth for our insurance subsidiaries. Our insurance subsidiaries provide their independent agents with ongoing support to enable them to better attract and service customers, including: • fully automated underwriting and policy issuance systems for both personal, commercial and farm lines of insurance; • training programs; • marketing support; • • availability of a service center that provides comprehensive service for our personal lines policyholders; and field visitations by marketing and underwriting personnel and senior management of our insurance subsidiaries. Our insurance subsidiaries appoint independent agencies with a strong underwriting and growth track record. We believe that our insurance subsidiaries, by carefully selecting, motivating and supporting their independent agencies, will drive continued long-term growth. -6- • Acquiring property and casualty insurance companies to augment the organic growth of our insurance subsidiaries in existing markets and to expand into new geographic regions. We have been an effective consolidator of smaller “main street” property and casualty insurance companies, and we expect to continue to acquire other insurance companies to expand our business in a given region or to commence operations in a new region. Since 1995, we have completed six acquisitions of property and casualty insurance companies or participated in their business through Donegal Mutual's entry into quota-share reinsurance agreements with them. We intend to continue our growth by pursuing affiliations and acquisitions that meet our criteria. Our primary criteria are: • • • • location in regions where our insurance subsidiaries are currently conducting business or that offer an attractive opportunity to conduct profitable business; a mix of business similar to the mix of business of our insurance subsidiaries; premium volume up to $100.0 million; and fair and reasonable transaction terms. We believe that our interrelationship with Donegal Mutual assists us in pursuing affiliations with, and subsequent acquisitions of, mutual insurance companies because, through Donegal Mutual, we understand the concerns and issues that mutual insurance companies face. In particular, Donegal Mutual has had success affiliating with underperforming mutual insurance companies, and we have either acquired them following their conversion to a stock company or benefited from their underwriting results as a result of Donegal Mutual's entry into a 100% quota-share reinsurance agreement with them and placement of its assumed business into the pooling agreement. We have utilized our strengths and financial position to improve the operations of those underperforming insurance companies significantly. We evaluate a number of areas for operational synergies when considering acquisitions, including product underwriting, expenses, the cost of reinsurance and technology. We and Donegal Mutual have the ability to employ a number of acquisition and affiliation methods. Our prior acquisitions and affiliations have taken one of the following forms: • • • • purchase of all of the outstanding stock of a stock insurance company; purchase of a book of business; quota-share reinsurance transaction; or two-step acquisition of a mutual insurance company in which: • • as the first step, Donegal Mutual purchases a surplus note from the mutual insurance company, Donegal Mutual enters into a services agreement with the mutual insurance company and Donegal Mutual’s designees become a majority of the members of the board of directors of the mutual insurance company; and as the second step, the mutual insurance company enters into a quota-share reinsurance agreement with Donegal Mutual or demutualizes, or converts, into a stock insurance company. Upon the demutualization or conversion, we purchase the surplus note from Donegal Mutual and exchange it for all of the stock of the stock insurance company resulting from the demutualization or conversion. We believe that our ability to make direct acquisitions of stock insurance companies and to make indirect acquisitions of mutual insurance companies through a sponsored conversion or a quota-share reinsurance agreement provides us with flexibility that is a competitive advantage in making acquisitions. We also believe our historic record clearly demonstrates our ability to acquire control of an underperforming insurance company, re-underwrite its book of business, reduce its cost structure and return it to sustained profitability. While Donegal Mutual and we generally engage in preliminary discussions with potential direct or indirect acquisition candidates on an almost continuous basis and are so engaged at the date of this Form 10-K Report, neither Donegal Mutual nor -7- we make any public disclosure regarding a proposed acquisition until Donegal Mutual or we have entered into a definitive acquisition agreement. The following table highlights our history of insurance company acquisitions and affiliations since 1988: Company Name Southern Mutual Insurance Company and now Southern Insurance Company of Virginia Pioneer Mutual Insurance Company and then Pioneer Insurance Company (1)(2) State of Domicile Virginia Year Control Acquired 1984 Ohio 1992 Delaware Mutual Insurance Delaware 1993 Company and then Delaware Atlantic Insurance Company (1)(2) New York 1995 Pioneer Mutual Insurance Company and then Pioneer Insurance Company (1)(2) Southern Heritage Insurance Company (2) Method of Acquisition/Affiliation Surplus note investment by Donegal Mutual in 1984; demutualization in 1988; acquisition of stock by us in 1988. Surplus note investment by Donegal Mutual in 1992; demutualization in 1993; acquisition of stock by us in 1997. Surplus note investment by Donegal Mutual in 1993; demutualization in 1994; acquisition of stock by us in 1995. Surplus note investment by Donegal Mutual in 1995; demutualization in 1998; acquisition of stock by us in 2001. Georgia 1998 Purchase of stock by us in 1998. Le Mars Mutual Insurance Company of Iowa and now Le Mars Insurance Company (1) Iowa Peninsula Insurance Group Sheboygan Falls Mutual Insurance Company and now Sheboygan Falls Insurance Company (1) Maryland Wisconsin Southern Mutual Insurance Company (3) Georgia Michigan Insurance Company Michigan 2002 2004 2007 2009 2010 Surplus note investment by Donegal Mutual in 2002; demutualization in 2004; acquisition of stock by us in 2004. Purchase of stock by us in 2004. Contribution note investment by Donegal Mutual in 2007; demutualization in 2008; acquisition of stock by us in 2008. Surplus note investment by Donegal Mutual and quota-share reinsurance in 2009. Purchase of stock by us and surplus note investment by Donegal Mutual in 2010. (1) Each of these acquisitions initially took the form of an affiliation with Donegal Mutual. Donegal Mutual provided surplus note financing to the insurance company, and, in connection therewith, sufficient designees of Donegal Mutual were appointed so as to constitute a majority of the members of the board of directors of the insurance company. Donegal Mutual and the insurance company simultaneously entered into a services agreement whereby Donegal Mutual provided services to improve the operations of the insurance company. Once the insurance company's results of operations improved to the satisfaction of Donegal Mutual, Donegal Mutual sponsored the demutualization of the insurance company. Upon the consummation of the demutualization, Donegal Mutual converted the surplus note to capital stock of the newly demutualized insurance company. We then purchased all of the capital stock of the insurance company from Donegal Mutual and made an additional capital contribution in cash to assure compliance with minimum capital and surplus requirements and to provide adequate surplus to support the insurance company's planned premium growth. (2) To reduce administrative and compliance costs and expenses, these subsidiaries subsequently merged into one of our existing insurance subsidiaries. (3) Control acquired by Donegal Mutual. • Providing responsive and friendly customer and agent service to enable our insurance subsidiaries to attract new policyholders and retain existing policyholders. We believe that excellent policyholder service is important in attracting new policyholders and retaining existing policyholders. Our insurance subsidiaries work closely with their independent agents to provide a consistently responsive level of claims service, underwriting and customer support. Our insurance subsidiaries seek to respond expeditiously and effectively to address customer and independent agent inquiries in a number of ways, including: -8- • • • • availability of a customer call center for claims reporting; availability of a secure website for access to policy information and documents, payment processing and other features; timely replies to information requests and policy submissions; and prompt responses to and processing of claims. Our insurance subsidiaries periodically conduct policyholder surveys to evaluate the effectiveness of their service to policyholders. The management of our insurance subsidiaries meets on a regular basis with the personnel of the independent insurance agents our insurance subsidiaries appoint to seek service improvement recommendations, react to service issues and better understand local market conditions. • Maintaining premium rate adequacy to enhance the underwriting results of our insurance subsidiaries, while maintaining their existing book of business and preserving their ability to write new business. Our insurance subsidiaries seek discipline in their pricing by effecting rate increases to maintain or improve their underwriting profitability without unduly affecting their customer retention. In addition to appropriate pricing, our insurance subsidiaries seek to ensure that their premium rates are adequate relative to the amount of risk they insure. Our insurance subsidiaries review loss trends on a periodic basis to identify changes in the frequency and severity of their claims and to assess the adequacy of their rates and underwriting standards. Our insurance subsidiaries also carefully monitor and audit the information they use to price their policies for the purpose of enabling them to receive an adequate level of premiums for the risk they assume. For example, our insurance subsidiaries inspect substantially all commercial lines risks and a substantial number of personal lines property risks before they commit to insure them to determine the adequacy of the insured amount to the value of the insured property, assess property conditions and identify any liability exposures. Our insurance subsidiaries audit the payroll data of their workers’ compensation customers to verify that the assumptions used to price a particular policy were accurate. By implementing appropriate rate increases and understanding the risks our insurance subsidiaries agree to insure, they are generally able to achieve their strategy of achieving consistent underwriting profitability. • Focusing on expense controls and utilization of technology to increase the operating efficiency of our insurance subsidiaries. Our insurance subsidiaries maintain stringent expense controls under direct supervision of their senior management. We centralize many processing and administrative activities of our insurance subsidiaries to realize operating synergies and better control expenses. Our insurance subsidiaries utilize technology to automate much of their underwriting and to facilitate agency and policyholder communications on an efficient, timely and cost-effective basis. We operate on a paperless basis. As a result of our focus on expense control, our insurance subsidiaries have reduced their expense ratio from 36.6% in 1999 to 31.8% in 2013. Our insurance subsidiaries have also increased their annual premium per employee, a measure of efficiency that our insurance subsidiaries use to evaluate their operations, from approximately $470,000 in 1999 to approximately $915,000 in 2013. Our insurance subsidiaries maintain technology comparable to that of the largest of their competitors. “Ease of doing business” is an increasingly important component of an insurer’s value to an independent agency. Our insurance subsidiaries provide a fully automated personal lines underwriting and policy issuance system called “WritePro®.” WritePro® is a web- based user interface that substantially eases data entry and facilitates the quoting and issuance of policies for the independent agents of our insurance subsidiaries. Our insurance subsidiaries also provide a similar commercial business system called “WriteBiz®.” WriteBiz® is a web-based user interface that provides the independent agents of our insurance subsidiaries with an online ability to quote and issue commercial automobile, workers’ compensation, business owners and tradesman policies automatically. WriteFarm® is a web-based user interface that provides the independent agents of our insurance subsidiaries with an online ability to quote and issue farm policies. As a result, applications of the independent agents for our insurance subsidiaries can become policies without further re-entry of information. These systems also interface with the policy management systems of the independent agents of our insurance subsidiaries. • Maintaining a conservative investment approach. Return on invested assets is an important element of the financial results of our insurance subsidiaries. The investment strategy of our insurance subsidiaries is to generate an appropriate amount of after-tax income on invested assets while minimizing credit risk through investments in high-quality securities. As a result, our insurance subsidiaries seek to invest a -9- high percentage of their assets in diversified, highly rated and marketable fixed-maturity instruments. The fixed-maturity portfolios of our insurance subsidiaries consist of both taxable and tax-exempt securities. Our insurance subsidiaries maintain a portion of their portfolios in short-term securities to provide liquidity for the payment of claims and operation of their respective businesses. Our insurance subsidiaries maintain a negligible percentage (1.5% at December 31, 2013) of their portfolios in equity securities. Competition The property and casualty insurance industry is highly competitive on the basis of both price and service. Numerous companies compete for business in the geographic areas where our insurance subsidiaries operate. Many of these other insurance companies are substantially larger and have greater financial resources than those of our insurance subsidiaries. In addition, because our insurance subsidiaries and Donegal Mutual market their respective insurance products exclusively through independent insurance agencies, most of which represent more than one insurance company, our insurance subsidiaries face competition within agencies, as well as competition to retain qualified independent agents. Products and Underwriting We report the results of our insurance operations in two segments: personal lines of insurance and commercial lines of insurance. The personal lines our insurance subsidiaries write consist primarily of private passenger automobile and homeowners insurance. The commercial lines our insurance subsidiaries write consist primarily of commercial automobile, commercial multi-peril and workers’ compensation insurance. We describe these lines of insurance in greater detail below: Personal • Private passenger automobile — policies that provide protection against liability for bodily injury and property damage arising from automobile accidents and protection against loss from damage to automobiles owned by the insured. • Homeowners — policies that provide coverage for damage to residences and their contents from a broad range of perils, including fire, lightning, windstorm and theft. These policies also cover liability of the insured arising from injury to other persons or their property while on the insured’s property and under other specified conditions. Commercial • Commercial automobile — policies that provide protection against liability for bodily injury and property damage arising from automobile accidents and protection against loss from damage to automobiles owned by the insured. • Commercial multi-peril — policies that provide protection to businesses against many perils, usually combining liability and physical damage coverages. • Workers’ compensation — policies employers purchase to provide benefits to employees for injuries sustained during employment. The workers’ compensation laws of each state determine the extent of the coverage we provide. -10- The following table sets forth the net premiums written of our insurance subsidiaries by line of insurance for the periods indicated: (dollars in thousands) Personal lines: Automobile Homeowners Other Total personal lines Commercial lines: Automobile Workers’ compensation Commercial multi-peril Other Total commercial lines Total business Year Ended December 31, 2013 2012 2011 Amount % Amount % Amount % $ 196,363 36.8% $ 195,132 39.3% $ 186,677 41.1% 106,420 15,915 318,698 58,165 77,589 74,516 4,463 214,733 20.0 3.0 59.8 10.9 14.5 14.0 0.8 40.2 97,120 16,319 308,571 51,261 65,390 64,476 6,749 187,876 19.6 3.3 62.2 10.3 13.2 13.0 1.3 37.8 89,405 14,983 291,065 46,168 51,849 57,988 6,981 162,986 19.7 3.3 64.1 10.2 11.4 12.8 1.5 35.9 $ 533,431 100.0% $ 496,447 100.0% $ 454,051 100.0% The personal lines and commercial lines underwriting departments of our insurance subsidiaries evaluate and select those risks that they believe will enable our insurance subsidiaries to achieve an underwriting profit. The underwriting departments have significant interaction with the independent agents regarding the underwriting philosophy and the underwriting guidelines of our insurance subsidiaries. Our underwriting personnel also assist the research and development department in the development of quality products at competitive prices to promote growth and profitability. In order to achieve underwriting profitability on a consistent basis, our insurance subsidiaries: • • • • assess and select quality standard and preferred risks; adhere to disciplined underwriting and re-underwriting guidelines; inspect substantially all commercial lines risks and a substantial number of personal lines property risks; and utilize various types of risk management and loss control services. Our insurance subsidiaries also review their existing policies and accounts to determine whether those risks continue to meet their underwriting guidelines. If a given policy or account no longer meets those underwriting guidelines, our insurance subsidiaries will take appropriate action regarding that policy or account, including raising premium rates or non-renewing the policy to the extent applicable law permits. As part of the effort of our insurance subsidiaries to maintain acceptable underwriting results, they conduct annual reviews of agencies that have failed to meet their underwriting profitability criteria. The review process includes an analysis of the underwriting and re-underwriting practices of the agency, the completeness and accuracy of the applications the agency submits, the adequacy of the training of the agency’s staff and the agency’s record of adherence to the underwriting guidelines and service standards of our insurance subsidiaries. Based on the results of this review process, the marketing and underwriting personnel of our insurance subsidiaries develop, together with the agency, a plan to improve its underwriting profitability. Our insurance subsidiaries monitor the agency’s compliance with the plan and take other measures as required in the judgment of our insurance subsidiaries, including the termination to the extent applicable law permits of agencies that are unable to achieve acceptable underwriting profitability. -11- Distribution Our insurance subsidiaries market their products primarily in the Mid-Atlantic, Midwestern, New England and Southern regions through approximately 2,600 independent insurance agencies. At December 31, 2013, the Donegal Insurance Group actively wrote business in 22 states (Alabama, Delaware, Georgia, Indiana, Iowa, Maine, Maryland, Michigan, Nebraska, New Hampshire, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Vermont, Virginia, West Virginia and Wisconsin). We believe the relationships of our insurance subsidiaries with their independent agents are valuable in identifying, obtaining and retaining profitable business. Our insurance subsidiaries maintain a stringent agency selection procedure that emphasizes appointing agencies with proven marketing strategies for the development of profitable business, and our insurance subsidiaries only appoint agencies with a strong underwriting history and potential growth capabilities. Our insurance subsidiaries also regularly evaluate the independent agencies that represent them based on their profitability and performance in relation to the objectives of our insurance subsidiaries. Our insurance subsidiaries seek to be among the top three insurers within each of their agencies for the lines of business they write. The following table sets forth the percentage of direct premiums our insurance subsidiaries write, including 80% of the direct premiums Donegal Mutual and Atlantic States write, in each of the states where they conducted a significant portion of their business in 2013: Pennsylvania Michigan Virginia Maryland Delaware Georgia Ohio Wisconsin Iowa Tennessee Nebraska South Dakota Ten other states Total 37.3% 18.1 9.0 8.5 5.6 5.1 3.3 2.9 2.5 2.2 2.0 1.0 2.5 100.0% Our insurance subsidiaries employ a number of policies and procedures that we believe enable them to attract, retain and motivate their independent agents. The consistency, competitiveness and stability of the product offerings of our insurance subsidiaries assist them in competing effectively for independent agents with other insurers whose product offerings may fluctuate based upon industry conditions. Our insurance subsidiaries have a competitive profit-sharing plan for their independent agents, consistent with applicable state laws and regulations, under which the independent agents may earn additional commissions based upon the volume of premiums produced and the profitability of the business our insurance subsidiaries receive from that agency. Our insurance subsidiaries encourage their independent agents to focus on “account selling,” or serving all of a particular insured’s property and casualty insurance needs, which our insurance subsidiaries believe generally results in more favorable loss experience than covering a single risk for an individual insured. Technology Donegal Mutual owns the majority of the technology systems our insurance subsidiaries use. The technology systems consist primarily of an integrated central processing computer system, a series of server-based computer networks and various communication systems that allow the home office of our insurance subsidiaries and their branch offices to utilize the same systems for the processing of business. Donegal Mutual maintains backup facilities and systems at the office of one of our insurance subsidiaries and through a contract with a leading provider of computer disaster recovery sites and tests these backup facilities and systems on a regular basis. Our insurance subsidiaries bear their proportionate share of information services expenses based on their respective percentage of the total net written premiums of the Donegal Insurance Group. -12- The business strategy of our insurance subsidiaries depends on the use, development and implementation of integrated technology systems. These systems enable our insurance subsidiaries to provide a high level of service to agents and policyholders by processing business in a timely and efficient manner, communicating and sharing data with agents, providing a variety of methods for the payment of premiums and allowing for the accumulation and analysis of information for the management of our insurance subsidiaries. We believe the availability and use of these technology systems has resulted in improved service to agents and policyholders, increased efficiencies in processing the business of our insurance subsidiaries and lower operating costs. Key components of these integrated technology systems are the agency interface system, the WritePro®, WriteBiz® and WriteFarm® systems, a claims processing system and an imaging system. The agency interface system provides our insurance subsidiaries with a high level of data sharing both to and from agents’ systems and also provides agents with an integrated means of processing new business. The WritePro®, WriteBiz® and WriteFarm® systems are fully automated underwriting and policy issuance systems that provide agents with the ability to generate underwritten quotes and automatically issue policies that meet the underwriting guidelines of our insurance subsidiaries with limited or no intervention by their personnel. The claims processing system allows our insurance subsidiaries to process claims efficiently and in an automated environment. The imaging system eliminates the need to handle paper files, while providing greater access to the same information by a variety of personnel. We believe our technology systems compare favorably to those of many national property and casualty insurance carriers in terms of quality and service levels. Claims The management of claims is a critical component of the philosophy of our insurance subsidiaries to achieve underwriting profitability on a consistent basis and is fundamental to the successful operations of our insurance subsidiaries and their dedication to excellent service. Our senior claims management oversees the claims processing units of each of our insurance subsidiaries to assure consistency in the claims settlement process. The field office staff of our insurance subsidiaries receives support from home office technical, litigation, material damage, subrogation and medical audit personnel. The claims departments of our insurance subsidiaries rigorously manage claims to assure that they settle legitimate claims quickly and fairly and that they identify questionable claims for defense. In the majority of cases, the personnel of our insurance subsidiaries, who have significant experience in the property and casualty insurance industry and know the service philosophy of our insurance subsidiaries, adjust claims. Our insurance subsidiaries provide various means of claims reporting on a 24-hours a day, seven-days a week basis, including toll-free numbers and electronic reporting through our website. Our insurance subsidiaries strive to respond to notifications of claims promptly, generally within the day reported. Our insurance subsidiaries believe that, by responding promptly to claims, they provide quality customer service and minimize the ultimate cost of the claims. Our insurance subsidiaries engage independent adjusters as needed to handle claims in areas in which the volume of claims is not sufficient to justify the hiring of internal claims adjusters by our insurance subsidiaries. Our insurance subsidiaries also employ private adjusters and investigators, structural experts and various outside legal counsel to supplement their internal staff and to assist in the investigation of claims. Our insurance subsidiaries have a special investigative unit staffed by former law enforcement officers that attempts to identify and prevent fraud and abuse and to control questionable claims. The management of the claims departments of our insurance subsidiaries develops and implements policies and procedures for the establishment of adequate claim reserves. Our insurance subsidiaries employ an actuarial staff that regularly reviews their reserves for incurred but not reported claims. The management and staff of the claims departments resolve policy coverage issues, manage and process reinsurance recoveries and handle salvage and subrogation matters. The litigation and personal injury sections of our insurance subsidiaries manage all claims litigation. Branch office claims above certain thresholds require home office review and settlement authorization. Our insurance subsidiaries provide their claims adjusters reserving and settlement authority based upon their experience and demonstrated abilities. Larger or more complicated claims require consultation and approval of senior department management. Liabilities for Losses and Loss Expenses Liabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to incurred policyholder claims based on facts and circumstances then known. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends and expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates of liability. We reflect any adjustments to our insurance -13- subsidiaries’ liabilities for losses and loss expenses in our operating results in the period in which our insurance subsidiaries record the changes in their estimates. Our insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss their policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries closely monitor their liabilities and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses. Reserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries’ external environment and, to a lesser extent, assumptions as to our insurance subsidiaries’ internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers’ compensation claims during the past several years while claims severity has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers’ compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries’ external environment include the absence of significant changes in tort law and legal decisions that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and the collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries attempt to make appropriate adjustments for such changes in their reserves. Accordingly, our insurance subsidiaries’ ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded at December 31, 2013. For every 1% change in our insurance subsidiaries’ loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $2.7 million. The establishment of appropriate liabilities is an inherently uncertain process, and we can provide no assurance that our insurance subsidiaries’ ultimate liability will not exceed our insurance subsidiaries’ loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries’ estimated future liabilities, since the historical conditions and events that serve as a basis for our insurance subsidiaries’ estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods, and, in other periods, their estimates have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimate of their liability for losses and loss expenses generally reflect actual payments and the evaluation of information received since the prior reporting date. Our insurance subsidiaries recognized an increase (decrease) in their liability for losses and loss expenses of prior years of $10.4 million, $7.6 million and ($168,460) in 2013, 2012 and 2011, respectively. Our insurance subsidiaries made no significant changes in their reserving philosophy, key reserving assumptions or claims management personnel, and have made no significant offsetting changes in estimates that increased or decreased their loss and loss expense reserves in these years. The 2013 development represented 4.1% of the December 31, 2012 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability, commercial multiple peril, commercial automobile and workers' compensation lines of business in accident years prior to 2013. The majority of the 2013 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. The 2012 development represented 3.1% of the December 31, 2011 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability and workers' compensation lines of business in accident years prior to 2012. The majority of the 2012 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. The 2011 development represented an immaterial percentage of the December 31, 2010 net carried reserves. Excluding the impact of catastrophic weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and slight downward trends in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs -14- and a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could be required to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries’ internal procedures which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses at December 31, 2013. Differences between liabilities reported in our financial statements prepared on a GAAP basis and our insurance subsidiaries’ financial statements prepared on a SAP basis result from anticipating salvage and subrogation recoveries for GAAP but not for SAP. These differences amounted to $13.1 million, $12.0 million and $11.2 million at December 31, 2013, 2012 and 2011, respectively. The following table sets forth a reconciliation of the beginning and ending GAAP net liability of our insurance subsidiaries for unpaid losses and loss expenses for the periods indicated: (in thousands) Year Ended December 31, 2013 2012 2011 Gross liability for unpaid losses and loss expenses at beginning of year $ 458,827 $ 442,408 $ Less reinsurance recoverable Net liability for unpaid losses and loss expenses at beginning of year Provision for net losses and loss expenses for claims incurred in the current year Change in provision for estimated net losses and loss expenses for claims incurred in prior years Total incurred Net losses and loss payments for claims incurred during: The current year Prior years Total paid Net liability for unpaid losses and loss expenses at end of year Plus reinsurance recoverable 207,891 250,936 199,393 243,015 10,358 343,128 201,782 126,677 328,459 265,605 230,014 7,596 332,872 205,876 119,074 324,950 250,936 207,891 Gross liability for unpaid losses and loss expenses at end of year $ 495,619 $ 458,827 $ 332,770 325,276 340,671 383,319 165,422 217,897 (168) 340,503 219,183 96,202 315,385 243,015 199,393 442,408 The following table sets forth the development of the liability for net unpaid losses and loss expenses of our insurance subsidiaries from 2003 to 2013. Loss data in the table includes business Atlantic States received from the underwriting pool. “Net liability at end of year for unpaid losses and loss expenses” sets forth the estimated liability for net unpaid losses and loss expenses recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of net losses and loss expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported. The “Net liability re-estimated as of” portion of the table shows the re-estimated amount of the previously recorded liability based on experience for each succeeding year. The estimate increases or decreases as payments are made and more information becomes known about the severity of the remaining unpaid claims. For example, the 2005 liability has developed a redundancy after eight years because we expect the re-estimated net losses and loss expenses to be $21.8 million less than the estimated liability we initially established in 2005 of $173.0 million. The “Cumulative (excess) deficiency” shows the cumulative excess or deficiency at December 31, 2013 of the liability estimate shown on the top line of the corresponding column. An excess in liability means that the liability established in prior years exceeded the amount of actual payments and currently re-estimated unpaid liability remaining. A deficiency in liability means that the liability established in prior years was less than the amount of actual payments and currently re-estimated remaining unpaid liability. The “Cumulative amount of liability paid through” portion of the table shows the cumulative net losses and loss expense payments made in succeeding years for net losses incurred prior to the balance sheet date. For example, the 2005 column -15- indicates that at December 31, 2013 payments equal to $146.9 million of the currently re-estimated ultimate liability for net losses and loss expenses of $151.2 million had been made. Amounts shown in the 2004 column of the table include information for Le Mars and Peninsula for all accident years prior to 2004. Amounts shown in the 2008 column of the table include information for Sheboygan for all accident years prior to 2008. Amounts shown in the 2010 column of the table include information for MICO for the month of December 2010. (in thousands) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Year Ended December 31, Net liability at end of year for unpaid losses and loss expenses Net liability re- estimated as of: $138,896 $171,431 $173,009 $163,312 $150,152 $161,307 $180,262 $217,896 $243,015 $250,936 $265,605 One year later 136,434 162,049 159,393 153,299 152,836 171,130 177,377 217,728 250,611 261,294 Two years later 130,030 152,292 153,894 150,934 154,435 167,446 177,741 217,355 255,612 Three years later 123,399 148,612 151,792 150,078 152,315 166,756 178,403 218,449 Four years later 120,917 147,280 150,183 148,745 151,120 166,852 179,909 Five years later 119,968 145,874 150,087 148,407 151,287 166,788 Six years later 119,731 146,101 150,555 149,031 151,739 Seven years later 120,425 146,739 151,161 149,487 Eight years later 120,768 147,597 151,243 Nine years later 121,505 147,705 Ten years later 121,631 Cumulative (excess) deficiency Cumulative amount of liability paid through: (17,265) (23,726) (21,766) (13,825) 1,587 5,481 (353) 553 12,597 10,358 One year later $ 51,965 $ 67,229 $ 71,718 $ 72,499 $ 71,950 $ 79,592 $ 84,565 $ 96,202 $119,074 $126,677 Two years later Three years later 81,183 99,910 102,658 107,599 104,890 105,576 116,035 123,204 148,140 181,288 123,236 125,926 121,711 124,659 136,837 147,165 178,073 Four years later 109,964 133,844 133,805 132,698 135,392 148,243 161,363 Five years later 113,684 136,377 139,935 138,878 140,280 155,331 Six years later 114,499 139,847 143,309 141,752 143,778 Seven years later 116,727 142,016 145,492 143,784 Eight years later 118,169 143,894 146,894 Nine years later 119,123 144,565 Ten years later 119,509 2005 2006 2007 2008 2009 2010 2011 2012 2013 Year Ended December 31, (in thousands) $265,730 $259,022 $226,432 $239,809 $263,599 $383,317 $442,408 $458,827 $495,619 92,721 95,710 76,280 78,502 83,337 165,421 199,393 207,891 230,014 173,009 163,312 150,152 161,307 180,262 217,896 243,015 250,936 265,605 243,402 241,395 232,173 253,815 207,525 370,297 473,949 488,557 92,159 91,908 80,434 87,027 27,616 151,848 218,337 227,263 151,243 149,487 151,739 166,788 179,909 218,449 255,612 261,294 Gross liability at end of year Reinsurance recoverable Net liability at end of year Gross re-estimated liability re-estimated recoverable Net re-estimated liability Gross cumulative deficiency (excess) (22,328) (17,627) 5,741 14,006 (56,074) (13,020) 31,542 29,730 -16- Third-Party Reinsurance Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, Peninsula, Sheboygan and MICO also have separate reinsurance programs that provide certain coverage that is commensurate with their relative size and exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- (Excellent) rating from A.M. Best. The external reinsurance our insurance subsidiaries and Donegal Mutual purchase includes: • • “excess of loss reinsurance,” under which their losses are automatically reinsured, through a series of contracts, over a set retention (generally $1,000,000 for 2013 and 2012 and $750,000 for 2011); and catastrophe reinsurance, under which Donegal Mutual, Atlantic States and Southern recover, through a series of reinsurance agreements, 100% of an accumulation of many losses resulting from a single event, including natural disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible ($5.0 million in 2013 and $0 in 2012 and 2011) up to aggregate losses of $145.0 million per occurrence. The amount of coverage each of these types of reinsurance provides depends upon the amount, nature, size and location of the risk being reinsured. For property insurance, our insurance subsidiaries have excess of loss treaties that provide for coverage of $4.0 million per loss over a set retention of $1.0 million. For liability insurance, our insurance subsidiaries have excess of loss treaties that provide for coverage of $49.0 million per occurrence over a set retention of $1.0 million. For workers’ compensation insurance, our insurance subsidiaries have excess of loss treaties that provide for coverage of $9.0 million on any one life over a set retention of $1.0 million. Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures from property and casualty losses that exceed the limits provided by their respective treaty reinsurance. MICO maintains a quota-share reinsurance agreement with third-party reinsurers to reduce its net exposures. Effective from December 1, 2010 to December 31, 2011, the quota-share reinsurance percentage was 50%. Effective January 1, 2012, MICO reduced the quota-share reinsurance percentage from 50% to 40%. Effective January 1, 2013, MICO reduced the quota- share reinsurance percentage from 40% to 30%. Effective January 1, 2014, MICO reduced the quota-share reinsurance percentage from 30% to 20%. Investments At December 31, 2013, 100% of all debt securities our insurance subsidiaries held had an investment-grade rating. The investment portfolios of our insurance subsidiaries did not contain any mortgage loans or any non-performing assets at December 31, 2013. The following table shows the composition of the debt securities (at carrying value) in the investment portfolios of our insurance subsidiaries, excluding short-term investments, by rating at December 31, 2013: (dollars in thousands) (1) Rating U.S. Treasury and U.S. agency securities(2) Aaa or AAA Aa or AA A BBB Total December 31, 2013 Amount Percent $ 202,494 31.4% 35,814 255,117 140,949 9,648 5.6 39.6 21.9 1.5 $ 644,022 100.0% (1) Ratings assigned by Moody’s Investors Services, Inc. or Standard & Poor’s Corporation. (2) Includes mortgage-backed securities of $140.2 million. -17- Our insurance subsidiaries invest in both taxable and tax-exempt securities as part of their strategy to maximize after-tax income. This strategy considers, among other factors, the alternative minimum tax. Tax-exempt securities made up approximately 59.0%, 59.8% and 63.8% of the debt securities in the combined investment portfolios of our insurance subsidiaries at December 31, 2013, 2012 and 2011, respectively. The following table shows the classification of our investments and the investments of our insurance subsidiaries at December 31, 2013, 2012 and 2011 (at carrying value): 2013 December 31, 2012 2011 Percent of Percent of Percent of Amount Total Amount Total Amount Total (dollars in thousands) Fixed maturities(1): Held to maturity: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 47,946 6.1% $ 1,000 0.1% $ 1,000 0.1% Obligations of states and political subdivisions 108,435 Corporate securities Mortgage-backed securities Total held to maturity Available for sale: 14,875 69,114 240,370 U.S. Treasury securities and obligations of U.S. government corporations and agencies 14,334 Obligations of states and political subdivisions 277,547 Corporate securities Mortgage-backed securities Total available for sale Total fixed maturities Equity securities(2) Investments in affiliates(3) Short-term investments(4) Total investments 13.7 1.9 8.7 30.4 1.8 35.1 5.1 8.9 50.9 81.3 1.6 4.5 12.6 40,909 — 191 42,100 71,311 416,987 77,356 128,856 694,510 736,610 8,757 37,236 23,826 5.1 — — 5.2 8.8 51.7 9.6 16.0 86.1 91.3 1.1 4.6 3.0 56,966 250 274 58,490 60,978 398,877 64,113 122,630 646,598 705,088 7,438 32,322 40,461 7.3 — — 7.4 7.8 50.8 8.2 15.6 82.4 89.8 1.0 4.1 5.1 40,672 71,099 403,652 644,022 12,423 35,685 99,678 $ 791,808 100.0% $ 806,429 100.0% $ 785,309 100.0% (1) We refer to Notes 1 and 4 to our Consolidated Financial Statements. We value those fixed maturities we classify as held to maturity at amortized cost; we value those fixed maturities we classify as available for sale at fair value. The total fair value of fixed maturities we classified as held to maturity was $238.8 million at December 31, 2013, $43.7 million at December 31, 2012 and $61.4 million at December 31, 2011. The amortized cost of fixed maturities we classified as available for sale was $390.3 million at December 31, 2013, $655.2 million at December 31, 2012 and $614.3 million at December 31, 2011. (2) We value equity securities at fair value. Total cost of equity securities was $12.2 million at December 31, 2013, $8.7 million at December 31, 2012 and $7.2 million at December 31, 2011. (3) We value investments in affiliates at cost, adjusted for our share of earnings and losses of our affiliates as well as changes in equity of our affiliates due to unrealized gains and losses. (4) We value short-term investments at cost, which approximates fair value. -18- The following table sets forth the maturities (at carrying value) in the fixed maturity portfolio of our insurance subsidiaries at December 31, 2013, 2012 and 2011: (dollars in thousands) Due in(1): One year or less Over one year through three years Over three years through five years Over five years through ten years Over ten years through fifteen years Over fifteen years Mortgage-backed securities 2013 Percent of Total Amount December 31, 2012 Percent of Total Amount 2011 Percent of Total Amount $ 8,257 1.3% $ 10,004 1.4% $ 16,181 2.3% 22,424 40,234 190,440 166,186 76,267 140,214 3.5 6.2 29.6 25.8 11.8 21.8 31,176 64,839 201,953 191,179 108,412 129,047 4.2 8.8 27.4 26.0 14.7 17.5 27,912 71,820 188,523 172,956 104,792 122,904 4.0 10.2 26.7 24.5 14.9 17.4 $ 644,022 100.0% $ 736,610 100.0% $ 705,088 100.0% (1) Based on stated maturity dates with no prepayment assumptions. Actual maturities will differ because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. As shown above, our insurance subsidiaries held investments in mortgage-backed securities having a carrying value of $140.2 million at December 31, 2013. The mortgage-backed securities consist primarily of investments in governmental agency balloon pools with stated maturities between one and 24 years. The stated maturities of these investments limit the exposure of our insurance subsidiaries to extension risk in the event that interest rates rise and prepayments decline. Our insurance subsidiaries perform an analysis of the underlying loans when evaluating a mortgage-backed security for purchase, and they select those securities that they believe will provide a return that properly reflects the prepayment risk associated with the underlying loans. The following table sets forth the investment results of our insurance subsidiaries for the years ended December 31, 2013, 2012 and 2011: (dollars in thousands) Invested assets(1) Investment income(2) Average yield Average tax-equivalent yield Year Ended December 31, $ 2013 799,119 18,795 $ 2012 795,869 20,169 $ 2011 756,925 20,858 2.4% 3.3 2.5% 3.5 2.8% 3.8 (1) Average of the aggregate invested amounts at the beginning and end of the period. (2) Investment income is net of investment expenses and does not include realized investment gains or losses or provision for income taxes. A.M. Best Rating Donegal Mutual and our insurance subsidiaries have an A.M. Best rating of A (Excellent), based upon the respective current financial condition and historical statutory results of operations of Donegal Mutual and our insurance subsidiaries. We believe that the A.M. Best rating of Donegal Mutual and our insurance subsidiaries is an important factor in their marketing of the products to their agents and customers. A.M. Best’s ratings are industry ratings based on a comparative analysis of the financial condition and operating performance of insurance companies. A.M. Best’s classifications are A++ and A+ (Superior), A and A- (Excellent), B++ and B+ (Good), B and B- (Fair), C++ and C+ (Marginal), C and C- (Weak), D (Poor) and E (Under Regulatory Supervision), F (Liquidation) and S (Suspended). A.M. Best bases its ratings upon factors relevant to the payment of claims of policyholders and are not directed toward the protection of investors in insurance companies. According to A.M. Best, the “Excellent” rating that the Donegal Insurance Group maintains is assigned to those companies that, in A.M. Best’s opinion, have an excellent ability to meet their ongoing obligations to policyholders. -19- Regulation The supervision and regulation of insurance companies consists primarily of the laws and regulations of the various states in which the insurance companies transact business, with the primary regulatory authority being the insurance regulatory authorities in the state of domicile of the insurance company. Such supervision and regulation relate to numerous aspects of an insurance company’s business and financial condition. The primary purpose of such supervision and regulation is the protection of policyholders. The authority of the state insurance departments includes the establishment of standards of solvency that insurers must meet and maintain, the licensing of insurers and insurance agents to do business, the nature of, and limitations on, investments, premium rates for property and casualty insurance, the provisions that insurers must make for current losses and future liabilities, the deposit of securities for the benefit of policyholders, the approval of policy forms, notice requirements for the cancellation of policies and the approval of certain changes in control. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies. In addition to state-imposed insurance laws and regulations, the National Association of Insurance Commissioners, or the NAIC, has established a risk-based capital system, or RBC, for assessing the adequacy of statutory capital and surplus that augments the states’ current fixed dollar minimum capital requirements for insurance companies. At December 31, 2013, our insurance subsidiaries and Donegal Mutual each exceeded the minimum levels of statutory capital the RBC rules require by a substantial margin. Generally, every state has guaranty fund laws under which insurers licensed to do business in that state can be assessed on the basis of premiums written by the insurer in that state in order to fund policyholder liabilities of insolvent insurance companies. Under these laws in general, an insurer is subject to assessment, depending upon its market share of a given line of business, to assist in the payment of policyholder claims against insolvent insurers. Our insurance subsidiaries and Donegal Mutual have made accruals for their portion of assessments related to such insolvencies based upon the most current information furnished by the guaranty associations. We are part of an insurance holding company system of which Donegal Mutual is the ultimate controlling person. All of the states in which our insurance companies and Donegal Mutual maintain a domicile have legislation that regulates insurance holding company systems. Each insurance company in the insurance holding company system must register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within the insurance holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Pursuant to these laws, the respective insurance departments in which our subsidiaries and Donegal Mutual maintain a domicile may examine our insurance subsidiaries or Donegal Mutual at any time, require disclosure of material transactions by the holding company with another member of the insurance holding company system and require prior notice or prior approval of certain transactions, such as “extraordinary dividends” from the insurance subsidiaries to the holding company. We have insurance subsidiaries domiciled in Iowa, Maryland, Michigan, Pennsylvania, Virginia and Wisconsin. The Pennsylvania Insurance Holding Companies Act, which generally applies to Donegal Mutual, us and our insurance subsidiaries, requires that all transactions within an insurance holding company system to which an insurer is a party must be fair and reasonable and that any charges or fees for services performed must be reasonable. Any management agreement, service agreement, cost sharing arrangement and material reinsurance agreement must be filed with the Pennsylvania Insurance Department, or the Department, and is subject to the Department's review. We have filed the pooling agreement between Donegal Mutual and Atlantic States that established the underwriting pool and all material agreements between Donegal Mutual and our insurance subsidiaries with the Department. Approval of the applicable insurance commissioner is also required prior to consummation of transactions affecting the control of an insurer. In virtually all states, including Iowa, Maryland, Michigan, Pennsylvania, Virginia and Wisconsin, where our insurance subsidiaries are domiciled, the acquisition of 10% or more of the outstanding capital stock of an insurer or its holding company or the intent to acquire such an interest creates a rebuttable presumption of a change in control. Pursuant to an order issued in April 2003, the Department approved Donegal Mutual’s ownership of up to 70% of our outstanding Class A common stock and up to 100% of our outstanding Class B common stock. Our insurance subsidiaries have the legal obligation under state insurance laws to participate in involuntary insurance programs for automobile insurance, as well as other property and casualty insurance lines, in the states in which they conduct business. These programs include joint underwriting associations, assigned risk plans, fair access to insurance requirements plans, reinsurance facilities, windstorm plans and tornado plans. Legislation establishing these programs requires all companies that write lines covered by these programs to provide coverage, either directly or through reinsurance, for insureds who are unable to obtain insurance in the voluntary market. The legislation creating these programs usually allocates a pro rata portion -20- of risks attributable to such insureds to each company on the basis of the direct premiums it has written in that state or the number of automobiles it insures in that state. Generally, state law requires participation in these programs as a condition to obtaining a certificate of authority. Our loss ratio on insurance we write under these involuntary programs has traditionally been significantly greater than our loss ratio on insurance we voluntarily write in those states. Regulatory requirements, including RBC requirements, may impact our insurance subsidiaries' ability to pay dividends. The amount of statutory capital and surplus necessary for our insurance subsidiaries to satisfy regulatory requirements, including RBC requirements, was not significant in relation to our insurance subsidiaries' statutory capital and surplus at December 31, 2013. Generally, the maximum amount that an insurance subsidiary may pay to us as ordinary dividends during any year after notice to, but without prior approval of, the insurance commissioner of its domiciliary state is limited to a stated percentage of that subsidiary’s statutory capital and surplus at December 31 of the preceding fiscal year or the net income of that subsidiary for its preceding fiscal year. Our insurance subsidiaries paid dividends to us of $12.5 million, $7.0 million and $16.0 million in 2013, 2012 and 2011, respectively. At December 31, 2013, the amount of dividends our insurance subsidiaries could pay to us during 2014, without the prior approval of their respective domiciliary insurance commissioners, is shown in the following table. Name of Insurance Subsidiary Atlantic States Southern Le Mars Peninsula Sheboygan MICO Total Ordinary Dividend Amount $ 18,660,666 4,195,635 2,762,791 4,189,149 1,086,411 4,159,470 $ 35,054,122 Donegal Mutual Insurance Company Donegal Mutual organized as a mutual fire insurance company in Pennsylvania in 1889. At December 31, 2013, Donegal Mutual had admitted assets of $383.8 million and policyholders’ surplus of $204.5 million. At December 31, 2013, Donegal Mutual had total liabilities of $179.4 million, including reserves for net losses and loss expenses of $48.7 million and unearned premiums of $44.2 million. Donegal Mutual’s investment portfolio of $228.9 million at December 31, 2013 consisted primarily of investment-grade bonds of $16.7 million, its investment in DFSC's common stock and its investment in our common stock. At December 31, 2013, Donegal Mutual owned 7,755,953 shares, or approximately 37%, of our Class A common stock, which Donegal Mutual carried on its books at $101.0 million, and 4,235,539 shares, or approximately 76%, of our Class B common stock, which Donegal Mutual carried on its books at $55.1 million. We present Donegal Mutual’s financial information in accordance with SAP as the NAIC Accounting Practices and Procedures Manual requires. Donegal Mutual does not, nor is it required to, prepare financial statements in accordance with GAAP. Donegal Financial Services Corporation In 2000, we and Donegal Mutual formed DFSC as a unitary thrift holding company and its wholly owned subsidiary, Province Bank FSB, as a federal savings bank. In May 2011, DFSC merged with Union National Financial Corporation, or UNNF, with DFSC as the surviving company in the merger. Under the merger agreement, Province Bank FSB and Union National Community Bank, which UNNF owned, also merged to form UCB. UCB is a state savings bank with 13 branch offices in Lancaster County, Pennsylvania, and approximately $512.8 million in assets at December 31, 2013. Because Donegal Mutual and we together own all of the outstanding capital stock of DFSC, the Board of Governors of the Federal Reserve System, or the FRB, regulates Donegal Mutual, DFSC and us as grandfathered savings and loan holding companies. As a result, Donegal Mutual, DFSC and we are subject to regulation by the FRB under the holding company provisions of the federal Home Owners’ Loan Act, or HOLA. However, if any of Donegal Mutual, DFSC or we were to lose this grandfathered status, they or we would become a bank holding company regulated by the FRB under the Bank Holding Company Act. UCB, as a state-chartered stock savings bank, is subject to regulation and supervision by the Pennsylvania Department of Banking and by the Federal Deposit Insurance Corporation. The primary purpose of the statutory and regulatory supervision of financial institutions is to protect depositors, the financial institutions and the financial system as a whole rather -21- than the stockholders of financial institutions or their holding companies. UCB converted from a federally-chartered stock savings bank to a Pennsylvania-chartered stock savings bank during 2013. Sections 23A and 23B of the Federal Reserve Act impose quantitative and qualitative restrictions on transactions between a savings association and its “affiliates.” Affiliates of a savings association include, among other entities, the savings association’s holding company and non-banking companies under common control with the savings association such as Donegal Mutual and us. These restrictions on transactions with affiliates apply to transactions between DFSC and UCB, on the one hand, and Donegal Mutual and us and our insurance subsidiaries, on the other hand. These restrictions also apply to transactions among DFSC, UCB and Donegal Mutual. Because DFSC directly controls UCB and Donegal Mutual and we indirectly control UCB, DFSC, Donegal Mutual and we are subject to the Change in Bank Control Act. Cautionary Statement Regarding Forward-Looking Statements This Form 10-K Annual Report and the documents we incorporate by reference in this Form 10-K Annual Report contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward- looking statements include certain discussions relating to underwriting, premium and investment income volumes, business strategies, reserves, profitability and business relationships and our other business activities during 2013 and beyond. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “objective,” “project,” “predict,” “potential,” “goal” and similar expressions. These forward-looking statements reflect our current views about future events, our current assumptions and are subject to known and unknown risks and uncertainties that may cause our results, performance or achievements to differ materially from those we anticipate or imply by our forward-looking statements. We cannot control or predict many of the factors that could determine our future financial conditions or results of operations. Such factors may include those we describe under “Risk Factors.” The forward-looking statements contained in this annual report reflect our views and assumptions only as of the date of this Form 10-K Report. Except as required by law, we do not intend to update, and we assume no responsibility for updating, any forward-looking statements we have made. We qualify all of our forward-looking statements by these cautionary statements. Item 1A. Risk Factors. Risk Factors Risks Relating to Us and Our Business Donegal Mutual is our controlling stockholder. Donegal Mutual and its directors and executive officers have potential conflicts of interest between the best interests of our stockholders and the best interests of the policyholders of Donegal Mutual. Donegal Mutual controls the election of all of the members of our board of directors. Six of the 11 members of our board of directors are also directors of Donegal Mutual. Donegal Mutual and we share the same executive officers. These common directors and executive officers have a fiduciary duty to our stockholders and also have a fiduciary duty to the policyholders of Donegal Mutual. Among the potential conflicts of interest that could arise from these separate fiduciary duties are the following: • We and Donegal Mutual periodically review the percentage participation of Atlantic States and Donegal Mutual in the underwriting pool that Donegal Mutual and Atlantic States have maintained since 1986; • Our insurance subsidiaries and Donegal Mutual annually review and then establish the terms of certain reinsurance agreements between them with the objective, over the long-term, of having an approximately equal balance between payments and recoveries; • We and Donegal Mutual periodically allocate certain shared expenses among ourselves and our insurance subsidiaries in accordance with various inter-company expense-sharing agreements; and • Our insurance subsidiaries may enter into other transactions or contractual relationships with Donegal Mutual, including, for example, our purchases from time to time from Donegal Mutual of the surplus note of a mutual insurance company that will convert into a stock insurance company and ultimately become one of our wholly owned subsidiaries. -22- Donegal Mutual has sufficient voting power to determine the outcome of all matters submitted to our stockholders for approval. Each share of our Class A common stock has one-tenth of a vote per share and generally votes as a single class with our Class B common stock. Our Class B common stock has one vote per share. Donegal Mutual has the right to vote approximately 65% of the aggregate voting power of our Class A common stock and our Class B common stock and has sufficient voting control to: • • elect all of the members of our board of directors, who determine our management and policies; and control the outcome of any corporate transaction or other matter submitted to a vote of our stockholders for approval, including mergers or other acquisition proposals and the sale of all or substantially all of our assets, in each case regardless of how all of our other stockholders other than Donegal Mutual vote their shares. The interests of Donegal Mutual in maintaining this greater-than-majority control of us may have an adverse effect on the price of our Class A common stock and the price of our Class B common stock because of the absence of any potential “takeover” premium and may, therefore, be inconsistent with the interests of our stockholders other than Donegal Mutual. Donegal Mutual’s majority voting control, certain provisions of our certificate of incorporation and by-laws and certain provisions of Delaware law make it remote that anyone could acquire actual control of us unless Donegal Mutual were in favor of the acquisition of actual control. Donegal Mutual’s majority voting control, certain anti-takeover provisions in our certificate of incorporation and by-laws and certain provisions of the Delaware General Corporation Law, or the DGCL, could delay or prevent the removal of members of our board of directors and could make a merger, tender offer or proxy contest involving us more expensive as well as unlikely to succeed, even if such events were in the best interests of our stockholders other than Donegal Mutual. These factors could also discourage a third party from attempting to acquire actual control of us. In particular, our certificate of incorporation and by-laws include the following anti-takeover provisions: • • • • • our board of directors is classified into three classes, so that our stockholders elect only one-third of the members of our board of directors each year; our stockholders may remove our directors only for cause; our stockholders may not take stockholder action except at an annual or special meeting of our stockholders; the request of stockholders holding at least 20% of the aggregate voting power of our Class A common stock and our Class B common stock is required for a stockholder to call a special meeting of our stockholders; our by-laws require that stockholders provide advance notice to us to nominate candidates for election to our board of directors or to propose any other item of stockholder business at a stockholders’ meeting; • we do not permit cumulative voting rights in the election of our directors; • • our certificate of incorporation does not provide for preemptive rights in connection with any issuance of securities by us; and our board of directors may issue, without stockholder approval unless otherwise required by law, preferred stock with such terms as our board of directors may determine. We have authorized preferred stock that we could issue without stockholder approval to make it more difficult for a third party to acquire us. We have 2.0 million authorized shares of preferred stock that we could issue in one or more series without further stockholder approval, unless the DGCL or the NASDAQ Global Select Market otherwise requires, and upon such terms and conditions, and having such rights, privileges and preferences, as our board of directors may determine our potential issuance of preferred stock and that may make it difficult for a third party to acquire control of us. -23- Because we are an insurance holding company, no person can acquire or seek to acquire a 10% or greater interest in us without first obtaining approval of the insurance commissioners of the states of domicile of our insurance subsidiaries. We own insurance subsidiaries domiciled in the states of Iowa, Maryland, Michigan, Pennsylvania, Virginia and Wisconsin, and Donegal Mutual controls an insurance company domiciled in Georgia. The insurance laws of each of these states provide that no person can acquire or seek to acquire a 10% or greater interest in us without first filing specified information with the insurance commissioner of that state and obtaining the prior approval of the proposed acquisition of a 10% or greater interest in us by the state insurance commissioner based on statutory standards designed to protect the safety and soundness of the insurance holding company and its subsidiary. Because we are a grandfathered unitary savings and loan holding company, no person can acquire or seek to acquire more than a 10% interest in either class of our common stock without first obtaining approval of, or an exemption from, the FRB. We own 48.2% of the outstanding stock of DFSC, which owns all of the outstanding stock of UCB. As a result of our ownership interest in DFSC, we are a grandfathered unitary savings and loan holding company regulated by the FRB under HOLA. No person may lawfully acquire more than 10% of any class of voting security of a unitary savings and loan holding company registered under the Exchange Act without first filing specified information with the FRB and obtaining the FRB's prior approval of the proposed acquisition or an exemption from the FRB. Our insurance subsidiaries currently conduct business in a limited number of states, with a concentration of business in Pennsylvania, Michigan, Maryland and Virginia. Any single catastrophe occurrence or other condition affecting losses in these states could adversely affect the results of operations of our insurance subsidiaries. Our insurance subsidiaries conduct business in 22 states located primarily in the Mid-Atlantic, Midwestern, New England and Southern states. A substantial portion of their business consists of private passenger and commercial automobile, homeowners and workers’ compensation insurance in Pennsylvania, Michigan, Maryland and Virginia. While our insurance subsidiaries and Donegal Mutual actively manage our respective exposure to catastrophes through their underwriting process and the purchase of reinsurance, a single catastrophic occurrence, destructive weather pattern, general economic trend, terrorist attack, regulatory development or other condition affecting one or more of the states in which our insurance subsidiaries conduct substantial business could materially adversely affect their business, financial condition and results of operations. Common catastrophic events include hurricanes, earthquakes, tornadoes, wind and hail storms, fires, explosions and severe winter storms. If the independent agents who market the products of our insurance subsidiaries do not maintain their current levels of premium writing with us, fail to comply with established underwriting guidelines of our insurance subsidiaries or otherwise inappropriately market the products of our insurance subsidiaries, the business, financial condition and results of operations of our insurance subsidiaries could be adversely affected. Our insurance subsidiaries market their insurance products solely through a network of approximately 2,600 independent insurance agencies. This agency distribution system is one of the most important components of the competitive profile of our insurance subsidiaries. As a result, our insurance subsidiaries depend to a material extent upon their independent agents, each of whom has the authority to bind our insurance subsidiaries to insurance coverage. To the extent that such independent agents’ marketing efforts fail to result in the maintenance of their current levels of volume and quality or they bind our insurance subsidiaries to unacceptable insurance risks, fail to comply with the established underwriting guidelines of our insurance subsidiaries or otherwise inappropriately market the products of our insurance subsidiaries, the business, financial condition and results of operations of our insurance subsidiaries could suffer. The business of our insurance subsidiaries may not continue to grow and may be materially adversely affected if our insurance subsidiaries cannot retain existing, and attract new, independent agents or if insurance consumers increase their use of insurance marketing systems other than independent agents. Our insurance subsidiaries' ability to retain existing, and to attract new, independent agents is essential to the continued growth of the business of our insurance subsidiaries. If independent agents find it easier to do business with the competitors of our insurance subsidiaries, our insurance subsidiaries could find it difficult to retain their existing business or to attract new business. While our insurance subsidiaries believe they maintain good relationships with the independent agents they have appointed, our insurance subsidiaries cannot be certain that these independent agents will continue to sell the products of our insurance subsidiaries to the consumers these independent agents represent. Some of the factors that could adversely affect the ability of our insurance subsidiaries to retain existing, and attract new, independent agents include: -24- • • • • the significant competition among insurance companies to attract independent agents; the labor-intensive and time-consuming process of selecting new independent agents; the insistence of our insurance subsidiaries that independent agents adhere to consistent underwriting standards; and the ability of our insurance subsidiaries to pay competitive and attractive commissions, bonuses and other incentives to independent agents. While our insurance subsidiaries sell insurance to policyholders solely through their network of independent agencies, many competitors of our insurance subsidiaries sell insurance through a variety of delivery methods, including independent agencies, captive agencies, the Internet and direct sales. To the extent that current and potential policyholders change their marketing system preference, the business, financial condition and results of operations of our insurance subsidiaries may be adversely affected. We are dependent on dividends from our insurance subsidiaries for the payment of our operating expenses, our debt service and dividends to our stockholders; however, there are regulatory restrictions and business considerations that regulate the amount of dividends our insurance subsidiaries may pay to us. As a holding company, we rely primarily on dividends from our insurance subsidiaries as a source of funds to meet our corporate obligations and to pay dividends to our stockholders. The amount of dividends our insurance subsidiaries can pay to us is subject to regulatory restrictions and depends on the amount of surplus our insurance subsidiaries maintain. From time to time, the NAIC and various state insurance regulators consider modifying the method of determining the amount of dividends that an insurance company may pay without prior regulatory approval. The maximum amount of ordinary dividends that our insurance subsidiaries can pay to us in 2014 without prior regulatory approval is approximately $35.1 million. Other business and regulatory considerations, such as the impact of dividends on surplus that could affect the ratings of our insurance subsidiaries, competitive conditions, RBC requirements, the investment results of our insurance subsidiaries and the amount of premiums that our insurance subsidiaries write could also adversely impact the ability of our insurance subsidiaries to pay dividends to us. If A.M. Best downgrades the rating it has assigned to Donegal Mutual or any of our insurance subsidiaries, it would adversely affect their competitive position. Industry ratings are a factor in establishing and maintaining the competitive position of insurance companies. A.M. Best, an industry-accepted source of insurance company financial strength ratings, rates Donegal Mutual and our insurance subsidiaries. A.M. Best ratings provide an independent opinion of an insurance company’s financial health and its ability to meet its obligations to its policyholders. We believe that the financial strength rating of A.M. Best is material to the operations of Donegal Mutual and our insurance subsidiaries. Currently, Donegal Mutual and our insurance subsidiaries each have an A (Excellent) rating from A.M. Best. If A.M. Best were to downgrade the rating of Donegal Mutual or any of our insurance subsidiaries, it would adversely affect the competitive position of Donegal Mutual or that insurance subsidiary and make it more difficult for it to market its products and retain its existing policyholders. Our strategy to grow in part through acquisitions of smaller insurance companies exposes us to risks that could adversely affect our results of operations and financial condition. The affiliation with and acquisition of smaller, and often undercapitalized, insurance companies involves risks that could adversely affect our results of operations and financial condition. The risks associated with these affiliations and acquisitions include: • • • the potential inadequacy of reserves for losses and loss expenses; the need to supplement management with additional experienced personnel; conditions imposed by regulatory agencies that make the realization of cost-savings through integration of operations more difficult; • a need for additional capital that was not anticipated at the time of the acquisition; and -25- • the use of more of our management’s time in improving operation of the subsidiary than we originally anticipated. If we cannot obtain sufficient capital to fund the organic growth of our insurance subsidiaries and to make acquisitions, we may not be able to expand our business. Our strategy is to expand our business through the organic growth of our insurance subsidiaries and through our strategic acquisitions of regional insurance companies. Our insurance subsidiaries will require additional capital in the future to support this strategy. If we cannot obtain sufficient capital on satisfactory terms and conditions, we may not be able to expand the business of our insurance subsidiaries or to make future acquisitions. Our ability to obtain additional financing will depend on a number of factors, many of which are beyond our control. For example, we may not be able to obtain additional debt or equity financing because we or our insurance subsidiaries may already have substantial debt at the time, because we or our insurance subsidiaries do not have sufficient cash flow to service or repay our existing or additional debt or because financial institutions are not making financing available. In addition, any equity capital we obtain in the future could be dilutive to our existing stockholders. A number of the competitors of our insurance subsidiaries have greater financial strength than our insurance subsidiaries, and these competitors may be able to offer their products at lower prices than our insurance subsidiaries can afford to offer their products. The property and casualty insurance industry is intensely competitive. Competition can be based on many factors, including: • • • • • • the perceived financial strength of the insurer; premium rates; policy terms and conditions; policyholder service; reputation; and experience. Our insurance subsidiaries compete with many regional and national property and casualty insurance companies, including direct sellers of insurance products, insurers having their own agency organizations and other insurers represented by independent agents. Many of these insurers have greater capital than our insurance subsidiaries, have substantially greater financial, technical and operating resources and have equal or higher ratings from A.M. Best than our insurance subsidiaries. In addition, our competitors may become increasingly better capitalized in the future as the property and casualty insurance industry continues to consolidate. The greater capitalization of many of the competitors of our insurance subsidiaries enables them to operate with lower profit margins and, therefore, allows them to market their products more aggressively, to take advantage more quickly of new marketing opportunities and to offer lower premium rates. Our insurance subsidiaries may not be able to maintain their current competitive position in the markets in which they operate if their competitors offer prices for their products that are lower than the prices our insurance subsidiaries are prepared to offer. Moreover, if these competitors lower the price of their products and our insurance subsidiaries meet their pricing, the profit margins and revenues of our insurance subsidiaries may decrease and their ratios of claims and expenses to premiums may increase. All of these factors could materially adversely affect the financial condition and results of operations of our insurance subsidiaries and their A.M. Best ratings. Because the investment portfolios of our insurance subsidiaries consist primarily of fixed-income securities, their investment income and the fair value of their investment portfolios could decrease as a result of a number of factors. Our insurance subsidiaries invest the premiums they receive from their policyholders and maintain investment portfolios that consist primarily of fixed-income securities. The management of these investment portfolios is an important component of the profitability of our insurance subsidiaries. Our insurance subsidiaries derive a significant portion of their operating income from the income they receive on their invested assets. A number of factors may affect the quality and/or yield of their portfolios, including the general economic and business environment, government monetary policy, changes in the credit quality of the issuers of the fixed-income securities our insurance subsidiaries own, changes in market conditions and -26- regulatory changes. The fixed-income securities our insurance subsidiaries own consist primarily of securities issued by domestic entities that are backed either by the credit or collateral of the underlying issuer. Factors such as an economic downturn, disruption in the credit market or the availability of credit, a regulatory change pertaining to a particular issuer’s industry, a significant deterioration in the cash flows of the issuer or a change in the issuer’s marketplace may adversely affect the ability of our insurance subsidiaries to collect principal and interest from the issuer in which they invest. The investments of our insurance subsidiaries are also subject to risk resulting from interest rate fluctuations. Increasing interest rates or a widening in the spread between interest rates available on U.S. Treasury securities and corporate debt or asset-backed securities, for example, will typically have an adverse impact on the market values of fixed-rate securities. If interest rates remain at historically low levels, our insurance subsidiaries will generally have a lower overall rate of return on investments of cash their operations generate. In addition, in the event of the call or maturity of investments in a low interest rate environment, our insurance subsidiaries may not be able to reinvest the proceeds in securities with comparable interest rates. Changes in interest rates may reduce both the profitability and the return on the invested capital of our insurance subsidiaries. We and our insurance subsidiaries depend on key personnel. The loss of any member of our executive management or the senior management of our insurance subsidiaries could negatively affect the continuation of our business strategies and achievement of our growth objectives. The loss of, or failure to attract, key personnel could significantly impede the financial plans, growth, marketing and other objectives of us and our insurance subsidiaries. The continued success of our insurance subsidiaries depends to a substantial extent on the ability and experience of their senior management. Our insurance subsidiaries and we believe that our future success is dependent on our ability to attract and retain additional skilled and qualified personnel and to expand, train and manage our employees. We and Donegal Mutual have two to five year automatically renewing employment agreements with our senior officers, including all of our named executive officers. The reinsurance agreements on which our insurance subsidiaries rely do not relieve our insurance subsidiaries from their primary liability to their policyholders, and our insurance subsidiaries face a risk of non-payment from their reinsurers as well as the non-availability of reinsurance in the future. Our insurance subsidiaries rely on reinsurance agreements to limit their maximum net loss from large single catastrophic risks or excess of loss risks in areas where our insurance subsidiaries may have a concentration of policyholders. Reinsurance also enables our insurance subsidiaries to increase their capacity to write insurance because it has the effect of leveraging the surplus of our insurance subsidiaries. Although the reinsurance our insurance subsidiaries maintain provides that the reinsurer is liable to them for any reinsured losses, the reinsurance agreements do not generally relieve our insurance subsidiaries from their primary liability to their policyholders if the reinsurer fails to pay the reinsurance claims of our insurance subsidiaries. To the extent that a reinsurer is unable to pay losses for which it is liable to our insurance subsidiaries, our insurance subsidiaries remain liable for such losses. At December 31, 2013, our insurance subsidiaries had approximately $128.4 million of reinsurance receivables from third-party reinsurers relating to paid and unpaid losses. Any insolvency or inability of these reinsurers to make timely payments to our insurance subsidiaries under the terms of their reinsurance agreements would adversely affect the results of operations of our insurance subsidiaries. Michigan law requires MICO to provide unlimited lifetime medical benefits under the personal injury protection, or PIP, coverage of the personal automobile and commercial automobile policies it writes in the State of Michigan. Michigan law also requires MICO to be a member of the Michigan Catastrophic Claims Association, or MCCA, in order to write automobile insurance. The MCCA receives funding through assessments that its members collect from policyholders in the state and provides reinsurance for PIP claims that exceed a set retention. At December 31, 2013, MICO had approximately $46.2 million of reinsurance receivables from MCCA relating to paid and unpaid losses. The MCCA has generated significant operating deficits in recent years. Although we currently consider the risk to be remote, should the MCCA be unable to fulfill its payment obligations to MICO in the future, MICO's financial condition and results of operations could be adversely affected. In addition, our insurance subsidiaries face a risk of the non-availability of reinsurance or an increase in reinsurance costs that could adversely affect their ability to write business or their results of operations. Market conditions beyond the control of our insurance subsidiaries, such as the amount of surplus in the reinsurance market and the frequency and severity of natural and man-made catastrophes, affect both the availability and the cost of the reinsurance our insurance subsidiaries purchase. If our insurance subsidiaries cannot maintain their current level of reinsurance or purchase new reinsurance protection in amounts that our insurance subsidiaries consider sufficient, our insurance subsidiaries would either have to accept an increase in their net risk retention or reduce their insurance writings, which would adversely affect them. -27- Our equity investment in DFSC subjects us to certain risks inherent to community banking organizations. Our equity in the earnings of DFSC primarily reflects the underlying profitability of UCB. UCB is subject to a number of risks, which include, but are not limited to, the following: • • • • • • variations in interest rates that may negatively affect UCB's financial performance; inherent risks associated with UCB's lending activities; a significant decline in general economic conditions in the specific markets in which UCB operates; the potential adverse impact of extensive federal and state regulation and supervision; potential declines in the value of UCB's investments that are considered other than temporary; competition for loans and deposits with numerous regional and national banks and other financial institutions; and • UCB's inability to attract and retain qualified key personnel. Risks Relating to the Property and Casualty Insurance Industry Industry trends, such as increased litigation against the insurance industry and individual insurers, the willingness of courts to expand covered causes of loss, rising jury awards, escalating medical costs and increasing loss severity may contribute to increased costs and result in the deterioration of the reserves of our insurance subsidiaries. Loss severity in the property and casualty insurance industry has increased in recent years, principally driven by larger court judgments and increasing medical costs. In addition, many classes of complainants have brought legal actions and proceedings that tend to increase the size of judgments. The propensity of policyholders and third-party claimants to litigate and the willingness of courts to expand causes of loss and the size of awards to eliminate exclusions and to increase coverage limits may make the loss reserves of our insurance subsidiaries inadequate for current and future losses. Loss or significant restriction of the use of credit scoring in the pricing and underwriting of the personal lines insurance products by our insurance subsidiaries could adversely affect their future profitability. Our insurance subsidiaries use credit scoring as a factor in making risk selection and pricing decisions where allowed by state law for personal lines insurance products. Recently, some consumer groups and regulators have questioned whether the use of credit scoring unfairly discriminates against people with low incomes, minority groups and the elderly. These consumer groups and regulators often call for the prohibition or restriction on the use of credit scoring in underwriting and pricing. Laws or regulations enacted in a number of states that significantly curtail the use of credit scoring in the underwriting process could reduce the future profitability of our insurance subsidiaries. Changes in applicable insurance laws or regulations or changes in the way regulators administer those laws or regulations could adversely affect the operating environment of our insurance subsidiaries and increase their exposure to loss or put them at a competitive disadvantage. Property and casualty insurers are subject to extensive supervision in their domiciliary states and in the states in which they do business. This regulatory oversight includes matters relating to: • • licensing and examination; approval of premium rates; • market conduct; • • • policy forms; limitations on the nature and amount of certain investments; claims practices; -28- • mandated participation in involuntary markets and guaranty funds; • • • • • reserve adequacy; insurer solvency; transactions between affiliates; the amount of dividends that insurers may pay; and restrictions on underwriting standards. Such regulation and supervision are primarily for the benefit and protection of policyholders rather than stockholders. For instance, our insurance subsidiaries are subject to involuntary participation in specified markets in various states in which they operate and the premium rates our insurance subsidiaries may charge do not always correspond with the underlying costs of providing that coverage. The NAIC and state insurance regulators are re-examining existing laws and regulations, specifically focusing on: • • • • • • • insurance company investments; issues relating to the solvency of insurance companies; risk-based capital guidelines; restrictions on the terms and conditions included in insurance policies; certain methods of accounting; reserves for unearned premiums, losses and other purposes; the values at which insurance companies may carry investment securities and the definition of other-than-temporary impairment; and • interpretations of existing laws and the development of new laws. Changes in state laws and regulations, as well as changes in the way state regulators view related-party transactions in particular, could change the operating environment of our insurance subsidiaries and have an adverse effect on their business. The state insurance regulatory framework has recently come under increased federal scrutiny. Congress is considering proposals that it should create an optional federal charter for insurers. Federal chartering has the potential to create an uneven playing field for insurers by subjecting federally-chartered and state-chartered insurers to different regulatory requirements. Federal chartering also raises the possibility of duplicative or conflicting federal and state requirements. In addition, if federal legislation repeals the partial exemption for the insurance industry from federal antitrust laws, our ability to collect and share loss cost data with the industry could adversely affect the results of operations of our insurance subsidiaries. Insurance companies are subject to assessments, based on their market share in a given line of business, to assist in the payment of unpaid claims and related costs of insolvent insurance companies. Such assessments could adversely affect the financial condition of our insurance subsidiaries. Our insurance subsidiaries must pay assessments pursuant to the guaranty fund laws of the various states in which they conduct business. Generally, under these laws, our insurance subsidiaries can be assessed, depending upon the market share of our insurance subsidiaries in a given line of insurance business, to assist in the payment of unpaid claims and related costs of insolvent insurance companies in those states. We cannot predict the number and magnitude of future insurance company failures in the states in which our insurance subsidiaries conduct business, but future assessments could adversely affect the business, financial condition and results of operations of our insurance subsidiaries. -29- Our insurance subsidiaries must establish premium rates and loss and loss expense reserves from forecasts of the ultimate costs they expect will arise from risks underwritten during the policy period, and the profitability of our insurance subsidiaries could be adversely affected if their premium rates or reserves are insufficient to satisfy their ultimate costs. One of the distinguishing features of the property and casualty insurance industry is that it prices its products before it knows its costs, since insurers generally establish their premium rates before they know the amount of losses they will incur. Accordingly, our insurance subsidiaries establish premium rates from forecasts of the ultimate costs they expect to arise from risks they have underwritten during the policy period. These premium rates may not be sufficient to cover the ultimate losses incurred. Further, our insurance subsidiaries must establish reserves for losses and loss expenses as balance sheet liabilities based upon estimates involving actuarial and statistical projections at a given time of what our insurance subsidiaries expect their ultimate liability to be. Significant periods of time often elapse from the occurrence of an insured loss to the reporting of the loss and the payment of that loss. It is possible that our insurance subsidiaries' ultimate liability could exceed these estimates because of the future development of known losses, the existence of losses that have occurred but are currently unreported and larger than historical settlements on pending and unreported claims. The process of estimating reserves is inherently judgmental and can be influenced by a number of factors, including the following: • • • • • trends in claim frequency and severity; changes in operations; emerging economic and social trends; inflation; and changes in the regulatory and litigation environments. If our insurance subsidiaries have insufficient premium rates or reserves, insurance regulatory authorities may require increases to these reserves. An increase in reserves results in an increase in losses and a reduction in net income for the period in which the deficiency in reserves exists. Accordingly, if an increase in reserves is not sufficient, it may adversely impact their business, liquidity, financial condition and results of operations. The financial results of our insurance subsidiaries depend primarily on their ability to underwrite risks effectively and to charge adequate rates to policyholders. The financial condition, cash flows and results of operations of our insurance subsidiaries depend on their ability to underwrite and set rates accurately for a full spectrum of risks across a number of lines of insurance. Rate adequacy is necessary to generate sufficient premium to pay losses, loss adjustment expenses and underwriting expenses and to earn a profit. The ability to underwrite and set rates effectively is subject to a number of risks and uncertainties, including: • • • • • • • the availability of sufficient, reliable data; the ability to conduct a complete and accurate analysis of available data; the ability to recognize in a timely manner changes in trends and to project both the severity and frequency of losses with reasonable accuracy; uncertainties generally inherent in estimates and assumptions; the ability to project changes in certain operating expense levels with reasonable certainty; the development, selection and application of appropriate rating formulae or other pricing methodologies; the use of modeling tools to assist with correctly and consistently achieving the intended results in underwriting and pricing; • the ability to innovate with new pricing strategies and the success of those innovations on implementation; -30- • • • • • • • • • • the ability to secure regulatory approval of premium rates on an adequate and timely basis; the ability to predict policyholder retention accurately; unanticipated court decisions, legislation or regulatory action; unanticipated changes in our claim settlement practices; changes in driving patterns for auto exposures; changes in weather patterns for property exposures; changes in the medical sector of the economy; unanticipated changes in auto repair costs, auto parts prices and used car prices; the impact of inflation and other factors on the cost of construction materials and labor; the ability to monitor property concentration in catastrophe-prone areas, such as hurricane, earthquake and wind/hail regions; and • the general state of the economy in the states in which our insurance subsidiaries operate. Such risks may result in the premium rates of our insurance subsidiaries being based on inadequate or inaccurate data or inappropriate assumptions or methodologies and may cause our estimates of future changes in the frequency or severity of claims to be incorrect. As a result, our insurance subsidiaries could underprice risks, which would negatively affect our margins, or our insurance subsidiaries could overprice risks, which could reduce their volume and competitiveness. In either event, underpricing or overpricing risks could adversely impact our operating results, financial condition and cash flows. The cyclical nature of the property and casualty insurance industry may reduce the revenues and profit margins of our insurance subsidiaries. The property and casualty insurance industry is highly cyclical with respect to both individual lines of business and the overall insurance industry. Premium rate levels relate to the availability of insurance coverage, which varies according to the level of surplus available in the insurance industry. The level of surplus in the industry varies with returns on invested capital and regulatory barriers to withdrawal of surplus. Increases in surplus may result in increased price competition among property and casualty insurers. If our insurance subsidiaries find it necessary to reduce premiums or limit premium increases due to these competitive pressures on pricing, our insurance subsidiaries may experience a reduction in their profit margins and revenues, an increase in their ratios of losses and expenses to premiums and, therefore, lower profitability. Risks Relating to Our Common Stock The price of our common stock may be adversely affected by its low trading volume. Our Class A common stock and our Class B common stock have limited liquidity. Reported average daily trading volume for our Class A common stock and our Class B common stock for the year ended December 31, 2013 was approximately 26,148 shares and approximately 823 shares, respectively. This limited liquidity could subject our shares of Class A common stock and our shares of Class B common stock to greater price volatility. Donegal Mutual’s ownership of our stock, anti-takeover provisions of our certificate of incorporation and by-laws and certain state laws make it unlikely anyone could acquire control of us unless Donegal Mutual were in favor of the acquisition of control. Donegal Mutual’s ownership of our Class A common stock and Class B common stock, certain anti-takeover provisions of our certificate of incorporation and by-laws, certain provisions of Delaware law and the insurance laws and regulations of Iowa, Georgia, Maryland, Michigan, Pennsylvania, Virginia and Wisconsin could delay or prevent the removal of members of our board of directors and could make it more difficult for a merger, tender offer or proxy contest involving us to succeed, even if our stockholders other than Donegal Mutual believed any of such events would be beneficial to them. These factors could -31- also discourage a third party from attempting to acquire control of us. The classification of our board of directors could also have the effect of delaying or preventing a change in our control. In addition, we have 2,000,000 authorized shares of preferred stock that we could issue in one or more series without stockholder approval, to the extent applicable law permits, and upon such terms and conditions, and having such rights, privileges and preferences, as our board of directors may determine. Our ability to issue preferred stock could make it difficult for a third party to acquire us. We have no current plans to issue any preferred stock. Moreover, the DGCL contains provisions that prohibit certain business combination transactions under certain circumstances. In addition, state insurance laws and regulations generally prohibit any person from acquiring, or seeking to acquire, a 10% or greater interest in an insurance company without the prior approval of the state insurance commissioner of the state of domicile of the insurer. Because of our indirect control of UCB, HOLA also prohibits the acquisition of a 10% or greater interest in either our Class A common stock or our Class B common stock without the prior approval of the FRB or the granting of an exemption by the FRB. -32- Item 1B. Unresolved Staff Comments. We have no unresolved written comments from the Securities and Exchange Commission ("SEC") staff regarding our filings under the Exchange Act. Item 2. Properties. We and our insurance subsidiaries share administrative headquarters with Donegal Mutual in a building in Marietta, Pennsylvania that Donegal Mutual owns. Donegal Mutual charges us and our insurance subsidiaries for an appropriate portion of the building expenses under an inter-company allocation agreement. The Marietta headquarters has approximately 230,000 square feet of office space. Southern owns a facility of approximately 10,000 square feet in Glen Allen, Virginia. Le Mars owns a facility of approximately 25,500 square feet in Le Mars, Iowa, Peninsula owns a facility of approximately 14,600 square feet in Salisbury, Maryland and Sheboygan owns a facility of approximately 8,800 square feet in Sheboygan Falls, Wisconsin. Item 3. Legal Proceedings. Our insurance subsidiaries are parties to routine litigation that arises in the ordinary course of their insurance business. We believe that the resolution of these lawsuits will not have a material adverse effect on the financial condition or results of operations of our insurance subsidiaries. Item 4. Reserved. Not applicable. -33- Executive Officers of the Company The following table sets forth information regarding the executive officers of Donegal Mutual and us, each of whom has served with us for more than 10 years: Name Donald H. Nikolaus Age Kevin G. Burke Cyril J. Greenya Jeffrey D. Miller Sanjay Pandey Position 71 President and Chief Executive Officer of Donegal Mutual since 1981; President and Chief Executive Officer of us since 1986. Chairman of our board of directors since April 2012. 48 Senior Vice President of Human Resources of Donegal Mutual and us since 2005; Vice President of Human Resources of Donegal Mutual and us from 2001 to 2005; other positions from 2000 to 2001. 69 Senior Vice President and Chief Underwriting Officer of Donegal Mutual and us since 2005; Senior Vice President, Underwriting, of Donegal Mutual from 1997 to 2005; other positions from 1986 to 2005. 49 Senior Vice President and Chief Financial Officer of Donegal Mutual and us since 2005; Vice President and Controller of Donegal Mutual and us from 2000 to 2005; other positions from 1995 to 2005. 47 Senior Vice President and Chief Information Officer of Donegal Mutual and us since 2013; Vice President and Chief Information Officer of Donegal Mutual and us from 2009 to 2013; other positions from 2000 to 2009. Robert G. Shenk 60 Senior Vice President, Claims, of Donegal Mutual and us since 1997; other positions from 1986 to 1997. Daniel J. Wagner 53 Senior Vice President and Treasurer of Donegal Mutual and us since 2005; Vice President and Treasurer of Donegal Mutual and us from 2000 to 2005; other positions from 1993 to 2005. -34- PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. Our Class A common stock and Class B common stock trade on the NASDAQ Global Select Market under the symbols “DGICA” and “DGICB,” respectively. The following table shows the dividends paid per share and the stock price range for both classes of stock for each quarter during 2013 and 2012: Quarter 2013 - Class A 1st 2nd 3rd 4th 2013 - Class B 1st 2nd 3rd 4th 2012 - Class A 1st 2nd 3rd 4th 2012 - Class B 1st 2nd 3rd 4th High Low Cash Dividend Declared Per Share $ 16.52 $ 12.93 $ — 15.59 14.90 16.88 13.90 0.1275 13.35 0.1275 14.15 0.2550 $ 28.49 27.85 $ 17.92 $ — 19.00 0.1150 24.03 26.00 18.00 0.1150 19.21 0.2300 $ 16.00 $ 12.73 $ — 15.36 14.93 14.69 12.87 0.1225 12.91 0.1225 12.25 0.2450 $ 17.89 $ 14.74 $ — 18.00 18.22 23.00 16.85 0.1100 16.04 0.1100 16.51 0.2200 At the close of business on March 3, 2014, we had approximately 1,926 holders of record of our Class A common stock and approximately 340 holders of record of our Class B common stock. We declared dividends of $0.51 per share on our Class A common stock and $0.46 per share on our Class B common stock in 2013, compared to $0.49 per share on our Class A common stock and $0.44 per share on our Class B common stock in 2012. -35- Between October 1, 2013 and December 31, 2013, we and Donegal Mutual purchased shares of our Class A common stock and Class B common stock as set forth in the table below: Period (a) Total Number of Shares (or Units Purchased (b) Average Price Paid per Share (or Unit) (c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs (d) Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1) Month #1 October 1-31, 2013 Class A — — Class B — — Class A — $— Class B — $— Class A — — Class B — — Month #2 November 1-30, 2013 Class A — — Class B — — Class A — $— Class B — $— Class A — — Class B — — Month #3 December 1-31, 2013 Class A — 20,000 Class B — 13,000 Class A — $15.82 Class B — $23.62 Class A — 20,000 Class B — 13,000 (1) (2) Total Class A — 20,000 Class B — 13,000 Class A — $15.82 Class B — $23.62 Class A — 20,000 Class B — 13,000 (1) We purchased these shares pursuant to our announcement first made on February 23, 2009 that we will purchase up to 300,000 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 may purchase up to 4,068 additional shares of our Class A common stock under this stock repurchase program. (2) Donegal Mutual purchased these shares pursuant to its announcement first made on August 17, 2004 that it will, at its discretion, purchase shares of our Class A common stock and Class B common stock at market prices prevailing from time to time in the open market subject to the provisions of SEC Rule 10b-18 and in privately negotiated transactions. Such announcement did not stipulate a maximum number of shares that may be purchased under this program. -36- Stock Performance Chart. The following graph provides an indicator of cumulative total stockholder returns on our Class A common stock and our Class B common stock for the period beginning on December 31, 2008 and ending on December 31, 2013, compared to the Russell 2000 Index and a peer group comprised of seven property and casualty insurance companies over the same period. The peer group consists of Cincinnati Financial Corp., EMC Insurance Group Inc., Hanover Insurance, Horace Mann Educators, Selective Insurance Group Inc., State Auto Financial Corp. and United Fire and Casualty Co. The graph shows the change in value of an initial $100 investment on December 31, 2008, assuming reinvestment of all dividends. Donegal Group Inc. Class A Donegal Group Inc. Class B Russell 2000 Index Peer Group 2008 $100.00 100.00 100.00 100.00 2009 $95.41 100.85 125.22 90.53 2010 $91.93 108.23 156.90 108.19 2011 $93.33 103.50 148.35 100.42 2012 $95.84 116.23 170.06 127.24 2013 $112.39 155.94 232.98 181.94 Value Line Publishing LLC prepared the foregoing performance graph and data. The performance graph and accompanying data shall not be deemed "filed" as part of this Form 10-K Annual Report for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section and should not be deemed incorporated by reference into any other filing we make under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate the performance graph and accompanying data by reference into such filing. -37- Item 6. Selected Financial Data. Year Ended December 31, 2013 2012 2011 2010 2009 Income Statement Data Premiums earned Investment income, net Realized investment gains Total revenues Income (loss) before income taxes (benefit) Income taxes (benefit) Net income Basic earnings per share - Class A Diluted earnings per share - Class A Cash dividends per share - Class A Basic earnings per share - Class B Diluted earnings per share - Class B Cash dividends per share - Class B Balance Sheet Data at Year End Total investments Total assets Debt obligations Stockholders' equity Book value per share $ 515,291,944 $ 475,002,222 $ 431,470,184 $ 378,030,129 $ 355,025,477 18,795,239 20,168,919 20,858,179 19,949,714 20,630,583 2,423,442 6,859,439 12,281,267 4,395,720 4,479,558 547,110,065 514,982,585 475,017,619 408,549,446 386,733,407 32,710,265 27,858,260 6,388,273 4,765,640 26,321,992 23,092,620 (6,739,313) (7,192,266) 452,953 9,844,149 (1,623,030) 11,467,179 20,676,689 1,846,611 18,830,078 1.04 1.02 0.51 0.94 0.94 0.46 0.92 0.91 0.49 0.83 0.83 0.44 0.02 0.02 0.48 0.01 0.01 0.43 0.46 0.46 0.46 0.41 0.41 0.41 0.76 0.76 0.45 0.68 0.68 0.40 $ 791,808,307 $ 806,429,032 $ 785,308,991 $ 728,541,814 $ 666,835,186 1,385,410,502 1,336,889,187 1,290,793,478 1,174,619,523 935,601,927 63,000,000 72,465,000 74,965,000 56,082,371 15,465,000 396,877,111 400,034,094 383,451,592 380,102,810 385,505,699 15.02 15.63 15.01 14.86 15.12 -38- Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. Overview Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. See “Business - History and Organizational Structure” for more information. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), The Peninsula Insurance Company and Peninsula Indemnity Company (collectively, “Peninsula”), Sheboygan Falls Insurance Company (“Sheboygan Falls”) and Michigan Insurance Company (“MICO”) write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid- Atlantic, Midwest, New England and Southern states. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers' compensation policies. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. At December 31, 2013, Donegal Mutual held approximately 37% of our outstanding Class A common stock and approximately 76% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 65% of the aggregate voting power of our outstanding shares of Class A common stock and our outstanding shares of Class B common stock. Donegal Mutual and Atlantic States entered into a proportional reinsurance agreement, or pooling agreement, effective October 1, 1986. Under this pooling agreement, Donegal Mutual and Atlantic States pool and then share proportionately substantially all of their respective premiums, losses and expenses. Atlantic States' participation in the pool has been 80% since March 1, 2008. The operations of our insurance subsidiaries and Donegal Mutual are interrelated due to the pooling agreement and other factors. While maintaining the separate corporate existence of each company, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. See “Business - History and Organizational Structure” for more information regarding the pooling agreement and other transactions with our affiliates. In May 2011, DFSC and Union National Financial Corporation (“UNNF”) merged, with DFSC as the surviving company in the merger. Under the merger agreement, Province Bank FSB, which DFSC owned, and Union National Community Bank, which UNNF owned, also merged and began doing business as Union Community Bank FSB (“UCB”). UCB became a state savings bank in 2013. UCB had 13 branch offices in Lancaster County, Pennsylvania, and $512.8 million in assets at December 31, 2013. Donegal Mutual contributed $22.1 million and we contributed $20.6 million to DFSC as additional capital to facilitate the mergers. We use the equity method of accounting for our investment in DFSC. Under the equity method, we record our investment at cost, with adjustments for our share of DFSC's earnings and losses as well as changes in DFSC's equity due to DFSC's unrealized gains and losses. In February 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 Securities and Exchange Commission (“SEC”) Rule 10b-18 and in privately negotiated transactions. We purchased 24,240 and 135,064 shares of our Class A common stock under this program during 2013 and 2012, respectively. At December 31, 2013, we had the authority remaining to purchase 4,068 shares under this program. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of the SEC Rule 10b-18 and in privately negotiated transactions. We did not purchase shares under this program during 2013. At our annual meeting of stockholders on April 18, 2013, our stockholders approved an amendment to our certificate of incorporation that increased the number of shares of our Class A common stock we have the authority to issue from 30.0 million shares to 40.0 million shares. -39- Critical Accounting Policies and Estimates We combine our financial statements with those of our insurance subsidiaries and present them on a consolidated basis in accordance with GAAP. Our insurance subsidiaries make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our financial statements. The most significant estimates relate to the reserves of our insurance subsidiaries for property and casualty insurance unpaid losses and loss expenses, valuation of investments and determination of other-than- temporary investment impairments and the policy acquisition costs of our insurance subsidiaries. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts may differ from the estimates we provided. We regularly review our methods for making these estimates and we reflect any adjustment we consider necessary in our current results of operations. Liability for Losses and Loss Expenses Liabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to policyholder claims based on facts and circumstances then known. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends, expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding individual claims, and, consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates of liability. We reflect any adjustments to our insurance subsidiaries' liabilities for losses and loss expenses in our consolidated results of operations in the period in which our insurance subsidiaries make the changes in estimates. Our insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss the policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries closely monitor their liabilities and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses. Reserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries' external environment and, to a lesser extent, assumptions related to our insurance subsidiaries' internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers' compensation claims during the past several years while claims severity has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers' compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries' external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectability of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries attempt to make appropriate adjustments for such changes in their reserves. Accordingly, our insurance subsidiaries' ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded at December 31, 2013. For every 1% change in our insurance subsidiaries' estimate for loss and loss expense reserves, net of reinsurance recoverable, the effect on our pre-tax results of operations would be approximately $2.7 million. The establishment of appropriate liabilities is an inherently uncertain process and we can provide no assurance that our insurance subsidiaries' ultimate liability will not exceed our insurance subsidiaries' loss and loss expense reserves and have an adverse effect on our results of operations and financial condition. Furthermore, we cannot predict the timing, frequency and extent of adjustments to our insurance subsidiaries' estimated future liabilities, since the historical conditions and events that serve as a basis for our insurance subsidiaries' estimates of ultimate claim costs may change. As is the case for substantially all -40- property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods and, in other periods, their estimates of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries' estimate of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. Our insurance subsidiaries recognized an increase (decrease) in their liability for losses and loss expenses of prior years of $10.4 million, $7.6 million and ($168,460) in 2013, 2012 and 2011, respectively. Our insurance subsidiaries made no significant changes in their reserving philosophy, key reserving assumptions or claims management personnel, and have made no significant offsetting changes in estimates that increased or decreased their loss and loss expense reserves in these years. The 2013 development represented 4.1% of the December 31, 2012 net carried reserves and resulted primarily from higher-than- expected severity in the private passenger automobile liability, commercial multiple peril, commercial automobile and workers' compensation lines of business in accident years prior to 2013. Excluding the impact of weather events, our insurance subsidiaries have noted stable amounts in the number of claims incurred and a slight downward trend in the number of claims outstanding at period ends relative to their premium base in recent years across most of their lines of business. However, the amount of the average claim outstanding has increased gradually over the past several years as the United States property and casualty insurance industry has experienced increased litigation trends and economic conditions that have extended the estimated length of disabilities and contributed to increased medical loss costs. We have also experienced a general slowing of settlement rates in litigated claims. Our insurance subsidiaries could have to make further adjustments to their estimates in the future. However, on the basis of our insurance subsidiaries' internal procedures, which analyze, among other things, their prior assumptions, their experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes, we believe that our insurance subsidiaries have made adequate provision for their liability for losses and loss expenses. Atlantic States' participation in the pool with Donegal Mutual exposes it to adverse loss development on the business of Donegal Mutual that the pool includes. However, pooled business represents the predominant percentage of the net underwriting activity of both companies, and Donegal Mutual and Atlantic States proportionately share any adverse risk development of the pooled business. The business in the pool is homogeneous and each company has a pro-rata share of the entire pool. Since substantially all of the business of Atlantic States and Donegal Mutual is pooled and the results shared by each company according to its participation level under the terms of the pooling agreement, the intent of the underwriting pool is to produce a more uniform and stable underwriting result from year to year for each company than either would experience individually and to spread the risk of loss between the companies. Our insurance subsidiaries' liability for losses and loss expenses by major line of business at December 31, 2013 and 2012 consisted of the following: Commercial lines: Automobile Workers' compensation Commercial multi-peril Other 2013 2012 (in thousands) $ 36,017 $ 32,012 79,932 39,822 2,716 67,715 39,645 4,142 Total commercial lines 158,487 143,514 Personal lines: Automobile Homeowners Other 92,280 13,367 1,471 93,966 11,643 1,813 Total personal lines 107,118 107,422 Total commercial and personal lines Plus reinsurance recoverable 265,605 230,014 250,936 207,891 Total liability for losses and loss expenses $ 495,619 $ 458,827 -41- We have evaluated the effect on our insurance subsidiaries' loss and loss expense reserves and our stockholders' equity in the event of reasonably likely changes in the variables we consider in establishing loss and loss expense reserves. We established the range of reasonably likely changes based on a review of changes in accident year development by line of business and applied it 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 effect on our insurance subsidiaries' 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: Change in Loss and Loss Expense Reserves Net of Reinsurance Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2013 Percentage Change in Equity at December 31, 2013(1) (dollars in thousands) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2012 Percentage Change in Equity at December 31, 2012(1) -10.0% $239,045 4.4% $225,842 4.1% -7.5 -5.0 -2.5 Base 2.5 5.0 7.5 10.0 245,685 252,325 258,965 265,605 272,245 278,885 285,525 292,166 (1) Net of income tax effect. 3.3 2.2 1.1 — -1.1 -2.2 -3.3 -4.4 232,116 238,389 244,663 250,936 257,209 263,483 269,756 276,030 3.1 2.0 1.0 — -1.0 -2.0 -3.1 -4.1 Our insurance subsidiaries base their reserves for unpaid losses and loss expenses on current trends in loss and loss expense development and reflect their best estimates for future amounts needed to pay losses and loss expenses with respect to incurred events currently known to them plus incurred but not reported (“IBNR”) claims. Our insurance subsidiaries develop their reserve estimates based on an assessment of known facts and circumstances, review of historical loss settlement patterns, estimates of trends in claims severity, frequency, legal and regulatory changes and other assumptions. Our insurance subsidiaries consistently apply actuarial loss reserving techniques and assumptions, which rely on historical information as adjusted to reflect current conditions, including consideration of recent case reserve activity. Our insurance subsidiaries use the most-likely number their actuaries determine. For the year ended December 31, 2013, the actuaries developed a range from a low of $238.8 million to a high of $295.5 million and with a most-likely number of $265.6 million. The actuaries' range of estimates for commercial lines in 2013 was $142.5 million to $176.2 million, and the actuaries selected the most-likely number of $158.5 million. The actuaries' range of estimates for personal lines in 2013 was $96.2 million to $119.3 million, and the actuaries selected the most-likely number of $107.1 million. For the year ended December 31, 2012, the actuaries developed a range from a low of $228.7 million to a high of $275.3 million and with a most-likely number of $250.9 million. The actuaries' range of estimates for commercial lines in 2012 was $130.9 million to $157.4 million, and the actuaries selected the most-likely number of $143.5 million. The actuaries' range of estimates for personal lines in 2012 was $97.8 million to $117.9 million, and the actuaries selected the most-likely number of $107.4 million. Our insurance subsidiaries seek to enhance their underwriting results by carefully selecting the product lines they underwrite. For personal lines products, our insurance subsidiaries insure standard and preferred risks in private passenger automobile and homeowners lines. For commercial lines products, the commercial risks that our insurance subsidiaries primarily insure are business offices, wholesalers, service providers, contractors, artisans and light manufacturing operations. Our insurance subsidiaries have limited exposure to asbestos and other environmental liabilities. Our insurance subsidiaries write no medical malpractice liability risks. Through the consistent application of this disciplined underwriting philosophy, our insurance subsidiaries have avoided many of the “long-tail” issues other insurance companies have faced. We consider workers' compensation to be a “long-tail” line of business, in that workers' compensation claims tend to be settled over a longer time frame than those in the other lines of business of our insurance subsidiaries. -42- The following table presents 2013 and 2012 claim count and payment amount information for workers' compensation. Workers' compensation losses primarily consist of indemnity and medical costs for injured workers. Number of claims pending, beginning of period (dollars in thousands) Number of claims reported Number of claims settled or dismissed Number of claims pending, end of period Losses paid Loss expenses paid Investments For the Year Ended December 31, 2013 2012 2,345 6,869 6,605 2,609 2,430 6,114 6,199 2,345 $ 32,419 $ 7,365 30,860 6,518 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of original cost and has been in such an unrealized loss position for more than six months. We held four equity securities that were in an unrealized loss position at December 31, 2013. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 216 debt securities that were in an unrealized loss position at December 31, 2013. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in 2013, 2012 or 2011. We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2013 as follows: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 50,802,809 $ 821,941 $ 4,642,775 $ 104,331 Less than 12 months 12 months or longer Fair Value Unrealized Losses Fair Value Unrealized Losses Obligations of states and political subdivisions 65,170,891 363,240 13,404,781 Corporate securities Mortgage-backed securities Equity securities Totals 98,676 71,802 16,693,759 83,535 6,851,898 72,878,347 535,944 19,013,889 213,414 1,628,893 92,867 — — $ 207,174,699 $ 1,897,527 $43,913,343 $ 488,223 -43- We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2012 as follows: Less than 12 months 12 months or longer Fair Value Unrealized Losses Fair Value Unrealized Losses U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 12,308,333 $ 43,951 $ Obligations of states and political subdivisions 22,134,226 606,065 — $ — — — Corporate securities Mortgage-backed securities Equity securities Totals 12,271,750 79,136 2,958,520 29,573 22,491,562 66,443 2,226,050 106,748 — — — — $ 71,431,921 $ 902,343 $ 2,958,520 $ 29,573 We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. 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 based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain are representative of fair values based upon their general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At December 31, 2013 and 2012, we received one estimate per security from one of the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at December 31, 2013 and 2012, we did not identify any discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We had no sales or transfers from the held to maturity portfolio in 2013, 2012 or 2011. Policy Acquisition Costs We defer our insurance subsidiaries' policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs, reduced by ceded commissions, that vary with and relate directly to the production of business. We amortize these costs over the period in which our insurance subsidiaries earn the premiums on that business. The method our insurance subsidiaries follow in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premium. Management Evaluation of Operating Results Despite headwinds from economic uncertainty, challenging insurance market conditions and unusually adverse weather conditions that affected our results in recent years, we believe that our focused business strategy, including our insurance subsidiaries' disciplined underwriting practices, have positioned us well for 2014 and beyond. The property and casualty insurance industry is highly cyclical, and individual lines of business experience their own cycles within the overall property and casualty insurance industry cycle. Premium rate levels relate to the availability of insurance coverage, which varies according to the level of surplus in the insurance industry and other factors. The level of surplus in the industry varies with returns on capital and regulatory barriers to the withdrawal of surplus. Increases in surplus have generally been accompanied by increased price competition among property and casualty insurers. If our insurance -44- subsidiaries were to find it necessary to reduce premiums or limit premium increases due to competitive pressures on pricing, our insurance subsidiaries could experience a reduction in profit margins and revenues, an increase in ratios of losses and expenses to premiums and, therefore, lower profitability. The cyclicality of the insurance market and its potential impact on our results is difficult to predict with any significant reliability. We evaluate the performance of our commercial lines and personal lines segments primarily based upon the underwriting results of our insurance subsidiaries as determined under statutory accounting practices (“SAP”), which our management uses to measure performance for the total business of our insurance subsidiaries. -45- We use the following financial data to monitor and evaluate our operating results: (in thousands) Net premiums written: Personal lines: Automobile Homeowners Other Total personal lines Commercial lines: Automobile Workers' compensation Commercial multi-peril Other Total commercial lines Year Ended December 31, 2013 2012 2011 $ 196,363 $ 195,132 $ 186,677 106,420 15,915 318,698 58,165 77,589 74,516 4,463 97,120 16,319 89,405 14,983 308,571 291,065 51,261 65,390 64,476 6,749 46,168 51,849 57,988 6,981 214,733 187,876 162,986 Total net premiums written $ 533,431 $ 496,447 $ 454,051 Components of GAAP combined ratio: Loss ratio Expense ratio Dividend ratio GAAP combined ratio Revenues: Premiums earned: Personal lines Commercial lines SAP premiums earned GAAP adjustments GAAP premiums earned Net investment income Realized investment gains Equity in earnings of DFSC Other Total revenues 66.6% 31.8 0.4 70.1% 31.2 0.3 78.9% 31.4 0.3 98.8% 101.6% 110.6% $ 312,309 $ 300,272 $ 282,498 202,983 515,292 — 515,292 18,795 2,423 2,908 7,692 174,735 475,007 (5) 475,002 20,169 6,859 4,533 8,420 152,247 434,745 (3,275) 431,470 20,858 12,281 2,023 8,386 $ 547,110 $ 514,983 $ 475,018 -46- (in thousands) Components of net income: Underwriting income (loss): Personal lines Commercial lines SAP underwriting income (loss) GAAP adjustments GAAP underwriting income (loss) Net investment income Realized investment gains Equity in earnings of DFSC Other Income (loss) before income tax (expense) benefit Income tax (expense) benefit Net income Statutory Combined Ratios Year Ended December 31, 2013 2012 2011 $ $ 1,654 (524) 1,130 5,175 6,305 18,795 2,423 2,908 2,279 32,710 (6,388) 26,322 $ $ (18,236) $ 5,251 (12,985) 5,545 (7,440) 20,169 6,859 4,533 3,737 27,858 (4,765) 23,093 $ (40,739) (6,560) (47,299) 1,532 (45,767) 20,858 12,281 2,023 3,866 (6,739) 7,192 453 We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting (loss) income, statutory combined ratio and net premiums written. An insurance company's statutory combined ratio is a standard measure of underwriting profitability. This ratio is the sum of the ratio of calendar-year incurred losses and loss expenses to premiums earned; the ratio of expenses incurred for commissions, premium taxes and underwriting expenses to premiums written and the ratio of dividends to policyholders to premiums earned. The statutory combined ratio does not reflect investment income, federal income taxes or other non-operating income or expense. A ratio of less than 100 percent generally indicates underwriting profitability. The statutory combined ratio differs from the GAAP combined ratio. In calculating the GAAP combined ratio, installment payment fees are not deducted from incurred expenses and the expense ratio is based on premiums earned instead of premiums written. The following table sets forth our insurance subsidiaries' statutory combined ratios by major line of business for the years ended December 31, 2013, 2012 and 2011: Year Ended December 31, 2013 2012 2011 104.9% 94.5% 105.4% 96.9 92.9 NM1 95.7 103.2 93.0 80.5 98.8 97.4 98.1 90.5 15.0 91.2 108.1 100.9 89.4 105.0 99.8 96.0 103.0 46.1 99.0 106.9 126.3 103.6 112.6 107.9 Commercial lines: Automobile Workers' compensation Commercial multi-peril Other Total commercial lines Personal lines: Automobile Homeowners Other Total personal lines Total commercial and personal lines _____________ 1Not meaningful -47- Results of Operations YEAR ENDED DECEMBER 31, 2013 COMPARED TO YEAR ENDED DECEMBER 31, 2012 Net Premiums Written Our insurance subsidiaries' 2013 net premiums written increased 7.5% to $533.4 million, compared to $496.4 million for 2012. We primarily attribute the increase to a reduction in MICO’s quota-share reinsurance, the impact of premium rate increases and an increase in the writing of commercial lines of insurance. Effective January 1, 2013, MICO reduced its external quota-share reinsurance percentage from 40% to 30%. Commercial lines net premiums written increased $26.6 million, or 14.1%, for 2013 compared to 2012. The increase includes $5.6 million related to the reduction in the amount of premium MICO reinsured in 2013, with the remainder attributable to increased writings of new accounts in the commercial automobile, commercial multi-peril and workers' compensation lines of business. Personal lines net premiums written increased $10.4 million, or 3.4%, for 2013 compared to 2012. The increase includes $4.2 million resulting from the reduction in the amount of premium MICO reinsured in 2013, with the remainder primarily attributable to premium rate increases our subsidiaries implemented throughout 2012 and 2013 and reduced reinsurance reinstatement premiums. Net Premiums Earned Our insurance subsidiaries' net premiums earned increased to $515.3 million for 2013, an increase of $40.3 million, or 8.5%, over 2012, reflecting increases in net premiums written during 2012 and 2013. Our insurance subsidiaries earn premiums and recognize them as income over the terms of the policies they issue. Such terms are generally 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 same period one year earlier. Investment Income For 2013, our net investment income was $18.8 million, a $1.4 million decrease from 2012. An increase in our average invested assets from $795.9 million in 2012 to $799.1 million in 2013 was offset by a decrease in our annualized average rate of return to 2.4% in 2013, compared to 2.5% in 2012. Installment Payment Fees Our insurance subsidiaries' installment fees decreased primarily as a result of their customers' increased usage of payment plans that have lower installment payment fees during 2013. Net Realized Investment Gains/Losses Our net realized investment gains in 2013 and 2012 were $2.4 million and $6.9 million, respectively. The net realized investment gains in 2013 and 2012 resulted from normal turnover within our investment portfolio. We did not recognize any impairment losses during 2013 or 2012. Equity in Earnings of DFSC Our equity in the earnings of DFSC in 2013 and 2012 was $2.9 million and $4.5 million, respectively. The decrease in DFSC’s earnings resulted from a lesser benefit from acquisition accounting adjustments and lower net realized gains during 2013 compared to 2012. Losses and Loss Expenses Our insurance subsidiaries' loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, was 66.6% in 2013, compared to 70.1% in 2012. Our insurance subsidiaries' commercial lines loss ratio increased to 67.1% in 2013, compared to 65.5% in 2012. This increase resulted primarily from the commercial automobile loss ratio increasing to 73.0% in 2013, compared to 63.8% in 2012, and the commercial multi-peril ratio increasing to 61.5% in 2013, compared to 60.2% in 2012. The personal lines loss ratio decreased to 66.3% in 2013, compared to 72.8% in 2012, primarily as a result of a decrease in the homeowners loss ratio to 57.7% in 2013, compared to 66.1% in 2012, as a result of a decrease in weather-related claims. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $10.4 million during 2013 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $7.6 million during -48- 2012. The change in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation, commercial automobile, commercial multi-peril and personal automobile reserves. Underwriting Expenses Our insurance subsidiaries' expense ratio, which is the ratio of policy acquisition and other underwriting expenses to premiums earned, was 31.8% in 2013, compared to 31.2% in 2012. Combined Ratio Our insurance subsidiaries' combined ratio was 98.8% and 101.6% in 2013 and 2012, respectively. The combined ratio represents the sum of the loss ratio, the expense ratio and the dividend ratio, which is the ratio of workers' compensation policy dividends incurred to premiums earned. Interest Expense Our interest expense in 2013 was $1.6 million, compared to $2.4 million in 2012. The decrease was related to a lower average interest rate on borrowings during 2013 compared to 2012 due to the utilization of Federal Home Loan Bank (“FHLB”) borrowings to prepay $15.5 million of subordinated debentures during the first quarter of 2013. Income Taxes Our income tax expense was $6.4 million in 2013, compared to $4.8 million in 2012. Our effective tax rate for 2013 was 19.5%, compared to 17.1% for 2012. The change in effective tax rates is primarily due to tax-exempt interest income representing a smaller proportion of income before income tax expense in 2013 compared to 2012. Net Income and Earnings Per Share Our net income in 2013 was $26.3 million, or $1.02 per share of Class A common stock on a diluted basis and $.94 per share of Class B common stock, compared to $23.1 million, or $.91 per share of Class A common stock on a diluted basis and $.83 per share of Class B common stock, in 2012. We had 20.8 million and 20.0 million Class A shares outstanding at December 31, 2013 and 2012, respectively. We had 5.6 million Class B shares outstanding for both periods. There are no outstanding securities that dilute our shares of Class B common stock. Book Value Per Share and Return on Equity Our stockholders' equity decreased by $3.2 million in 2013. We attribute the decrease to net after-tax unrealized losses within our available-for-sale fixed maturity investment portfolio during 2013. Book value per share decreased to $15.02 at December 31, 2013, compared to $15.63 a year earlier. Our return on average equity was 6.6% for 2013, compared to 5.9% for 2012. YEAR ENDED DECEMBER 31, 2012 COMPARED TO YEAR ENDED DECEMBER 31, 2011 Net Premiums Written Our insurance subsidiaries' 2012 net premiums written increased 9.3% to $496.4 million, compared to $454.1 million for 2011. We primarily attribute the increase to a change in MICO’s quota-share reinsurance, the impact of premium rate increases and an increase in the writing of commercial lines of insurance. Effective January 1, 2012, MICO reduced its external quota- share reinsurance percentage from 50% to 40%. Commercial lines net premiums written increased $26.7 million, or 16.5%, for 2012 compared to 2011. The increase includes $5.3 million related to the reduction in the amount of premium MICO reinsured in 2012, with the remainder attributable to increased writings of new accounts in the commercial automobile, commercial multi-peril and workers' compensation lines of business. Personal lines net premiums written increased $15.7 million, or 5.4%, for 2012 compared to 2011. The increase includes $4.6 million resulting from the reduction in the amount of premium MICO reinsured in 2012, with the remainder primarily attributable to premium rate increases our subsidiaries implemented throughout 2011 and 2012 and reduced reinsurance reinstatement premiums. -49- Net Premiums Earned Our insurance subsidiaries' net premiums earned increased to $475.0 million for 2012, an increase of $43.5 million, or 10.1%, over 2011, reflecting increases in net premiums written during 2011 and 2012. Our insurance subsidiaries earn premiums and recognize them as income over the terms of the policies they issue. Such terms are generally 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 same period one year earlier. Investment Income For 2012, our net investment income was $20.2 million, a slight decrease from 2011. An increase in our average invested assets from $756.9 million in 2011 to $795.9 million in 2012 was offset by a decrease in our annualized average rate of return to 2.5% in 2012, compared to 2.8% in 2011. Installment Payment Fees Our insurance subsidiaries' installment fees increased primarily as a result of increases in policy counts during 2012. Net Realized Investment Gains/Losses Our net realized investment gains in 2012 and 2011 were $6.9 million and $12.3 million, respectively. The net realized investment gains in 2012 resulted from normal turnover within our investment portfolio. The net realized investment gains for 2011 included $8.0 million in gains that resulted from the previously planned periodic sales of a portion of our holdings of an equity security that we obtained in an initial public offering and for which a selling restriction expired during 2011. We did not recognize any impairment losses during 2012 or 2011. Equity in Earnings of DFSC Our equity in the earnings of DFSC in 2012 and 2011 was $4.5 million and $2.0 million, respectively. The increase in DFSC's earnings reflects the impact of the merger of UNNF and DFSC. Losses and Loss Expenses Our insurance subsidiaries' loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, was 70.1% in 2012, compared to 78.9% in 2011. Our insurance subsidiaries' commercial lines loss ratio decreased to 65.5% in 2012, compared to 71.8% in 2011. This decrease resulted primarily from the commercial automobile loss ratio decreasing to 63.8% in 2012, compared to 72.4% in 2011, and the commercial multi-peril ratio decreasing to 60.2% in 2012, compared to 74.8% in 2011, as a result of decreased claim severity. The personal lines loss ratio decreased to 72.8% in 2012, compared to 82.8% in 2011, primarily as a result of a decrease in the homeowners loss ratio to 66.1% in 2012, compared to 97.1% in 2011, as a result of a decrease in weather-related claims. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $7.6 million during 2012 in their reserves for prior accident years, compared to virtually no development for 2011. The change in loss reserve development patterns occurred primarily within our insurance subsidiaries’ workers’ compensation and personal automobile reserves. Underwriting Expenses Our insurance subsidiaries' expense ratio, which is the ratio of policy acquisition and other underwriting expenses to premiums earned, was 31.2% in 2012, compared to 31.4% in 2011. Combined Ratio Our insurance subsidiaries' combined ratio was 101.6% and 110.6% in 2012 and 2011, respectively. The combined ratio represents the sum of the loss ratio, expense ratio and dividend ratio, which is the ratio of workers' compensation policy dividends incurred to premiums earned. Interest Expense Our interest expense in 2012 was $2.4 million, compared to $2.1 million in 2011. The higher interest expense in 2012 reflected an increase in our borrowings under our line of credit. -50- Income Taxes Our income tax expense was $4.8 million in 2012, compared to a tax benefit of $7.2 million in 2011. Our effective tax rate for 2012 was 17.1%. Net Income and Earnings Per Share Our net income in 2012 was $23.1 million, or $.91 per share of Class A common stock on a diluted basis and $.83 per share of Class B common stock, compared to $452,953, or $.02 per share of Class A common stock on a diluted basis and $.01 per share of Class B common stock, in 2011. We had 20.0 million Class A shares and 5.6 million Class B shares outstanding for both periods. There are no outstanding securities that dilute our shares of Class B common stock. Book Value Per Share and Return on Equity Our stockholders' equity increased by $16.6 million in 2012. We attribute the increase to our net income of $23.1 million and an increase in our net after-tax unrealized gains within our available-for-sale fixed maturity and equity investment portfolio from $23.5 million at December 31, 2011 to $26.4 million at December 31, 2012. Book value per share increased by 4.1% to $15.63 at December 31, 2012, compared to $15.01 a year earlier. Our return on average equity was 5.9% for 2012, compared to 0.1% for 2011. Financial Condition 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 pooling agreement with Donegal Mutual historically has been cash flow positive because of the profitability of the underwriting pool. Because we settle the pool monthly, cash flows are substantially similar to cash flows that would result from the underwriting of direct business. We maintain a high degree of liquidity in our investment portfolio in the form of marketable fixed maturities, equity securities and short-term investments. We structure our fixed-maturity investment portfolio following a “laddering” approach so that projected cash flows from investment income and principal maturities are evenly distributed from a timing perspective. This laddering provides an additional measure of liquidity to meet our obligations and the obligations of our insurance subsidiaries should an unexpected variation occur in the future. Net cash flows provided by operating activities in 2013, 2012 and 2011 were $46.0 million, $25.0 million and $21.1 million, respectively. In June 2013, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit now expires in July 2016. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the agreement. At December 31, 2013, we had $43.0 million in outstanding borrowings and had the ability to borrow an additional $17.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings is adjustable quarterly. At December 31, 2013, the interest rate on our outstanding borrowings was 2.42%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We complied with all requirements of the credit agreement during 2013. MICO has an agreement with the FHLB of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. There were no outstanding borrowings at December 31, 2013 or 2012. Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. During 2013, Atlantic States issued secured debt in the principal amount of $15.0 million to the FHLB of Pittsburgh in exchange for cash advances in the amount of $15.0 million. The interest -51- rate on the advances was .26% at December 31, 2013. Atlantic States then loaned $15.0 million to us. We used the proceeds of our loan from Atlantic States to fund our prepayment of our subordinated debentures. Atlantic States had no outstanding borrowings with the FHLB of Pittsburgh at December 31, 2012. The following table shows expected payments for our significant contractual obligations at December 31, 2013: (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries Subordinated debentures Borrowings under line of credit Total contractual obligations Total Less than 1 year 1-3 years 4-5 years After 5 years $ 265,605 $ 125,781 $ 118,706 $ 9,713 $ 11,405 5,000 — — 58,000 15,000 43,000 — — 5,000 — $ 328,605 $ 140,781 $ 161,706 $ 9,713 $ 16,405 We estimated the timing of the amounts for the net liability for unpaid losses and loss expenses of our insurance subsidiaries based on historical experience and expectations of future payment patterns. We have shown the liability net of reinsurance recoverable on unpaid losses and loss expenses to reflect expected future cash flows related to such liability. Assumed amounts from the underwriting pool with Donegal Mutual represent a substantial portion of our insurance subsidiaries' gross liability for unpaid losses and loss expenses, and ceded amounts to the underwriting pool represent a substantial portion of our insurance subsidiaries' reinsurance recoverable on unpaid losses and loss expenses. We include cash settlements of Atlantic States' assumed liability from the pool in our monthly settlements of pooled activity. In these monthly settlements, we net amounts ceded to and assumed from the pool. Although Donegal Mutual and Atlantic States do not anticipate any further 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 for Atlantic States' proportionate liability for pooled losses occurring in periods prior to the effective date of such change. We estimated the timing of the amounts for the borrowings under our lines of credit based on their contractual maturities that we discuss in Note 9 - Borrowings. Our borrowings under our lines of credit carry interest rates that vary as discussed in Note 9 - Borrowings. Based upon the interest rates in effect at December 31, 2013, our annual interest cost associated with our borrowings under our lines of credit is approximately $1.1 million. For every 1% change in the interest rate associated with our borrowings under our lines of credit, the effect on our annual interest cost would be approximately $580,000. Cash dividends declared to stockholders totaled $13.0 million, $12.3 million and $12.0 million in 2013, 2012 and 2011, respectively. There are no regulatory restrictions on our payment of dividends to our stockholders, although there are state law restrictions on the payment of dividends from our insurance subsidiaries to us. Our insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis and are subject to regulations under which their payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are subject to risk-based capital (“RBC”) requirements. The amount of statutory capital and surplus necessary for our insurance subsidiaries to satisfy regulatory requirements, including the RBC requirements, was not significant in relation to our insurance subsidiaries' statutory capital and surplus at December 31, 2013. In 2014, amounts available for distribution as dividends to us from our insurance subsidiaries without prior approval of their domiciliary insurance regulatory authorities are $18.7 million from Atlantic States, $4.2 million from Southern, $2.8 million from Le Mars, $4.2 million from Peninsula, $1.1 million from Sheboygan and $4.1 million from MICO, or a total of approximately $35.1 million. . -52- Investments At December 31, 2013 and 2012, our investment portfolio of primarily investment-grade bonds, common stock, short-term investments and cash totaled $819.4 million and $826.2 million, respectively, representing 59.1% and 61.8%, respectively, of our total assets (see “Business - Investments” for more information). 2013 December 31, 2012 2011 Percent of Percent of Percent of Amount Total Amount Total Amount Total (dollars in thousands) Fixed maturities: Total held to maturity $ 240,370 30.4% $ 42,100 5.2% $ 58,490 7.4% Total available for sale Total fixed maturities Equity securities Investments in affiliates Short-term investments 403,652 644,022 12,423 35,685 99,678 51.0 81.4 1.5 4.5 12.6 694,510 736,610 8,757 37,236 23,826 86.1 91.3 1.1 4.6 3.0 646,598 705,088 7,438 32,322 40,461 82.3 89.7 1.0 4.1 5.2 Total investments $ 791,808 100.0% $ 806,429 100.0% $ 785,309 100.0% The carrying value of our fixed maturity investments represented 81.4% and 91.3% of our total invested assets at December 31, 2013 and 2012, respectively. Our fixed maturity investments consisted of high-quality marketable bonds, of which 100.0% and 99.0% were rated at investment-grade levels at December 31, 2013 and 2012, respectively. At December 31, 2013, the net unrealized gain on available-for-sale fixed maturity investments, net of deferred taxes, amounted to $8.7 million, compared to $25.6 million at December 31, 2012. At December 31, 2013, the net unrealized gain on our equity securities, net of deferred taxes, amounted to $165,573, compared to $61,149 at December 31, 2012. Impact of Inflation Our insurance subsidiaries establish their property and casualty insurance premium rates before they know the amount of losses and loss settlement 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. Impact of New Accounting Standards In February 2013, the Financial Accounting Standards Board (“FASB”) issued guidance that requires an entity to provide information about amounts it reclassifies out of accumulated other comprehensive income. If GAAP requires an entity to reclassify amounts out of accumulated other comprehensive income to net income in their entirety in the same reporting period, the guidance requires an entity to present significant amounts it reclassifies out of accumulated other comprehensive income by the respective line items of net income, either on the face of the statement where the entity presents net income or in the notes to the entity’s financial statements,. For other amounts that GAAP does not require an entity to reclassify to net income in their entirety, the guidance requires an entity to cross-reference such amounts to other disclosures GAAP requires that provide additional detail about those amounts. The guidance was effective for interim and annual reporting periods after December 15, 2012. We adopted this new guidance as of January 1, 2013. Our adoption of this new guidance did not impact our financial position, results of operations or cash flows. -53- Item 7A. Quantitative and Qualitative Disclosures About Market Risk. We are exposed to the impact of interest rate changes, to changes in fair values of investments and to credit risk. In the normal course of business, we employ established policies and procedures to manage our exposure to changes in interest rates, fluctuations in the fair market value of our debt and equity securities and credit risk. We seek to mitigate these risks by various actions described below. Interest Rate Risk Our exposure to market risk for a change in interest rates is concentrated in our investment portfolio. We monitor this exposure through periodic reviews of our asset and liability positions. We regularly monitor estimates of cash flows and the impact of interest rate fluctuations relating to the investment portfolio. Generally, we do not hedge our exposure to interest rate risk because we have the capacity to, and do, hold fixed maturity investments to maturity. Principal cash flows and related weighted-average interest rates by stated maturity dates for financial instruments sensitive to interest rates at December 31, 2013 are as follows: (in thousands) Fixed maturity and short-term investments: 2014 2015 2016 2017 2018 Thereafter Total Fair value Debt: 2014 2015 Thereafter Total Fair value Principal Cash Flows Weighted- Average Interest Rate $ 107,794 0.38% 4.35 4.05 3.88 4.38 3.62 0.26% 2.42 5.00 9,664 13,265 20,015 21,535 569,970 742,243 742,120 15,000 43,000 5,000 63,000 63,000 $ $ $ $ $ Actual cash flows from investments may differ from those depicted above as a result of calls and prepayments. Equity Price Risk Our portfolio of equity securities, which we carry on our consolidated balance sheets at estimated fair value, has exposure to price risk, which is the risk of potential loss in estimated fair value resulting from an adverse change in prices. Our objective is to earn competitive relative returns by investing in a diverse portfolio of high-quality, liquid securities. Credit Risk Our objective is to earn competitive returns by investing in a diversified portfolio of securities. Our portfolio of fixed maturity securities and, to a lesser extent, short-term investments is subject to credit risk. We define this risk as the potential loss in fair 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 amount of our total investment portfolio that we invest in any one security. -54- Our insurance subsidiaries provide property and liability insurance coverages through independent insurance agencies located throughout their operating areas. Our insurance subsidiaries bill the majority of this business directly to the insured, although our insurance subsidiaries bill a portion of their commercial business through their agents, to whom they 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. Through November 30, 2010, MICO and West Bend were parties to quota-share reinsurance agreements whereby MICO ceded 75% of its business to West Bend. MICO and West Bend terminated the reinsurance agreement in effect at November 30, 2010 on a run-off basis. West Bend's obligations related to all past reinsurance agreements with MICO remain in effect for all policies with effective dates prior to December 1, 2010. West Bend and MICO entered into a trust agreement on December 1, 2010. Under the terms of the trust agreement, West Bend placed into trust, for the sole benefit of MICO, assets with a fair value equal to the amount of unearned premiums and unpaid losses and loss expenses, reduced by any net premium balances not yet paid by MICO, that West Bend had assumed pursuant to such reinsurance agreements at November 30, 2010. The amount of assets required to be held in trust adjusts monthly based upon the remaining net obligations of West Bend. West Bend may terminate the trust agreement on the earlier of December 1, 2020 or the date on which the obligations of West Bend are equal to or less than $5.0 million. As of December 31, 2013, West Bend's net obligations under the reinsurance agreements were approximately $15.9 million, and the fair value of assets held in trust was approximately $17.9 million. -55- Item 8. Financial Statements and Supplementary Data. Consolidated Balance Sheets Consolidated Statements of Income and Comprehensive Income Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Registered Public Accounting Firm - Consolidated Financial Statements 57 58 59 60 61 91 -56- Donegal Group Inc. Consolidated Balance Sheets December 31, 2013 2012 Assets Investments Fixed maturities Held to maturity, at amortized cost (fair value $238,790,476 and $43,735,739 ). . . . . . $ 240,370,277 403,651,965 Available for sale, at fair value (amortized cost $390,254,251 and $655,173,806) . . . . 12,422,837 Equity securities, available for sale, at fair value (cost $12,168,110 and $8,663,183). . . . 35,685,433 Investments in affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99,677,795 Short-term investments, at cost, which approximates fair value . . . . . . . . . . . . . . . . . . . . 791,808,307 Total investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,636,416 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,423,531 Accrued investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123,904,629 Premiums receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244,239,113 Reinsurance receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,627,510 Deferred policy acquisition costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,310,558 Deferred tax asset, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,663,942 Prepaid reinsurance premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,424,703 Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,187,866 Accounts receivable - securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,952 Federal income taxes recoverable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,625,354 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 958,010 1,179,611 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,385,410,502 $ 42,100,196 694,509,821 8,757,258 37,235,530 23,826,227 806,429,032 19,801,290 6,332,085 117,196,478 215,893,322 40,121,697 6,267,536 111,156,162 5,953,833 — — 5,625,354 958,010 1,154,388 $ 1,336,889,187 Liabilities and Stockholders' Equity Liabilities Losses and loss expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 495,619,269 382,734,642 Unearned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,265,097 Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,948,808 Reinsurance balances payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,000,000 Borrowings under lines of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,299,182 Cash dividends declared to stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000 Subordinated debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751,641 Accounts payable - securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Federal income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,170,225 Due to affiliate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,386,285 Drafts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,358,242 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 988,533,391 Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 458,827,395 363,088,103 17,140,832 13,941,337 52,000,000 3,066,532 20,465,000 — 583,977 4,579,437 863,589 2,298,891 936,855,093 Stockholders' Equity Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued . . . . . . . . . . . . Class A common stock, $.01 par value, authorized 40,000,000 and 30,000,000 shares, issued 21,786,765 and 20,941,821 shares and outstanding 20,845,903 and 20,025,199 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive (loss) income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,492 189,116,410 (2,312,890) 222,888,887 (13,089,656) 396,877,111 Total liabilities and stockholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,385,410,502 56,492 176,416,585 26,394,577 209,670,214 (12,713,193) 400,034,094 $ 1,336,889,187 — — 217,868 209,419 See accompanying notes to consolidated financial statements. -57- Donegal Group Inc. Consolidated Statements of Income and Comprehensive Income Years Ended December 31, 2012 2011 2013 Statements of Income Revenues Net premiums earned (includes affiliated reinsurance of $156,938,714, $142,608,940 and $130,555,613 - see note 3). . . . . . . . . . . . . . . . . . . . . . $ 515,291,944 18,795,239 $ 475,002,222 $ 431,470,184 20,168,919 20,858,179 Investment income, net of investment expenses . . . . . . . . . . . . . . . . . . . . . . Installment payment fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net realized investment gains (includes $2,423,442 accumulated other comprehensive income reclassification) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in earnings of DFSC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,841,778 7,465,532 7,427,509 849,795 953,216 957,353 2,423,442 2,907,867 6,859,439 4,533,257 12,281,267 2,023,127 547,110,065 514,982,585 475,017,619 Expenses Net losses and loss expenses (includes affiliated reinsurance of $86,962,750, $81,219,926 and $87,950,502 - see note 3). . . . . . . . . . . . . Amortization of deferred policy acquisition costs . . . . . . . . . . . . . . . . . . . . Other underwriting expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Policyholder dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (benefit) (includes $823,970 income tax expense from reclassification items) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343,127,951 332,871,584 340,502,777 81,753,000 74,314,000 68,571,000 82,196,700 73,914,514 66,923,764 1,909,569 1,635,323 3,777,257 1,342,582 2,358,711 2,322,934 1,240,079 2,126,784 2,392,528 514,399,800 487,124,325 481,756,932 32,710,265 27,858,260 (6,739,313) 6,388,273 4,765,640 (7,192,266) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,321,992 $ 23,092,620 $ 452,953 Basic earnings per common share: Class A common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Class B common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Diluted earnings per common share: Class A common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Class B common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.04 0.94 1.02 0.94 $ $ $ $ 0.92 0.83 0.91 0.83 $ $ $ $ 0.02 0.01 0.02 0.01 Statements of Comprehensive Income Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,321,992 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: $ 23,092,620 $ 452,953 Unrealized holding (loss) gain arising during the period, net of income tax (benefit) expense of ($14,633,895), $4,833,143 and 12,237,669 . . (27,107,995) 9,171,817 23,077,997 Reclassification adjustment for gains included in net income, net of (4,527,230) income tax of $823,970 $2,332,209 and $4,175,631. . . . . . . . . . . . . . . 4,644,587 Other comprehensive (loss) income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Comprehensive (loss) income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (2,385,475) $ 27,737,207 (1,599,472) (28,707,467) (8,105,636) 14,972,361 $ 15,425,314 See accompanying notes to consolidated financial statements. -58- Donegal Group Inc. Consolidated Statements of Stockholders' Equity Common Stock Class A Shares Class B Shares Class A Amount Class B Amount Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Treasury Stock Total Stockholders' Equity Balance, January 1, 2011 . . . . . . . . . . . . . . 20,656,527 5,649,240 $ 206,566 $ 56,492 $ 167,093,504 $ 8,561,086 $213,435,095 $ (9,249,933) $380,102,810 Issuance of common stock (stock compensation plans) . Net income . . . . . . . . . . . Cash dividends . . . . . . . . Grant of stock options . . Purchase of treasury stock. . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . Balance, December 31, 96,472 964 1,459,579 2,283,860 452,953 (11,999,488) (2,283,860) 1,460,543 452,953 (11,999,488) — (1,537,587) (1,537,587) 14,972,361 14,972,361 2011 . . . . . . . . . . . . . . 20,752,999 5,649,240 $ 207,530 $ 56,492 $ 170,836,943 $ 23,533,447 $199,604,700 $(10,787,520) $383,451,592 Issuance of common stock (stock compensation plans) . Net income . . . . . . . . . . . Cash dividends . . . . . . . . Grant of stock options . . Tax benefit on exercise of stock options . . . . . Purchase of treasury stock. . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . Other . . . . . . . . . . . . . . . Balance, December 31, 188,822 1,889 2,995,622 23,092,620 (12,278,965) (2,531,598) 2,531,598 52,422 2,997,511 23,092,620 (12,278,965) — 52,422 (1,925,673) (1,925,673) 4,644,587 (1,783,457) 1,783,457 4,644,587 — 2012 . . . . . . . . . . . . . . 20,941,821 5,649,240 209,419 56,492 176,416,585 26,394,577 209,670,214 (12,713,193) 400,034,094 Issuance of common stock (stock compensation plans) . Net income . . . . . . . . . . . Cash dividends . . . . . . . . Grant of stock options . . Tax benefit on exercise of stock options . . . . . Purchase of treasury stock. . . . . . . . . . . . . . Other comprehensive loss. . . . . . . . . . . . . . . Balance, December 31, 844,944 8,449 12,108,468 26,321,992 (13,043,121) (60,198) 60,198 531,159 12,116,917 26,321,992 (13,043,121) — 531,159 (376,463) (376,463) (28,707,467) (28,707,467) 2013 . . . . . . . . . . . . . . 21,786,765 5,649,240 $ 217,868 $ 56,492 $ 189,116,410 $ (2,312,890) $222,888,887 $(13,089,656) $396,877,111 See accompanying notes to consolidated financial statements. -59- Donegal Group Inc. Consolidated Statements of Cash Flows Years Ended December 31, 2012 2011 2013 Cash Flows from Operating Activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,321,992 Adjustments to reconcile net income to net cash provided by operating $ 23,092,620 $ 452,953 activities: Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net realized investment gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in earnings of DFSC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,049,101 (2,423,442) (2,907,867) 3,950,693 (6,859,439) (4,533,257) 4,106,561 (12,281,267) (2,023,127) Changes in Assets and Liabilities: Losses and loss expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned premiums. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premiums receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred policy acquisition costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reinsurance receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amounts due to affiliate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reinsurance balances payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid reinsurance premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . 36,791,874 19,646,539 2,124,265 (6,708,151) (3,505,813) 1,414,843 (28,345,791) 908,554 (2,409,212) 4,007,471 (1,507,780) (1,004,929) 556,815 19,686,477 46,008,469 16,419,780 26,150,842 (3,815,717) (12,481,151) (3,696,742) 1,151,250 (6,069,415) 380,953 (806,954) (6,098,002) (4,706,144) 3,245,785 (360,477) 1,872,005 24,964,625 59,088,943 39,665,100 (330,857) (8,247,378) (1,979,376) (5,922,491) (35,987,161) 652,133 2,460,287 899,017 (17,084,247) (1,713,483) (674,296) 20,628,358 21,081,311 Cash Flows from Investing Activities: Purchases of fixed maturities: Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales of fixed maturities: (148,486,404) (47,156,954) (241,343,085) (31,254,324) (189,111,596) (23,857,802) Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133,890,611 90,484,097 122,873,102 Maturity of fixed maturities: Held to maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales of equity securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of MICO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net decrease (increase) in investment in affiliates . . . . . . . . . . . . . . . . . . . . . Net purchases of property and equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . Net (purchases) sales of short-term investments. . . . . . . . . . . . . . . . . . . . . . . Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash Flows from Financing Activities: Issuance of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments on subordinated debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments on line of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings under lines of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash (used in) provided by financing activities . . . . . . . . . . . . . . . . . . 13,767,271 52,675,833 43,204,703 — 1,139,800 (1,254,767) (75,851,568) (28,071,475) 12,550,066 (12,810,471) (376,463) (15,465,000) (15,500,000) 21,500,000 (10,101,868) 16,061,587 115,501,507 30,001,187 — (100,000) (744,082) 16,635,183 (4,757,930) 2,983,399 (12,208,509) (1,925,673) — (6,000,000) 3,500,000 (13,650,783) 5,888,236 53,763,701 27,036,422 (7,207,471) (20,570,000) (238,538) 314,583 (31,109,363) 1,460,543 (11,874,367) (1,537,587) — (3,617,371) 22,500,000 6,931,218 7,835,126 Net increase (decrease) in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,801,290 Cash at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 27,636,416 6,555,912 13,245,378 $ 19,801,290 (3,096,834) 16,342,212 $ 13,245,378 See accompanying notes to consolidated financial statements. -60- Donegal Group Inc. Notes to Consolidated Financial Statements 1 - Summary of Significant Accounting Policies Organization and Business Donegal Mutual Insurance Company (”Donegal Mutual”) organized us as an insurance holding company on August 26, 1986. Our insurance subsidiaries, Atlantic States Insurance Company (“Atlantic States”), Southern Insurance Company of Virginia (“Southern”), Le Mars Insurance Company (“Le Mars”), the Peninsula Insurance Group (“Peninsula”), which consists of Peninsula Indemnity Company and The Peninsula Insurance Company, Sheboygan Falls Insurance Company (“Sheboygan”) and Michigan Insurance Company (“MICO”), write personal and commercial lines of property and casualty coverages exclusively through a network of independent insurance agents in certain Mid-Atlantic, Midwestern, New England and Southern states. We also own 48.2% of the outstanding stock of Donegal Financial Services Corporation (“DFSC”), a grandfathered unitary savings and loan holding company that owns Union Community Bank (“UCB”), a state savings bank. UCB has 13 banking offices, all of which are located in Lancaster County, Pennsylvania. Donegal Mutual owns the remaining 51.8% of the outstanding stock of DFSC. We have four segments: our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. The personal lines products of our insurance subsidiaries consist primarily of homeowners and private passenger automobile policies. The commercial lines products of our insurance subsidiaries consist primarily of commercial automobile, commercial multi-peril and workers' compensation policies. At December 31, 2013, Donegal Mutual held approximately 37% of our outstanding Class A common stock and approximately 76% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 65% of the total voting power of our common stock. Our insurance subsidiaries and Donegal Mutual have interrelated operations due to a pooling agreement and other intercompany agreements and transactions. While each company maintains its separate corporate existence, our insurance subsidiaries and Donegal Mutual conduct business together as the Donegal Insurance Group. As such, Donegal Mutual and our insurance subsidiaries share the same business philosophy, the same management, the same employees and the same facilities and offer the same types of insurance products. Atlantic States, our largest subsidiary, participates in a pooling agreement with Donegal Mutual. Under the pooling agreement, the two companies pool their insurance business and each company receives an allocated percentage of the pooled business. Atlantic States has an 80% share of the results of the pooled business, and Donegal Mutual has a 20% share of the results of the pooled business. The same executive management and underwriting personnel administer products, classes of business underwritten, pricing practices and underwriting standards of Donegal Mutual and our insurance subsidiaries. In addition, as the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to achieve market penetration and underwriting profitability objectives. The products our insurance subsidiaries and Donegal Mutual market are generally complementary, thereby allowing the Donegal Insurance Group to offer a broader range of products to a given market and to expand the Donegal Insurance Group's ability to service an entire personal lines or commercial lines account. Distinctions within the products of Donegal Mutual and our insurance subsidiaries generally relate to specific risk profiles targeted within similar classes of business, such as preferred tier versus standard tier products, but we do not allocate all of the standard risk gradients to one company. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, as the risk characteristics of all business Donegal Mutual and Atlantic States write directly are homogenized within the underwriting pool, Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the pool. Pooled business represents the predominant percentage of the net underwriting activity of both Donegal Mutual and Atlantic States. We refer to Note 3 - Transactions with Affiliates for more information regarding the pooling agreement. In May 2011, DFSC and Union National Financial Corporation (“UNNF”) merged, with DFSC as the surviving company in the merger. Under the merger agreement, Province Bank FSB, which DFSC owned, and Union National Community Bank, which UNNF owned, also merged and began doing business as UCB. Donegal Mutual contributed $22.1 million and we contributed $20.6 million to DFSC as additional capital to facilitate the mergers. We use the equity method of accounting for our investment in DFSC. Under the equity method, we record our investment at cost, with adjustments for our share of DFSC's earnings and losses as well as changes in DFSC's equity due to unrealized gains and losses. -61- Basis of Consolidation Our consolidated financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"), include our accounts and those of our wholly owned subsidiaries. We have eliminated all significant inter-company accounts and transactions in consolidation. The terms “we,” “us,” “our” or the “Company” as used herein refer to the consolidated entity. Use of Estimates In preparing our consolidated financial statements, our management makes estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. We make estimates and assumptions that can have a significant effect on amounts and disclosures we report in our consolidated 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 and our insurance subsidiaries' policy acquisition costs. While we believe our estimates and the estimates of our insurance subsidiaries are appropriate, the ultimate amounts may differ from the estimates provided. We regularly review our methods for making these estimates as well as the continuing appropriateness of the estimated amounts, and we reflect any adjustment we consider necessary in our current results of operations. Investments We classify our debt and equity securities into the following categories: Held to Maturity - Debt securities that we have the positive intent and ability to hold to maturity; reported at amortized cost. Available for Sale - Debt and equity securities not classified as held to maturity; reported at fair value, with unrealized gains and losses excluded from income and reported as a separate component of stockholders' equity (net of tax effects). Short-term investments carried at amortized cost, which approximates fair value. We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual investment to be other than temporary. We individually monitor all of our investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more than 20% of original cost and has been in such an unrealized loss position for more than six months. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security and rating agency downgrades. We 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. -62- 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 the affiliate's earnings and losses as well as changes in the affiliate's equity due to unrealized gains and losses. Fair Values of Financial Instruments We use the following methods and assumptions in estimating our fair value disclosures: Investments - We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values 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 based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates obtained are representative of fair values based upon their general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services' pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. We refer to Note 5 - Fair Value Measurements for more information regarding our methods and assumptions in estimating fair values. Cash and Short-Term Investments - The carrying amounts reported in the balance sheet for these instruments approximate their fair values. Premiums and Reinsurance Receivables and Payables - The carrying amounts reported in the balance sheet for these instruments related to premiums and paid losses and loss expenses approximate their fair values. Subordinated Debentures - The carrying amounts reported in the balance sheet for these instruments approximate their fair values. Revenue Recognition Our insurance subsidiaries recognize insurance premiums as income over the terms of the policies they issue. Our insurance subsidiaries calculate unearned premiums on a daily pro-rata basis. Policy Acquisition Costs We defer our insurance subsidiaries' policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs, reduced by ceding commissions, that vary with and relate directly to the production of business. We amortize these deferred policy acquisition costs over the period in which our insurance subsidiaries earn the 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 premium to be earned, related investment income, losses and loss expenses and certain other costs we expect to incur as our insurance subsidiaries earn the premium. Estimates in the calculation of policy acquisition costs have not shown material variability because of uncertainties in applying accounting principles or as a result of sensitivities to changes in key assumptions. Property and Equipment We report property and equipment at depreciated cost that we compute using the straight-line method based upon estimated useful lives of the assets. -63- Losses and Loss Expenses Liabilities for losses and loss expenses are estimates at a given point in time of the amounts an insurer expects to pay with respect to policyholder claims based on facts and circumstances then known. At the time of establishing its estimates, an insurer recognizes that its ultimate liability for losses and loss expenses will exceed or be less than such estimates. Our insurance subsidiaries base their estimates of liabilities for losses and loss expenses on assumptions as to future loss trends and expected claims severity, judicial theories of liability and other factors. However, during the loss adjustment period, our insurance subsidiaries may learn additional facts regarding certain claims, and consequently, it often becomes necessary for our insurance subsidiaries to refine and adjust their estimates of liability. We reflect any adjustments to our insurance subsidiaries' liabilities for losses and loss expenses in our operating results in the period in which our insurance subsidiaries record the changes in estimates. Our insurance subsidiaries maintain liabilities for the payment of losses and loss expenses with respect to both reported and unreported claims. Our insurance subsidiaries establish these liabilities for the purpose of covering the ultimate costs of settling all losses, including investigation and litigation costs. Our insurance subsidiaries base the amount of their liability for reported losses primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss their policyholder incurred. Our insurance subsidiaries determine the amount of their liability for unreported claims and loss expenses on the basis of historical information by line of insurance. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Our insurance subsidiaries closely monitor their liabilities and recompute them periodically using new information on reported claims and a variety of statistical techniques. Our insurance subsidiaries do not discount their liabilities for losses. Reserve estimates can change over time because of unexpected changes in assumptions related to our insurance subsidiaries' external environment and, to a lesser extent, assumptions as to our insurance subsidiaries' internal operations. For example, our insurance subsidiaries have experienced a decrease in claims frequency on workers' compensation claims during the past several years while claims severity has gradually increased. These trend changes give rise to greater uncertainty as to the pattern of future loss settlements on workers' compensation claims. Related uncertainties regarding future trends include the cost of medical technologies and procedures and changes in the utilization of medical procedures. Assumptions related to our insurance subsidiaries' external environment include the absence of significant changes in tort law and the legal environment that increase liability exposure, consistency in judicial interpretations of insurance coverage and policy provisions and the rate of loss cost inflation. Internal assumptions include consistency in the recording of premium and loss statistics, consistency in the recording of claims, payment and case reserving methodology, accurate measurement of the impact of rate changes and changes in policy provisions, consistency in the quality and characteristics of business written within a given line of business and consistency in reinsurance coverage and collectibility of reinsured losses, among other items. To the extent our insurance subsidiaries determine that underlying factors impacting their assumptions have changed, our insurance subsidiaries attempt to make appropriate adjustments for such changes in their reserves. Accordingly, our insurance subsidiaries' ultimate liability for unpaid losses and loss expenses will likely differ from the amount recorded. Our insurance subsidiaries seek to enhance their underwriting results by carefully selecting the product lines they underwrite. Our insurance subsidiaries' personal lines products include standard and preferred risks in private passenger automobile and homeowners lines. Our insurance subsidiaries' commercial lines products primarily include business offices, wholesalers, service providers, contractors, artisans and light manufacturing operations. Our insurance subsidiaries have limited exposure to asbestos and other environmental liabilities. Our insurance subsidiaries write no medical malpractice liability risks. Income Taxes We currently file a consolidated federal income tax return. We account for income taxes using the asset and liability method. The objective of the asset and liability method is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of our assets and liabilities at enacted tax rates expected to be in effect when we realize or settle such amounts. Credit Risk Our objective is to earn competitive returns by investing in a diversified portfolio of securities. Our portfolio of fixed maturity securities and, to a lesser extent, short-term investments is subject to credit risk. We define this risk as the potential loss in fair value resulting from adverse changes in the borrower's ability to repay the debt. We manage this risk by performing -64- an analysis of prospective investments and through regular reviews of our portfolio by our investment staff. We also limit the amount of our total investment portfolio that we invest in any one security. Our insurance subsidiaries provide property and liability insurance coverages through independent insurance agencies located throughout their operating areas. Our insurance subsidiaries bill the majority of this business directly to their policyholders, although our insurance subsidiaries bill a portion of their commercial business through their agents, to whom they extend credit in the normal course of business. Our insurance subsidiaries have reinsurance agreements with Donegal Mutual and with a number of major unaffiliated reinsurers. Reinsurance Accounting and Reporting Our insurance subsidiaries rely upon reinsurance agreements to limit their maximum net loss from large single risks or risks in concentrated areas and to increase their capacity to write insurance. Reinsurance does not relieve our insurance subsidiaries from liability to their respective policyholders. To the extent that a reinsurer cannot pay losses for which it is liable under the terms of a reinsurance agreement with one of our insurance subsidiaries, our insurance subsidiaries retain continued liability for such losses. However, in an effort to reduce the risk of non-payment, our insurance subsidiaries require all of their reinsurers to have an A.M. Best rating of A- or better or, with respect to foreign reinsurers, to have a financial condition that, in the opinion of management, is equivalent to a company with an A.M. Best rating of A- or better. We refer to Note 10 - Reinsurance for more information regarding our reinsurance agreements. Stock-Based Compensation We measure all share-based payments to employees, including grants of stock options, using a fair-value-based method and record such expense in our results of operations. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, expected term, dividend yield and expected volatility. In 2013 and 2012, we realized $531,159 and $52,422, respectively in tax benefits upon the exercise of stock options. We did not realize any tax benefits upon the exercise of stock options in 2011. Earnings per Share We calculate basic earnings per share by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. We have two classes of common stock, which we refer to as Class A common stock and Class B common stock. Our Class A common stock is entitled to the declaration and payment of cash dividends that are at least 10% higher than those we declare and pay on our Class B common stock. Accordingly, we use the two-class method for the computation of 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 declared and an allocation of remaining undistributed earnings using a participation percentage that reflects the dividend rights of each class. Goodwill and Other Intangible Assets Goodwill represents the excess of the purchase price over the underlying fair value of acquired entities. When completing acquisitions, we seek also to identify separately identifiable intangible assets that we have acquired. We assess goodwill and intangible assets with an indefinite useful life for impairment annually. We also assess goodwill and other intangible assets for impairment upon the occurrence of certain events. In making our assessment, we consider a number of factors including operating results, business plans, economic projections, anticipated future cash flows and current market data. Inherent uncertainties exist with respect to these factors and to our judgment in applying them when we make our assessment. Impairment of goodwill and other intangible assets could result from changes in economic and operating conditions in future periods. -65- 2 - Impact of New Accounting Standards In February 2013, the Financial Accounting Standards Board (“FASB”) issued guidance that requires an entity to provide information about amounts it reclassifies out of accumulated other comprehensive income. If GAAP requires an entity to reclassify amounts out of accumulated other comprehensive income to net income in their entirety in the same reporting period, the guidance requires an entity to present significant amounts it reclassifies out of accumulated other comprehensive income by the respective line items of net income, either on the face of the statement where the entity presents net income or in the notes to the entity’s financial statements,. For other amounts that GAAP does not require an entity to reclassify to net income in their entirety, the guidance requires an entity to cross-reference such amounts to other disclosures GAAP requires that provide additional detail about those amounts. The guidance was effective for interim and annual reporting periods after December 15, 2012. We adopted this new guidance as of January 1, 2013. Our adoption of this new guidance did not impact our financial position, results of operations or cash flows. 3 - Transactions with Affiliates Our insurance subsidiaries conduct business and have various agreements with Donegal Mutual that we describe in the following subparagraphs: a. Reinsurance Pooling and Other Reinsurance Arrangements Atlantic States, our largest insurance subsidiary, and Donegal Mutual have a pooling agreement under which both companies contribute all of their direct written business to the pool and receive an allocated percentage of their combined underwriting results, excluding certain reinsurance Donegal Mutual assumes from our insurance subsidiaries. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool. The intent of the pooling agreement is to produce more uniform and stable underwriting results from year to year for each pool participant than they would experience individually and to spread the risk of loss between the participants based on each participant's relative amount of surplus and relative access to capital. Each participant in the pool has at its disposal the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own capital and surplus. The following amounts represent reinsurance Atlantic States ceded to the pool during 2013, 2012 and 2011: Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses 2013 2012 $ 145,678,744 $ 132,876,094 $ 118,812,725 2011 95,037,273 92,459,147 97,130,846 75,232,651 70,572,281 64,214,378 88,035,924 83,623,652 77,312,645 The following amounts represent reinsurance Atlantic States assumed from the pool during 2013, 2012 and 2011: Premiums earned Losses and loss expenses Unearned premiums Liability for losses and loss expenses 2013 2012 $ 337,548,492 $ 298,803,060 $ 266,687,610 2011 198,785,775 187,415,893 206,907,170 176,845,395 157,140,642 141,880,039 175,497,405 162,863,045 156,941,512 -66- Donegal Mutual and Le Mars have a quota-share reinsurance agreement whereby Le Mars assumes 100% of the premiums and losses related to certain products Donegal Mutual offers in certain Midwestern states, which provide the availability of complementary products to Le Mars' commercial accounts. Until October 31, 2012, Donegal Mutual and Southern had a quota- share reinsurance agreement whereby Southern assumed 100% of the premiums and losses related to personal lines products Donegal Mutual offered in Virginia through the use of its automated policy quoting and issuance system. The following amounts represent reinsurance Southern and Le Mars assumed from Donegal Mutual pursuant to the quota-share reinsurance agreements during 2013, 2012 and 2011: Premiums earned Losses and loss expenses Unearned premiums Liability for losses and loss expenses 2013 2012 $ 12,170,155 $ 22,189,399 $ 17,757,409 2011 10,839,444 19,620,587 14,983,405 1,831,672 9,926,381 10,225,922 7,838,274 8,873,592 7,770,053 Donegal Mutual and MICO have a quota-share reinsurance agreement whereby Donegal Mutual assumes 25% of the premiums and losses related to the business of MICO. Donegal Mutual and Peninsula have a quota-share reinsurance agreement whereby Donegal Mutual assumes 100% of the premiums and losses related to the workers' compensation product line of Peninsula in certain states. The business Donegal Mutual assumes becomes part of the pooling agreement between Donegal Mutual and Atlantic States. The following amounts represent reinsurance ceded to Donegal Mutual pursuant to these quota-share reinsurance agreements during 2013, 2012 and 2011: Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses 2013 2012 $ 34,992,435 $ 33,046,914 $ 22,123,229 2011 25,301,470 22,569,557 16,038,590 16,032,985 15,457,605 14,181,338 25,298,464 18,285,182 11,868,641 Atlantic States, Southern and Le Mars each have a catastrophe reinsurance agreement with Donegal Mutual that provides coverage under any one catastrophic occurrence above a set retention ($2,500,000, $2,000,000 and $500,000 for Atlantic States, Southern and Le Mars, respectively), with a combined retention of $5,000,000 for a catastrophe involving a combination of these subsidiaries, up to the amount Donegal Mutual and our insurance subsidiaries retain under catastrophe reinsurance agreements with unaffiliated reinsurers . Donegal Mutual and Southern have an excess of loss reinsurance agreement in which Donegal Mutual assumes up to $500,000 ($350,000 in 2011) of losses in excess of $500,000 ($400,000 in 2011). The following amounts represent reinsurance that our insurance subsidiaries ceded to Donegal Mutual pursuant to these reinsurance agreements during 2013, 2012 and 2011: Premiums earned Losses and loss expenses Liability for losses and loss expenses 2013 2012 $ 12,108,754 $ 12,460,511 $ 12,953,452 2011 2,323,726 10,787,850 20,770,637 2,366,370 2,206,786 3,980,024 The following amounts represent the effect of affiliated reinsurance transactions on net premiums our insurance subsidiaries earned during 2013, 2012 and 2011: Assumed Ceded Net 2013 $ 349,718,647 (192,779,933) $ 156,938,714 2012 $ 320,992,459 (178,383,519) $ 142,608,940 2011 $ 284,445,019 (153,889,406) $ 130,555,613 -67- The following amounts represent the effect of affiliated reinsurance transactions on net losses and loss expenses our insurance subsidiaries incurred during 2013, 2012 and 2011: Assumed Ceded Net b. Expense Sharing 2013 2012 $ 209,625,219 $ 207,036,480 $ 221,890,575 (133,940,073) (125,816,554) $ 86,962,750 $ 81,219,926 $ 87,950,502 (122,662,469) 2011 Donegal Mutual provides facilities, management and other services to us and our insurance subsidiaries. Donegal Mutual allocates certain related expenses to Atlantic States in relation to the relative participation of Atlantic States and Donegal Mutual in the pooling agreement. Our insurance subsidiaries other than Atlantic States reimburse Donegal Mutual for their personnel costs and bear their proportionate share of information services costs based on their percentage of the total written premiums of the Donegal Insurance Group. Charges for these services totalled $94,021,056, $78,778,333 and $64,711,860 for 2013, 2012 and 2011, respectively. c. Lease Agreement We lease office equipment and automobiles with terms ranging from 3 to 10 years to Donegal Mutual under a 10-year lease agreement dated January 1, 2011. d. Legal Services Donald H. Nikolaus, our Chairman of the Board and President and one of our directors, is a partner in the law firm of Nikolaus & Hohenadel. Such firm has served as our general counsel since 1986, principally in connection with the defense of claims litigation arising in Lancaster, Dauphin and York counties of Pennsylvania. We pay such firm its customary fees for such services. e. Union Community Bank At December 31, 2013 and 2012, we had $24,001,726 and $18,806,576, respectively, in checking accounts with UCB, a wholly owned subsidiary of DFSC. We earned $1,954, $1,591 and $1,019 in interest on these accounts during 2013, 2012 and 2011, respectively. 4 - Investments The amortized cost and estimated fair values of fixed maturities and equity securities at December 31, 2013 and 2012 are as follows: Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies 2013 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 47,945,882 $ — $ 869,683 $ 47,076,199 Obligations of states and political subdivisions 108,435,110 465,309 446,695 108,453,724 Corporate securities Mortgage-backed securities Totals 14,874,969 69,114,316 17,337 32,810 111,957 14,780,349 666,922 68,480,204 $ 240,370,277 $ 515,456 $ 2,095,257 $ 238,790,476 -68- Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies 2013 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 14,272,550 $ 117,736 $ 56,589 $ 14,333,697 Obligations of states and political subdivisions 265,783,151 11,778,794 15,221 277,546,724 Corporate securities Mortgage-backed securities Fixed maturities Equity securities Totals Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies Obligations of states and political subdivisions Mortgage-backed securities Totals 39,939,873 70,258,677 775,430 923,380 43,380 40,671,923 82,436 71,099,621 390,254,251 13,595,340 197,626 403,651,965 12,168,110 347,594 92,867 12,422,837 $ 402,422,361 $ 13,942,934 $ 290,493 $ 416,074,802 2012 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 1,000,000 40,909,132 $ 191,064 $ 11,510 1,609,211 14,822 $ 42,100,196 $ 1,635,543 $ — $ — 1,011,510 42,518,343 — 205,886 — $ 43,735,739 Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies 2012 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 70,253,846 $ 1,101,208 $ 43,951 $ 71,311,103 Obligations of states and political subdivisions 385,371,983 32,221,045 606,065 416,986,963 Corporate securities Mortgage-backed securities Fixed maturities Equity securities Totals 73,941,532 3,522,954 108,709 77,355,777 125,606,445 3,315,976 66,443 128,855,978 655,173,806 40,161,183 825,168 694,509,821 8,663,183 200,823 106,748 8,757,258 $ 663,836,989 $ 40,362,006 $ 931,916 $ 703,267,079 At December 31, 2013, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $294.1 million and an amortized cost of $284.9 million. Our holdings also included special revenue bonds with an aggregate fair value of $91.9 million and an amortized cost of $89.3 million. With respect to both categories, we held no securities of any issuer that comprised more than 10% of the category at December 31, 2013. Education bonds and water and sewer utility bonds represented 56% and 23%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2013. Many of the issuers of the special revenue bonds we held at December 31, 2013 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. At December 31, 2012, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $358.5 million and an amortized cost of $332.4 million. Our holdings also included special revenue bonds with an aggregate fair value of $101.0 million and an amortized cost of $93.9 million. With respect to both categories, we held no securities of any issuer that comprised more than 10% of the category at December 31, 2012. Education bonds and water and sewer utility bonds represented 54% and 19%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2012. Many of the issuers of the special revenue bonds we held at -69- December 31, 2012 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. We made reclassifications from available for sale to held to maturity of fixed maturities at fair value on November 30, 2013. We present the impact of the transfers in the following table, summarized by type of securities, at November 30, 2013: U.S. Treasury securities and obligations of U.S. government corporations and agencies Obligations of states and political subdivisions Corporate securities Mortgage-backed securities Totals Amortized Cost Estimated Fair Value $ 50,627,225 $ 47,914,311 88,456,842 79,866,801 15,745,976 14,879,294 72,465,250 69,567,883 $ 227,295,293 $ 212,228,289 We have segregated within accumulated other comprehensive loss the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities reclassified from available for sale to held to maturity. We will amortize this balance over the remaining life of the related securities as an adjustment of yield in a manner consistent with the accretion of discount on the same fixed maturities. We set forth below the amortized cost and estimated fair value of fixed maturities at December 31, 2013 by contractual maturity. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Held to maturity Due after one year through five years Due after five years through ten years Due after ten years Mortgage-backed securities Total held to maturity Available for sale Due in one year or less Due after one year through five years Due after five years through ten years Due after ten years Mortgage-backed securities Total available for sale Amortized Cost Estimated Fair Value $ 26,553,403 $ 26,883,591 65,434,886 64,537,687 79,267,672 78,888,994 69,114,316 68,480,204 $ 240,370,277 $ 238,790,476 $ 8,172,570 $ 8,256,627 35,310,675 36,104,054 119,933,647 125,005,089 156,578,682 163,186,574 70,258,677 71,099,621 $ 390,254,251 $ 403,651,965 The amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2013 and 2012 amounted to $10,553,953 and $10,565,116, respectively. Investments in affiliates consisted of the following at December 31, 2013 and 2012: DFSC Other Total 2013 2012 $ 35,685,433 $ 36,770,530 — 465,000 $ 35,685,433 $ 37,235,530 We account for investments in our affiliates using the equity method of accounting. Under this method, we record our investment at cost, with adjustments for our share of our affiliates' earnings and losses as well as changes in our affiliates' equity due to unrealized gains and losses. Our investments in affiliates at December 31, 2013 represented our 48.2% ownership interest -70- in DFSC. In May 2011, DFSC merged with UNNF, with DFSC as the surviving company in the merger. Under the merger agreement, Province Bank FSB, which DFSC owned, and Union National Community Bank, which UNNF owned, also merged and began doing business as UCB. Donegal Mutual contributed $22.1 million and we contributed $20.6 million to DFSC as additional capital to facilitate the mergers. We made an additional equity investment in DFSC in the amount of $100,000 during 2012. We include our share of DFSC's net income in our results of operations. We have compiled the following summary financial information for DFSC at December 31, 2013 and 2012 from the financial statements of DFSC. Balance sheets: Total assets Total liabilities Stockholders' equity December 31, 2013 2012 $ 512,577,883 $ 509,670,100 $ 438,649,355 $ 433,490,583 73,928,528 76,179,517 Total liabilities and stockholders' equity $ 512,577,883 $ 509,670,100 Income statements: Net income Year Ended December 31, 2013 2012 2011 $ 6,030,292 $ 9,401,001 $ 4,196,054 Other comprehensive (loss) income in our statements of comprehensive income includes net unrealized (losses) gains of ($2.2 million), $138,771 and $479,401 for 2013, 2012 and 2011, respectively, representing our share of DFSC's unrealized investment gains or losses. At December 31, 2012, our investments in affiliates included our investments in statutory trusts that held our subordinated debentures that we discuss in Note 9 - Borrowings. We derive net investment income, consisting primarily of interest and dividends, from the following sources: Fixed maturities Equity securities Short-term investments Other Investment income Investment expenses Net investment income 2013 $ 23,621,977 2012 $ 24,642,897 2011 $ 25,044,316 122,603 98,817 41,608 85,905 34,482 44,874 162,934 57,296 48,588 23,885,005 (5,089,766) $ 18,795,239 24,808,158 (4,639,239) $ 20,168,919 25,313,134 (4,454,955) $ 20,858,179 -71- We present below gross realized gains and losses from investments, including those we classified as held to maturity, and the change in the difference between fair value and cost of investments: Gross realized gains: Fixed maturities Equity securities Gross realized losses: Fixed maturities Equity securities Net realized gains Change in difference between fair value and cost of investments: Fixed maturities Equity securities Totals 2013 2012 2011 $ 4,774,437 $ 6,730,331 $ 4,959,707 1,634,315 6,408,752 926,053 8,760,511 7,656,384 13,720,218 3,091,538 893,772 3,985,310 42,135 754,810 796,945 163,316 1,275,635 1,438,951 $ 2,423,442 $ 6,859,439 $ 12,281,267 $(29,153,645) $ 5,739,506 (104,660) $(28,992,993) $ 5,634,846 160,652 $ 29,646,545 (7,459,314) $ 22,187,231 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2013 as follows: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 50,802,809 $ 821,941 $ 4,642,775 $ 104,331 Less than 12 months 12 months or longer Fair Value Unrealized Losses Fair Value Unrealized Losses Obligations of states and political subdivisions 65,170,891 363,240 13,404,781 Corporate securities Mortgage-backed securities Equity securities Totals 16,693,759 83,535 6,851,898 72,878,347 535,944 19,013,889 213,414 1,628,893 92,867 — — $207,174,699 $ 1,897,527 $ 43,913,343 $ 488,223 98,676 71,802 We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2012 as follows: Less than 12 months 12 months or longer Fair Value Unrealized Losses Fair Value Unrealized Losses U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 12,308,333 $ 43,951 $ Obligations of states and political subdivisions 22,134,226 606,065 — $ — — — Corporate securities Mortgage-backed securities Equity securities Totals 12,271,750 79,136 2,958,520 29,573 22,491,562 66,443 2,226,050 106,748 — — — — $ 71,431,921 $ 902,343 $ 2,958,520 $ 29,573 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, we write down the investment to its fair value, and we reflect the amount of the write-down as a realized loss in our results of operations when we consider the decline in value of an individual investment to be other than temporary. We individually monitor all investments for other-than-temporary declines in value. Generally, we assume there has been an other-than-temporary decline in value if an individual equity security has depreciated in value by more -72- than 20% of original cost and has been in such an unrealized loss position for more than six months. We held four equity securities that were in an unrealized loss position at December 31, 2013. Based upon our analysis of general market conditions and underlying factors impacting these equity securities, we considered these declines in value to be temporary. With respect to a debt security that is in an unrealized loss position, we first assess if we intend to sell the debt security. If we determine we intend to sell the debt security, we recognize the impairment loss in our results of operations. If we do not intend to sell the debt security, we determine whether it is more likely than not that we will be required to sell the debt security prior to recovery. If we determine it is more likely than not that we will be required to sell the debt security prior to recovery, we recognize an impairment loss in our results of operations. If we determine it is more likely than not that we will not be required to sell the debt security prior to recovery, we then evaluate whether a credit loss has occurred. We determine whether a credit loss has occurred by comparing the amortized cost of the debt security to the present value of the cash flows we expect to collect. If we expect a cash flow shortfall, we consider that a credit loss has occurred. If we determine that a credit loss has occurred, we consider the impairment to be other than temporary. We then recognize the amount of the impairment loss related to the credit loss in our results of operations, and we recognize the remaining portion of the impairment loss in our other comprehensive income, net of applicable taxes. In addition, we may write down securities in an unrealized loss position based on a number of other factors, including when the fair value of an investment is significantly below its cost, when the financial condition of the issuer of a security has deteriorated, the occurrence of industry, company or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 216 debt securities that were in an unrealized loss position at December 31, 2013. Based upon our analysis of general market conditions and underlying factors impacting these debt securities, we considered these declines in value to be temporary. We did not recognize any impairment losses in 2013, 2012 or 2011. We had no sales or transfers from the held to maturity portfolio in 2013, 2012 or 2011. We have no derivative instruments or hedging activities. 5 - 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 price estimates we obtain from independent pricing services. We classify our fixed maturity investments as Level 2. Our fixed maturity investments consist of U.S. Treasury securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate securities and mortgage-backed securities. We present our investments in available-for-sale fixed maturity and equity securities at estimated fair value. The estimated fair value of a security may differ from the amount that could be realized if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. 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 based predominantly on observable market inputs. The pricing services do not use broker quotes in determining the fair values of our investments. Our investment personnel review the estimates of fair value the pricing services provide to determine if the estimates we obtain are representative of fair values based upon their general knowledge of the market, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our -73- investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At December 31, 2013 and 2012, we received one estimate per security from one of the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at December 31, 2013 and 2012, 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 receivables and reinsurance receivables and payables for premiums and paid losses and loss expenses approximate their fair values. The carrying amounts reported in the balance sheet for our subordinated debentures and borrowings under lines of credit approximate their fair values. We classify these items as Level 3. We evaluate our assets and liabilities on a recurring basis to determine the appropriate level at which to classify them for each reporting period. We evaluate our assets and liabilities on a regular basis to determine the appropriate level at which to classify them for each reporting period. Based on our review of the methodology and summary of inputs the pricing services use, we have concluded that our Level 1 and Level 2 investments were classified properly at December 31, 2013 and 2012. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2013: U.S. Treasury securities and obligations of U.S. government corporations and agencies Obligations of states and political subdivisions Corporate securities Mortgage-backed securities Equity securities Totals Fair Value Measurements Using Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Fair Value $ 14,333,697 $ — $ 14,333,697 $ 277,546,724 40,671,923 71,099,621 — 277,546,724 — 40,671,923 — 71,099,621 12,422,837 6,467,766 5,955,071 $ 416,074,802 $ 6,467,766 $ 409,607,036 $ — — — — — — The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2012: U.S. Treasury securities and obligations of U.S. government corporations and agencies Obligations of states and political subdivisions Corporate securities Mortgage-backed securities Equity securities Totals Fair Value Measurements Using Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Fair Value $ 71,311,103 $ — $ 71,311,103 $ 416,986,963 77,355,777 128,855,978 — 416,986,963 — 77,355,777 — 128,855,978 8,757,258 5,365,721 3,391,537 $ 703,267,079 $ 5,365,721 $ 697,901,358 $ — — — — — — -74- 6 - Deferred Policy Acquisition Costs Changes in our insurance subsidiaries' deferred policy acquisition costs are as follows: Balance, January 1 Acquisition costs deferred Amortization charged to earnings Balance, December 31 7 - Property and Equipment 2013 $ 40,121,697 2012 $ 36,424,955 2011 $ 34,445,579 85,258,813 (81,753,000) $ 43,627,510 78,010,742 (74,314,000) $ 40,121,697 70,550,376 (68,571,000) $ 36,424,955 Property and equipment at December 31, 2013 and 2012 consisted of the following: Office equipment Automobiles Real estate Software Accumulated depreciation 2013 9,116,070 $ 2012 8,863,377 $ Estimated Useful Life 5-15 years 2,106,116 2,010,762 3 years 5,911,129 5,356,705 15-50 years 2,717,205 2,717,206 5 years 19,850,520 (13,425,817) 18,948,050 (12,994,217) $ 6,424,703 $ 5,953,833 Depreciation expense for 2013, 2012 and 2011 amounted to $783,897, $944,632 and $1.0 million, respectively. 8 - Liability for Losses and Loss Expenses The establishment of an appropriate liability for losses and loss expenses is an inherently uncertain process, and we can provide no assurance that our insurance subsidiaries' ultimate liability will not exceed their 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, because the historical conditions and events that serve as a basis for our insurance subsidiaries' estimates of ultimate claim costs may change. As is the case for substantially all property and casualty insurance companies, our insurance subsidiaries have found it necessary in the past to increase their estimated future liabilities for losses and loss expenses in certain periods, and, in other periods, their estimates have exceeded their actual liabilities. Changes in our insurance subsidiaries' estimate of their liability for losses and loss expenses generally reflect actual payments and their evaluation of information received since the prior reporting date. -75- We summarize activity in our insurance subsidiaries' liability for losses and loss expenses as follows: Balance at January 1 Less reinsurance recoverable Net balance at January 1 Incurred related to: Current year Prior years Total incurred Paid related to: Current year Prior years Total paid Net balance at December 31 Plus reinsurance recoverable Balance at December 31 2013 $ 458,827,395 (207,891,560) 250,935,835 2012 $ 442,407,615 (199,392,836) 243,014,779 2011 $ 383,318,672 (165,422,373) 217,896,299 332,770,088 325,275,882 10,357,863 7,595,702 343,127,951 332,871,584 340,671,237 (168,460) 340,502,777 201,781,955 205,876,331 219,183,102 126,676,599 119,074,197 96,201,195 328,458,554 324,950,528 315,384,297 265,605,232 250,935,835 243,014,779 230,014,037 207,891,560 199,392,836 $ 495,619,269 $ 458,827,395 $ 442,407,615 Our insurance subsidiaries recognized an increase (decrease) in their liability for losses and loss expenses of prior years of $10.4 million, $7.6 million and ($168,460) in 2013, 2012 and 2011, respectively. Our insurance subsidiaries made no significant changes in their reserving philosophy, key reserving assumptions or claims management personnel, and they have made no significant offsetting changes in estimates that increased or decreased their loss and loss expense reserves in these years. The 2013 development represented 4.1% of the December 31, 2012 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability, commercial multiple peril, commercial automobile and workers' compensation lines of business in accident years prior to 2013. The majority of the 2013 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. The 2012 development represented 3.1% of the December 31, 2011 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability and workers' compensation lines of business in accident years prior to 2012. The majority of the 2012 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. The 2011 development represented an immaterial percentage of the December 31, 2010 net carried reserves. 9 - Borrowings Lines of Credit In June 2013, we renewed our existing credit agreement with Manufacturers and Traders Trust Company (“M&T”) relating to a $60.0 million unsecured, revolving line of credit. The line of credit now expires in July 2016. We have the right to request a one-year extension of the credit agreement as of each anniversary date of the agreement. At December 31, 2013, we had $43.0 million in outstanding borrowings and had the ability to borrow an additional $17.0 million at interest rates equal to M&T’s current prime rate or the then current LIBOR rate plus 2.25%. The interest rate on our outstanding borrowings is adjustable quarterly. At December 31, 2013, the interest rate on our outstanding borrowings was 2.42%. We pay a fee of 0.2% per annum on the loan commitment amount regardless of usage. The credit agreement requires our compliance with certain covenants. These covenants include minimum levels of our net worth, leverage ratio, statutory surplus and the A.M. Best ratings of our insurance subsidiaries. We complied with all requirements of the credit agreement during 2013. -76- MICO has an agreement with the Federal Home Loan Bank (“FHLB”) of Indianapolis. Through its membership, MICO has the ability to issue debt to the FHLB of Indianapolis in exchange for cash advances. There were no outstanding borrowings at December 31, 2013 or 2012. The table below presents the amount of FHLB of Indianapolis stock MICO purchased, collateral pledged and assets related to MICO's agreement at December 31, 2013. FHLB stock purchased and owned as part of the agreement $ 252,100 Collateral pledged, at par (carrying value $2,789,386) Borrowing capacity currently available 3,700,000 2,413,882 Atlantic States is a member of the FHLB of Pittsburgh. Through its membership, Atlantic States has the ability to issue debt to the FHLB of Pittsburgh in exchange for cash advances. During 2013, Atlantic States issued secured debt in the principal amount of $15.0 million to the FHLB of Pittsburgh in exchange for cash advances in the amount of $15.0 million. Atlantic States then loaned $15.0 million to us. We used the proceeds of our loan from Atlantic States to fund our prepayment of our subordinated debentures, as we discuss below. The interest rate on the advances was .26% at December 31, 2013. Atlantic States had no outstanding borrowings with the FHLB of Pittsburgh at December 31, 2012. The table below presents the amount of FHLB of Pittsburgh stock Atlantic States purchased, collateral pledged and assets related to Atlantic States’ membership in the FHLB of Pittsburgh at December 31, 2013. FHLB stock purchased and owned as part of the agreement $ 870,300 Collateral pledged, at par (carrying value $15,305,496) Borrowing capacity currently available 19,000,000 305,496 Subordinated Debentures On October 29, 2003, we received $10.0 million in net proceeds from the issuance of subordinated debentures. The debentures had a maturity date of October 29, 2033 and were callable at our option, at par. The debentures carried an interest rate equal to the three-month LIBOR rate plus 3.85%. On January 28, 2013, we prepaid these subordinated debentures in full and liquidated our investment in the statutory trust. On May 24, 2004, we received $5.0 million in net proceeds from the issuance of subordinated debentures. The debentures had a maturity date of May 24, 2034 and were callable at our option, at par. The debentures carried an interest rate equal to the three-month LIBOR rate plus 3.85%. On February 25, 2013, we prepaid these subordinated debentures in full and liquidated our investment in the statutory trust. In January 2002, West Bend purchased a surplus note from MICO for $5.0 million to increase MICO's statutory surplus. On December 1, 2010, Donegal Mutual purchased the surplus note from West Bend at face value. The surplus note carries an interest rate of 5.00%, and any repayment of principal or interest requires prior insurance regulatory approval. Upon receipt of regulatory approval, MICO paid $250,000 in interest to Donegal Mutual during each of 2013 and 2012. 10 - Reinsurance Unaffiliated Reinsurers Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also have separate third-party reinsurance programs that provide certain coverage that is commensurate with their relative size and exposures. Our insurance subsidiaries use several different reinsurers, all of which, consistent with the requirements of our insurance subsidiaries and Donegal Mutual, have an A.M. Best rating of A- (Excellent) or better, or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The external reinsurance our insurance subsidiaries and Donegal Mutual purchase includes “excess of loss reinsurance,” under which their losses are automatically reinsured, through a series of contracts, over a set retention (generally $1.0 million for 2013 and 2012 and $750,000 prior to 2012), and “catastrophic reinsurance,” under which they recover, through a series of contracts, 100% of an accumulation of many losses resulting from a single event, including natural disasters, over a set retention (generally $5.0 million) and after exceeding an annual aggregate deductible ($5.0 million in 2013 and $0 in 2012 and 2011) up to aggregate losses of $145.0 million per occurrence. For -77- property insurance, our insurance subsidiaries had excess of loss treaties that provided for coverage up to $5.0 million per loss. For liability insurance, our insurance subsidiaries had excess of loss treaties that provided for coverage up to $40.0 million per occurrence. For workers' compensation insurance, our insurance subsidiaries had excess of loss treaties that provided for coverage up to $10.0 million on any one life. Our insurance subsidiaries and Donegal Mutual had property catastrophe coverage through a series of layered treaties up to aggregate losses of $150.0 million for any single event. As many as 25 reinsurers provided coverage on any one treaty with no reinsurer taking more than 30.0% of any one treaty. The amount of coverage provided under each of these types of reinsurance depends upon the amount, nature, size and location of the risks being reinsured. Donegal Mutual and our insurance subsidiaries also purchased facultative reinsurance to cover exposures from losses that exceeded the limits provided by the treaty reinsurance Donegal Mutual and our insurance subsidiaries purchased. In order to write automobile insurance in the State of Michigan, MICO is required to be a member of the Michigan Catastrophic Claims Association ("MCCA"). The MCCA provides reinsurance to MICO for personal automobile and commercial automobile personal injury claims in the State of Michigan over a set retention. Through December 1, 2010, MICO and West Bend were parties to quota-share reinsurance agreements whereby MICO ceded 75% of its business to West Bend. MICO and West Bend agreed to terminate the reinsurance agreement in effect at November 30, 2010 on a run-off basis. West Bend's obligations related to all past reinsurance agreements with MICO remain in effect for all policies effective prior to December 1, 2010. MICO maintains a quota-share reinsurance agreement with third-party reinsurers to reduce its net exposures. Effective from December 1, 2010 to December 31, 2011, the quota-share reinsurance percentage was 50%. Effective January 1, 2012, MICO reduced the quota-share reinsurance percentage from 50% to 40%. Effective January 1, 2013, MICO reduced the quota- share reinsurance percentage from 40% to 30%. Effective January 1, 2014, MICO reduced the quota-share reinsurance percentage from 30% to 20%. The following amounts represent ceded reinsurance transactions with unaffiliated reinsurers during 2013, 2012 and 2011: Premiums written Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses Total Reinsurance 2013 2012 $ 69,776,461 $ 76,736,510 $ 80,265,127 2011 73,504,433 79,680,782 88,297,408 58,556,283 56,179,284 82,836,893 21,398,306 25,126,276 28,054,302 114,313,279 103,775,940 106,231,527 The following amounts represent our total ceded reinsurance transactions with both affiliated and unaffiliated reinsurers during 2013, 2012 and 2011: Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses 2013 2012 $ 266,284,366 $ 258,064,301 $ 242,186,814 216,776,966 181,995,838 181,218,752 2011 112,663,942 111,156,162 106,450,018 230,014,037 207,891,560 199,392,836 The following amounts represent the effect of reinsurance on premiums written for 2013, 2012 and 2011: Direct Assumed Ceded Net premiums written 2013 2012 $ 441,469,330 $ 419,811,847 $ 397,810,566 2011 359,753,517 (267,792,144) 306,416,861 339,389,274 (250,176,390) (262,754,201) $ 533,430,703 $ 496,446,920 $ 454,051,037 -78- The following amounts represent the effect of reinsurance on premiums earned for 2013, 2012 and 2011: Direct Assumed Ceded Net premiums earned 2013 2012 $ 431,788,593 $ 408,846,530 $ 385,737,801 2011 349,787,717 (266,284,366) 287,919,197 324,219,993 (242,186,814) (258,064,301) $ 515,291,944 $ 475,002,222 $ 431,470,184 11 - Income Taxes Our provision for income tax consists of the following: Current Deferred Federal income tax (benefit) provision 2013 4,973,430 $ 1,414,843 6,388,273 $ $ $ 2011 2012 3,614,390 $ (1,269,775) (5,922,491) 1,151,250 $ (7,192,266) 4,765,640 Our effective tax rate is different from the amount computed at the statutory federal rate of 35% for 2013, 2012 and 2011. The reasons for such difference and the related tax effects are as follows: Income (loss) before income taxes Computed “expected” taxes (benefit) Tax-exempt interest Proration Other, net Federal income tax (benefit) provision 2013 2012 2011 $ 32,710,265 $ 27,858,260 $ 11,448,593 (5,789,963) 868,306 (138,663) 6,388,273 $ 9,750,391 (5,824,281) 869,551 (30,021) 4,765,640 $ $ (6,739,313) (2,358,760) (6,038,463) 905,326 299,631 (7,192,266) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2013 and 2012 are as follows: Deferred tax assets: Unearned premium Loss reserves Net operating loss carryforward Net operating loss carryforward - Le Mars Alternative minimum tax credit carryforward Net unrealized losses Other Total gross deferred assets Less valuation allowance Net deferred tax assets Deferred tax liabilities: Deferred policy acquisition costs Net unrealized gains Other Total gross deferred tax liabilities Net deferred tax asset -79- 2013 2012 $ 18,875,418 $ 17,613,415 6,966,581 — 1,665,748 7,275,091 1,942,128 1,797,194 10,011,483 7,964,853 1,245,400 — 1,261,546 1,413,285 40,026,176 (440,778) 39,585,398 38,005,966 (440,778) 37,565,188 15,269,629 14,042,594 — 14,212,465 4,005,211 3,042,593 19,274,840 31,297,652 $ 20,310,558 $ 6,267,536 We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of the tax asset. At December 31, 2013 and 2012, we established a valuation allowance of $440,778 related to a portion of the net operating loss carryforward of Le Mars that we acquired on January 1, 2004. We determined that we were not required to establish a valuation allowance for the other net deferred tax assets of $39.6 million and $37.6 million at December 31, 2013 and 2012, respectively, since it is more likely than not that we will realize these deferred tax assets through reversals of existing temporary differences, future taxable income and the implementation of tax-planning strategies. Tax years 2010 through 2013 remained open for examination at December 31, 2013. The net operating loss carryforward of $4.8 million from Le Mars will begin to expire in 2020 if not utilized and is subject to an annual limitation of approximately $376,000. We also had an alternative minimum tax credit carryforward of $10.0 million with an indefinite life. 12 - Stockholders' Equity On April 19, 2001, our stockholders approved an amendment to our certificate of incorporation. Among other things, the amendment reclassified our common stock as Class B common stock and effected a one-for-three reverse split of our Class B common stock effective April 19, 2001. The amendment also authorized a new class of common stock with one-tenth of a vote per share designated as Class A common stock. Our board of directors also declared a dividend of two shares of Class A common stock for each share of Class B common stock, after the one-for-three reverse split, held of record at the close of business April 19, 2001. At our annual meeting of stockholders on April 18, 2013, our stockholders approved an amendment to our certificate of incorporation that increased the number of shares of our Class A common stock we have the authority to issue from 30.0 million shares to 40.0 million shares. Each share of Class A common stock outstanding at the time of the declaration of any dividend or other distribution payable in cash upon the shares of Class B common stock is entitled to a dividend or distribution payable at the same time and to stockholders of record on the same date in an amount at least 10% greater than any dividend declared upon each share of Class B common stock. In the event of our merger or consolidation with or into another entity, the holders of Class A common stock and the holders of Class B common stock are entitled to receive the same per share consideration in such merger or consolidation. In the event of our liquidation, dissolution or winding-up, any assets available to common stockholders will be distributed pro-rata to the holders of Class A common stock and Class B common stock after payment of all of our obligations. In February 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 market 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 purchased 24,240 and 135,064 shares of our Class A common stock under this program during 2013 and 2012, respectively. At December 31, 2013, we had the authority remaining to purchase 4,068 shares under this program. On July 18, 2013, our board of directors authorized a share repurchase program pursuant to which we have the authority to purchase up to 500,000 additional shares of our Class A common stock at prices prevailing from time to time in the open market subject to the provisions of SEC Rule 10b-18 and in privately negotiated transactions. We did not purchase shares under this program during 2013. At December 31, 2013, our treasury stock consisted of 940,862 and 72,465 shares of Class A common stock and Class B common stock, respectively. At December 31, 2012, our treasury stock consisted of 916,622 and 72,465 shares of Class A common stock and Class B common stock, respectively. 13 - Stock Compensation Plans Equity Incentive Plans During 1996, we adopted an Equity Incentive Plan for Employees. During 2001, we adopted a nearly identical plan that made a total of 2,666,667 shares of Class A common stock available for issuance to employees of our subsidiaries and affiliates. During 2005, we amended the plan to make a total of 4,000,000 shares of Class A common stock available for issuance. During 2007, we adopted a nearly identical plan that made a total of 3,500,000 shares of Class A common stock available for issuance to employees of our subsidiaries and affiliates. During 2011, we adopted a nearly identical plan that made a total of 3,500,000 shares of Class A common stock available for issuance to employees of our subsidiaries and affiliates. During 2013, we adopted a nearly identical plan that made a total of 4,500,000 shares of Class A common stock available for issuance to employees of our subsidiaries and affiliates. Each plan provides for the granting of awards by our board of directors -80- in the form of stock options, stock appreciation rights, restricted stock or any combination of the above. The plans provide that stock options may become exercisable up to ten years from date of grant, with an option price not less than fair market value on date of grant. We have not granted any stock appreciation rights. During 1996, we adopted an Equity Incentive Plan for Directors. During 2001, we adopted a nearly identical plan that made 355,556 shares of Class A common stock available for issuance to our directors and those of our subsidiaries and affiliates. During 2007, we adopted a nearly identical plan that made 400,000 shares of Class A common stock available for issuance to our directors and the directors of our subsidiaries and affiliates. During 2011, we adopted a nearly identical plan that made 400,000 shares of Class A common stock available for issuance to our directors and the directors of our subsidiaries and affiliates. During 2013, we adopted a nearly identical plan that made 600,000 shares of Class A common stock available for issuance to our directors and the directors of our subsidiaries and affiliates. We may make awards in the form of stock options. The plan also provides for the issuance of 400 shares of restricted stock on the first business day of January in each year to each of our directors and each director of Donegal Mutual who does not serve as one of our directors. We issued 6,800, 6,800 and 5,598 shares of restricted stock on January 2, 2013, 2012 and 2011, respectively. We measure all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and record such expense in our results of operations. In determining the expense we record for stock options granted to directors and employees of our subsidiaries and affiliates, we estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The significant assumptions we utilize in applying the Black-Scholes option pricing model are the risk-free interest rate, expected term, dividend yield and expected volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero coupon issues with a remaining term equal to the expected term used as the assumption in the model. We base the expected term of an option award on our historical experience for similar awards. We determine the dividend yield by dividing the per share dividend by the grant date stock price. We base the expected volatility on the volatility of our stock price over a historical period comparable to the expected term. The weighted-average grant date fair value of options granted during 2013 was $2.20. We calculated this fair value based upon a risk-free interest rate of 1.63%, expected life of five years, expected volatility of 23% and expected dividend yield of 3%. The weighted-average grant date fair value of options granted during 2012 was $2.85. We calculated this fair value based upon a risk-free interest rate of .43%, expected life of five years, expected volatility of 33% and expected dividend yield of 3%. The weighted-average grant date fair value of options granted during 2011 was $1.90. We calculated this fair value based upon a risk-free interest rate of .75%, expected life of five years, expected volatility of 31% and expected dividend yield of 4%. We charged compensation expense for our stock compensation plans against income before income taxes of $547,374, $420,735 and $283,811 for the years ended December 31, 2013, 2012 and 2011, respectively, with a corresponding income tax benefit of $186,107, $143,050 and $96,496. At December 31, 2013 and 2012, our total unrecognized compensation cost related to non-vested share-based compensation granted under our stock compensation plans was $1.1 million and $1.2 million, respectively. We expect to recognize this cost over a weighted average period of 1.0 years. During 2013, we received cash from option exercises under all stock compensation plans of $9.7 million. We realized actual tax benefits for the tax deductions from option exercises of share-based compensation of $531,159 for 2013. During 2012, we received cash from option exercises under all stock compensation plans of $1.1 million. We realized actual tax benefits for the tax deductions from option exercises of share-based compensation of $52,422 for 2012. We did not receive any cash from option exercises in 2011. No further shares are available for future option grants for plans in effect prior to 2013. -81- Information regarding activity in our stock option plans follows: Outstanding at December 31, 2010 Granted - 2011 Forfeited - 2011 Expired - 2011 Outstanding at December 31, 2011 Granted - 2012 Exercised - 2012 Forfeited - 2012 Expired - 2012 Outstanding at December 31, 2012 Granted - 2013 Exercised - 2013 Forfeited - 2013 Expired - 2013 Outstanding at December 31, 2013 Exercisable at: December 31, 2011 December 31, 2012 December 31, 2013 Number of Options 3,998,667 $ 2,321,000 (52,000) (958,667) 5,309,000 1,593,600 (82,102) (109,673) (10,000) 6,700,825 2,543,500 (722,322) (116,669) (1,204,000) 7,201,334 $ 1,821,333 $ 3,072,970 $ 3,028,619 $ Weighted- Average Exercise Price Per Share 16.80 12.52 15.63 21.00 14.18 14.50 13.01 13.84 21.00 14.27 15.90 13.45 13.65 17.52 14.39 16.42 15.03 13.47 Shares available for future option grants at December 31, 2013 totaled 2,556,500 shares under all plans. The following table summarizes information about fixed stock options outstanding at December 31, 2013: Exercise Price $12.50 14.00 14.50 15.00 15.90 17.50 Total Number of Options Outstanding 1,863,627 1,284,207 1,502,000 3,000 Weighted-Average Remaining Contractual Life 8.0 years 2.0 years 9.0 years 2.0 years 2,543,500 10.0 years 5,000 0.25 years 7,201,334 Number of Options Exercisable 1,242,417 1,277,540 500,662 3,000 — 5,000 3,028,619 Employee Stock Purchase Plans During 1996, we adopted an Employee Stock Purchase Plan. During 2001, we adopted a nearly identical plan that made 533,333 shares of Class A common stock available for issuance. During 2011, we adopted another nearly identical plan that made 300,000 shares of Class A common stock available for issuance. The 2011 plan extends over a 10-year period and provides for shares to be offered to all eligible employees at a purchase price equal to the lesser of 85% of the fair market value of our Class A common stock on the last day before the first day of each enrollment period (June 1 and December 1 of each year) under the plan or 85% of the fair market value of our common stock on the last day of each subscription period (June 30 and December 31 of each year). -82- A summary of plan activity follows: January 1, 2011 July 1, 2011 January 1, 2012 July 1, 2012 January 1, 2013 July 1, 2013 $ Shares Issued Price Shares 11.02 10.88 11.91 11.29 11.93 11.76 13,243 11,371 10,523 19,031 16,485 19,805 On January 1, 2014, we issued an additional 16,964 shares at a price of $12.58 per share under this plan. Agency Stock Purchase Plans During 1996, we adopted an Agency Stock Purchase Plan. During 2001, we adopted a nearly identical plan that made 533,333 shares of Class A common stock available for issuance. During 2011, we adopted another nearly identical plan that made 300,000 shares of Class A common stock available for issuance. The plan provides for agents of our insurance subsidiaries and Donegal Mutual to invest up to $12,000 per subscription period (April 1 to September 30 and October 1 to March 31 of each year) under various methods. We issue stock at the end of each subscription period at a price equal to 90% of the average market price during the last ten trading days of each subscription period. During 2013, 2012 and 2011, we issued 79,532, 70,366 and 66,260 shares, respectively, under this plan. Expense recognized under the plan was not material. -83- 14 - Statutory Net Income, Capital and Surplus and Dividend Restrictions The following table presents selected information, as filed with insurance regulatory authorities, for our insurance subsidiaries as determined in accordance with accounting practices prescribed or permitted by such insurance regulatory authorities: Atlantic States: Statutory capital and surplus Statutory unassigned surplus Statutory net income (loss) Southern: Statutory capital and surplus Statutory unassigned surplus Statutory net income (loss) Le Mars: Statutory capital and surplus Statutory unassigned surplus Statutory net income (loss) Peninsula: Statutory capital and surplus Statutory unassigned surplus Statutory net income Sheboygan: Statutory capital and surplus Statutory unassigned surplus (deficit) Statutory net income (loss) MICO: Statutory capital and surplus Statutory unassigned surplus Statutory net income 2013 2012 2011 $ 186,606,655 $ 180,465,658 $ 173,505,872 131,028,806 124,924,794 12,596,844 12,507,540 113,497,280 (7,729,040) 62,702,432 58,841,059 60,876,093 11,701,045 4,195,635 7,843,473 (1,539,943) 9,364,037 1,795,195 27,627,914 26,803,140 24,720,327 15,032,372 790,147 14,210,400 2,423,225 11,373,158 (1,661,327) 41,891,487 42,471,092 40,744,215 24,089,092 24,671,678 22,601,043 1,481,670 1,478,823 1,210,247 12,085,839 52,211 1,374,543 10,944,235 (1,087,936) (33,316) 10,800,499 (1,437,493) (1,237,478) 41,594,701 42,443,200 39,264,423 15,588,110 16,440,388 12,689,880 1,170,008 2,698,257 2,889,619 Our principal source of cash for payment of dividends is dividends from our insurance subsidiaries. State insurance laws require our insurance subsidiaries to maintain certain minimum capital and surplus amounts on a statutory basis. Our insurance subsidiaries are subject to regulations that restrict the payment of dividends from statutory surplus and may require prior approval of their domiciliary insurance regulatory authorities. Our insurance subsidiaries are also subject to risk based capital ("RBC") requirements that may further impact their ability to pay dividends. Our insurance subsidiaries' statutory capital and surplus at December 31, 2013 exceeded the amount of statutory capital and surplus necessary to satisfy regulatory requirements, including the RBC requirements, by a significant margin. Amounts available for distribution to us as dividends from our insurance subsidiaries without prior approval of insurance regulatory authorities in 2014 are $18.7 million from Atlantic States, $4.2 million from Southern, $2.8 million from Le Mars, $4.2 million from Peninsula, $1.1 million from Sheboygan and $4.1 million from MICO, or a total of approximately $35.1 million. -84- 15 - Reconciliation of Statutory Filings to Amounts Reported Herein Our insurance subsidiaries must file financial statements with state insurance regulatory authorities using accounting principles and practices prescribed or permitted by those authorities. We refer to these accounting principles and practices as statutory accounting principles (“SAP”). Accounting principles used to prepare these SAP financial statements differ from those used to prepare financial statements on the basis of GAAP. Reconciliations of statutory net income and capital and surplus, as determined using SAP, to the amounts included in the accompanying GAAP financial statements are as follows: Statutory net income (loss) of insurance subsidiaries Increases (decreases): Deferred policy acquisition costs Deferred federal income taxes Salvage and subrogation recoverable Amortization of MICO fair value adjustments Consolidating eliminations and adjustments Parent-only net income Year Ended December 31, 2013 $ 21,608,847 2012 $ 17,534,586 2011 $ (4,732,784) 3,505,813 (1,414,843) 1,059,400 — (10,648,834) 12,211,609 3,696,742 (1,151,250) 772,600 (5,416) (5,421,779) 7,667,137 1,979,376 5,922,490 1,273,000 (3,275,777) (15,080,164) 14,366,812 Net income as reported herein $ 26,321,992 $ 23,092,620 $ 452,953 Statutory capital and surplus of insurance subsidiaries Increases (decreases): Deferred policy acquisition costs Deferred federal income taxes Salvage and subrogation recoverable Non-admitted assets and other adjustments, net Fixed maturities Parent-only equity and other adjustments Stockholders' equity as reported herein 16 - Supplementary Cash Flow Information Year Ended December 31, 2013 $ 372,509,028 2012 $ 361,968,384 2011 $ 349,911,429 43,627,510 (12,251,398) 13,060,000 40,121,697 (25,682,004) 12,000,600 36,424,955 (21,007,223) 11,228,000 2,363,038 (1,465,363) (20,965,704) $ 396,877,111 2,005,603 1,478,988 39,607,340 (29,987,526) $ 400,034,094 33,165,065 (27,749,622) $ 383,451,592 The following table reflects net income taxes and interest paid during 2013, 2012 and 2011: Income taxes Interest 2013 5,450,000 $ 2012 1,626,965 $ $ 2011 324,291 1,527,037 2,128,693 1,793,366 -85- 17 - Earnings Per Share We have two classes of common stock, which we refer to as Class A common stock and Class B common stock. Our Class A common stock is entitled to be paid cash dividends that are at least 10% higher than the cash we pay on our Class B common stock. Accordingly, we use the two-class method for the computation of 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 declared and an allocation of remaining undistributed earnings using a participation percentage reflecting the dividend rights of each class. We present below a reconciliation of the numerators and denominators we used in the basic and diluted per share computations for our Class A common stock: (dollars in thousands, except per share data) Basic earnings per share: Numerator: Allocation of net income Denominator: Weighted-average shares outstanding Basic earnings per share Diluted earnings per share: Numerator: Allocation of net income Denominator: Number of shares used in basic computation Weighted-average effect of dilutive securities Add: Director and employee stock options Number of shares used in per share computations Diluted earnings per share Year Ended December 31, 2013 2012 2011 $ $ $ 21,110 $ 18,455 $ 390 20,363,677 20,031,455 1.04 $ 0.92 $ 19,997,146 0.02 21,110 $ 18,455 $ 390 20,363,677 20,031,455 19,997,146 398,708 20,762,385 274,103 20,305,558 $ 1.02 $ 0.91 $ 36,499 20,033,645 0.02 We used the following information in the basic and diluted per share computations for our Class B common stock: (dollars in thousands, except per share data) Basic and diluted earnings per share: Numerator: Allocation of net income Denominator: Weighted-average shares outstanding Basic and diluted earnings per share Year Ended December 31, 2013 2012 2011 $ $ 5,212 $ 4,638 $ 63 5,576,775 5,576,775 5,576,775 0.94 $ 0.83 $ 0.01 During 2013, 2012 and 2011, we did not include certain options to purchase shares of our Class A common stock in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price of our Class A common stock. The following table reflects such options that remained outstanding at December 31, 2013, 2012 and 2011: Options excluded from diluted earnings per share 2013 2,548,500 2012 1,209,000 2011 1,238,000 -86- 18 - Condensed Financial Information of Parent Company December 31, Assets Condensed Balance Sheets (in thousands) 2013 2012 Investment in subsidiaries/affiliates (equity method) $ 457,886 $ 470,565 Short-term investments Cash Property and equipment Other Total assets Liabilities and Stockholders' Equity Liabilities 149 1,604 927 586 326 805 883 304 $ 461,152 $ 472,883 Cash dividends declared to stockholders $ 3,299 $ Borrowings under lines of credit Subordinated debentures Other Total liabilities Stockholders' equity Total liabilities and stockholders' equity 58,000 — 2,976 64,275 3,067 52,000 15,465 2,316 72,848 396,877 400,035 $ 461,152 $ 472,883 Condensed Statements of Income and Comprehensive Income (in thousands) Year Ended December 31, Statements of Income Revenues Dividends from subsidiaries Other Total revenues Expenses Operating expenses Interest Total expenses Income before income tax (benefit) expense and equity in undistributed net income (loss) of subsidiaries Income tax (benefit) expense Income before equity in undistributed net income (loss) of subsidiaries Equity in undistributed net income (loss) of subsidiaries Net income Statements of Comprehensive Income Net income Other comprehensive (loss) income, net of tax Unrealized (loss) gain - subsidiaries Other comprehensive (loss) income, net of tax Comprehensive (loss) income -87- 2013 2012 2011 $ 12,500 $ 7,000 $ 16,000 3,758 16,258 3,777 1,488 5,265 10,993 (1,219) 12,212 14,110 5,487 12,487 2,323 2,118 4,441 8,046 378 7,668 15,425 26,322 $ 23,093 $ 2,995 18,995 2,392 1,864 4,256 14,739 372 14,367 (13,914) 453 26,322 $ 23,093 $ 453 (28,707) (28,707) (2,385) $ 4,644 4,644 27,737 $ 14,972 14,972 15,425 $ $ $ Condensed Statements of Cash Flows (in thousands) Year Ended December 31, Cash flows from operating activities: Net income Adjustments: Equity in undistributed net (income) loss of subsidiaries Other Net adjustments Net cash provided Cash flows from investing activities: Net sale of short-term investments Net purchase of property and equipment Investment in subsidiaries Other Net cash provided (used) Cash flows from financing activities: Cash dividends paid Issuance of common stock Payments on subordinated debentures Payments on line of credit Borrowings under lines of credit Repurchase of treasury stock Net cash (used) provided Net change in cash Cash at beginning of year Cash at end of year 2013 2012 2011 $ 26,322 $ 23,093 $ 453 (14,110) (2,200) (16,310) 10,012 176 (420) 990 44 790 (12,809) 12,648 (15,465) (15,500) 21,500 (377) (10,003) 799 805 $ 1,604 $ (15,425) (2,624) (18,049) 5,044 8,932 (147) (100) 44 8,729 (12,208) 2,983 — (6,000) 3,500 (1,927) (13,652) 121 684 805 13,914 (396) 13,518 13,971 6,437 (380) (27,777) 43 (21,677) (11,874) 1,461 — (3,000) 22,500 (1,538) 7,549 (157) 841 $ 684 -88- 19 - Segment Information We have four reportable segments, which consist of our investment function, our personal lines of insurance, our commercial lines of insurance and our investment in DFSC. Using independent agents, our insurance subsidiaries market personal lines of insurance to individuals and commercial lines of insurance to small and medium-sized businesses. We evaluate the performance of the personal lines and commercial lines primarily based upon our insurance subsidiaries' underwriting results as determined under SAP for our total business. We do not allocate assets to the personal and commercial lines and review the two segments in total for purposes of decision-making. We operate only in the United States and no single customer or agent provides 10 percent or more of our revenues. Financial data by segment is as follows: Revenues: Premiums earned: Commercial lines Personal lines SAP premiums earned GAAP adjustments GAAP premiums earned Net investment income Realized investment gains Equity in earnings of DFSC Other Total revenues Income before income taxes: Underwriting income (loss): Commercial lines Personal lines SAP underwriting income (loss) GAAP adjustments GAAP underwriting income (loss) Net investment income Realized investment gains Equity in earnings of DFSC Other 2013 2012 2011 (in thousands) $ $ 202,983 312,309 515,292 — 515,292 18,795 2,423 2,908 7,692 $ 174,735 300,272 475,007 (5) 475,002 20,169 6,859 4,533 8,420 152,247 282,498 434,745 (3,275) 431,470 20,858 12,281 2,023 8,386 $ 547,110 $ 514,983 $ 475,018 2013 2012 2011 (in thousands) $ (524) $ 1,654 1,130 5,175 6,305 18,795 2,423 2,908 2,279 $ 5,251 (18,236) (12,985) 5,545 (7,440) 20,169 6,859 4,533 3,737 (6,560) (40,739) (47,299) 1,532 (45,767) 20,858 12,281 2,023 3,866 (6,739) Income (loss) before income taxes $ 32,710 $ 27,858 $ 20 - Guaranty Fund and Other Insurance-Related Assessments Our insurance subsidiaries' liabilities for guaranty fund and other insurance-related assessments were $1,511,186 and $1,403,829 at December 31, 2013 and 2012, respectively. These liabilities included $527,241 and $433,994 related to surcharges collected by our insurance subsidiaries on behalf of regulatory authorities for 2013 and 2012, respectively. -89- 21 - Interim Financial Data (unaudited) Net premiums earned Total revenues Net losses and loss expenses Net income Net earnings per common share: Class A common stock - basic Class A common stock - diluted Class B common stock - basic and diluted Net premiums earned Total revenues Net losses and loss expenses Net income Net earnings per common share: Class A common stock - basic Class A common stock - diluted Class B common stock - basic and diluted 2013 First Quarter Fourth Quarter $ 124,702,041 $ 126,963,328 $ 130,645,011 $ 132,981,564 Second Quarter Third Quarter 133,872,592 135,507,635 138,334,960 139,394,878 85,533,016 89,519,350 84,882,734 83,192,851 6,475,436 2,628,987 7,653,734 9,563,835 0.26 0.25 0.23 0.10 0.10 0.09 2012 0.30 0.30 0.27 0.38 0.37 0.35 First Quarter Fourth Quarter $ 114,691,791 $ 117,569,122 $ 120,916,960 $ 121,824,349 Second Quarter Third Quarter 125,348,162 76,609,219 127,299,190 86,385,353 130,431,531 82,105,094 131,903,702 87,771,918 8,010,147 2,023,067 6,839,384 6,220,022 0.32 0.31 0.29 0.08 0.08 0.07 0.27 0.27 0.25 0.25 0.25 0.22 -90- Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of Donegal Group Inc. We have audited the accompanying consolidated balance sheets of Donegal Group Inc. and subsidiaries (the Company) as of December 31, 2013 and 2012, and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2013. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of Donegal Financial Services Corporation (a 48.2 percent owned investee company). The Company's investment in Donegal Financial Services Corporation at December 31, 2013 and 2012, was $35,685,433 and $36,770,530, respectively, and its equity in earnings of Donegal Financial Services Corporation was $2,907,867 and $4,533,257 for the years 2013 and 2012, respectively. The financial statements of Donegal Financial Services Corporation were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Donegal Financial Services Corporation, is based solely on the report of the other auditors. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Donegal Group Inc. and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Oversight Board (United States), Donegal Group Inc.'s internal control over financial reporting as of December 31, 2013 based on the criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2014 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. Philadelphia, Pennsylvania March 14, 2014 -91- Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. Item 9A. Controls and Procedures. Evaluation of Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) at December 31, 2013 covered by this Form 10-K Report. Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, at December 31, 2013, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information we are required to disclose in the reports that we file or submit under the Exchange Act and our disclosure controls and procedures are also effective to ensure that information we disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure. Management's Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as that term is defined in Rule 13a-15(f) under the Exchange Act. Under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, our management has conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework and criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the "COSO Framework"). Based on our evaluation under the COSO Framework, our management has concluded that our internal control over financial reporting was effective at December 31, 2013. The effectiveness of our internal control over financial reporting at December 31, 2013 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included in this Form 10-K Annual Report. Changes in Internal Control over Financial Reporting We did not make any changes to our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter of 2013 that have materially affected, or are reasonably likely to affect materially, our internal control over financial reporting. Item 9B. Other Information. None. -92- Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of Donegal Group Inc. We have audited Donegal Group Inc.'s (the Company) internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Donegal Group Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Donegal Group Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Donegal Group Inc. and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2013, and our report dated March 14, 2014 expressed an unqualified opinion on those consolidated financial statements. Philadelphia, Pennsylvania March 14, 2014 -93- Item 10. Directors, Executive Officers and Corporate Governance of the Registrant. PART III We incorporate the response to this Item 10 by reference to our proxy statement we will file with the SEC on or about March 18, 2014 relating to our annual meeting of stockholders that we will hold on April 17, 2014, or our Proxy Statement. We respond to this Item with respect to our executive officers by reference to Part I of this Form 10-K Report. We incorporate the full text of our Code of Business Conduct and Ethics by reference to Exhibit 14 to this Form 10-K Report. Item 11. Executive Compensation. We incorporate the response to this Item 11 by reference to our Proxy Statement. Neither the Report of our Compensation Committee nor the Report of our Audit Committee included in our Proxy Statement shall constitute or be deemed to constitute a filing with the SEC under the Securities Act or the Exchange Act or be deemed to have been incorporated by reference into any filing we make under the Securities Act or the Exchange Act, except to the extent we specifically incorporate the Report of Our Compensation Committee or the Report of Our Audit Company by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. We incorporate the response to this Item 12 by reference to our Proxy Statement. Item 13. Certain Relationships and Related Transactions and Director Independence. We incorporate the response to this Item 13 by reference to our Proxy Statement. Item 14. Principal Accountant Fees and Services. We incorporate the response to this Item 14 by reference to our Proxy Statement. -94- PART IV Item 15. Exhibits and Financial Statement Schedule. (a) Financial statements, financial statement schedule and exhibits filed: (a) Consolidated Financial Statements Reports of Independent Registered Public Accounting Firm Donegal Group Inc. and Subsidiaries: Consolidated Balance Sheets at December 31, 2013 and 2012 Consolidated Statements of Income and Comprehensive Income for each of the years in the three-year period ended December 31, 2013, 2012 and 2011 Consolidated Statements of Stockholders’ Equity for each of the years in the three-year period ended December 31, 2013, 2012 and 2011 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2013, 2012 and 2011 Notes to Consolidated Financial Statements Report and Consent of Independent Registered Public Accounting Firm (Filed as Exhibit 23.1) Consent of Independent Registered Public Accounting Firm (Filed as Exhibit 23.2) Consent of Independent Registered Public Accounting Firm (Filed as Exhibit 23.3) (b) Financial Statement Schedule Schedule III — Supplementary Insurance Information Consolidated Financial Statements of Donegal Financial Services Corporation Page 91 57 58 59 60 61 Filed herewith Filed herewith We have omitted all other schedules since they are not required, not applicable or the information is included in the financial statements or notes to the financial statements. (c) Exhibits Description of Exhibits Reference Exhibit No. 3.1 3.2 Certificate of Incorporation of Donegal Group Inc., as amended. Amended and Restated By-laws of Donegal Group Inc. Management Contracts and Compensatory Plans or Arrangements 10.1 10.2 10.3 10.4 10.5 Donegal Group Inc. 2013 Equity Incentive Plan for Employees. Donegal Group Inc. 2013 Equity Incentive Plan for Directors. Donegal Group Inc. 2011 Employee Stock Purchase Plan. Donegal Group Inc. 2011 Equity Incentive Plan for Employees. Donegal Group Inc. 2011 Equity Incentive Plan for Directors. -95- (a) (i) (c) (c) (c) (c) (c) 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 10.14 10.15 10.16 10.17 10.18 10.19 Employment Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Donald H. Nikolaus. Consulting Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Donald H. Nikolaus. Employment Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Kevin G. Burke. Employment Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Cyril J. Greenya. Employment Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Jeffrey D. Miller. (d) (d) (d) (d) (d) Employment Agreement dated as of July 18, 2013 among Donegal Mutual Insurance Company, Donegal Group Inc. and Sanjay Pandey. Filed herewith Employment Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Robert G. Shenk. Employment Agreement dated as of July 29, 2011 among Donegal Mutual Insurance Company, Donegal Group Inc. and Daniel J. Wagner. Donegal Mutual Insurance Company 401(k) Plan. Amendment No. 1 effective January 1, 2000 to Donegal Mutual Insurance Company 401(k) Plan. Amendment No. 2 effective January 6, 2000 to Donegal Mutual Insurance Company 401(k) Plan. Amendment No. 3 effective July 23, 2001 to Donegal Mutual Insurance Company 401(k) Plan. Amendment No. 4 effective January 1, 2002 to Donegal Mutual Insurance Company 401(k) Plan. Amendment No. 5 effective December 31, 2001 to Donegal Mutual Insurance Company 401(k) Plan. 10.20 Amendment No. 6 effective July 1, 2002 to Donegal Mutual Insurance Company 401(k) Plan. 10.21 Donegal Group Inc. 2007 Equity Incentive Plan for Employees. 10.22 Donegal Group Inc. 2007 Equity Incentive Plan for Directors. 10.23 Donegal Group Inc. Incentive Compensation Program. Other Material Contracts 10.24 10.25 10.26 10.27 10.28 10.29 10.30 Reinsurance and Retrocession Agreement dated May 21, 1996 between Donegal Mutual Insurance Company and Southern Insurance Company of Virginia. Surplus Note Purchase Agreement dated September 8, 2009 between Donegal Mutual Insurance Company and Southern Mutual Insurance Company. Quota-share Reinsurance Agreement dated October 30, 2009 but effective 11:59 p.m. on October 31, 2009 between Donegal Mutual Insurance Company and Southern Mutual Insurance Company. Services and Affiliation Agreement dated October 30, 2009 between Donegal Mutual Insurance Company and Southern Mutual Insurance Company. Technology License Agreement dated October 30, 2009 between Donegal Mutual Insurance Company and Southern Mutual Insurance Company. Amended and Restated Proportional Reinsurance Agreement dated March 1, 2010 between Donegal Mutual Insurance Company and Atlantic States Insurance Company. Agreement and Plan of Merger dated April 19, 2010, and as amended May 20, 2010, among Donegal Acquisition Inc., Donegal Financial Services Corporation, Donegal Group Inc. and Union National Financial Corporation; amended dated September 1, 2010; amended dated December 8, 2010. -96- (d) (d) (e) (e) (b) (b) (b) (b) (h) (j) (j) (k) (f) (l) (l) (l) (l) (l) (m) 10.31 10.32 10.33 10.34 10.35 10.36 10.37 10.38 14 21 Amended and Restated Agreement and Plan of Merger dated December 6, 2010 among Michigan Insurance Company, West Bend Mutual Insurance Company, Donegal Group Inc. and DGI Acquisition Corp. Amended and Restated Tax Sharing Agreement dated December 1, 2010 among Donegal Group Inc., Atlantic States Insurance Company, Southern Insurance Company of Virginia, Le Mars Insurance Company, The Peninsula Insurance Company, Peninsula Indemnity Company and Michigan Insurance Company. Amended and Restated Services Allocation Agreement dated December 1, 2010 among Donegal Group Inc., Atlantic States Insurance Company, Southern Insurance Company of Virginia, Le Mars Insurance Company, The Peninsula Insurance Company, Peninsula Indemnity Company and Michigan Insurance Company. Quota-share Reinsurance Agreement dated December 1, 2010 between Donegal Mutual Insurance Company and Michigan Insurance Company. Donegal Group Inc. 2011 Agency Stock Purchase Plan. Credit Agreement dated June 21, 2010 between Donegal Group Inc. and Manufacturers and Traders Trust Company, First Amendment to Credit Agreement dated October 12, 2010 and Second Amendment to Credit Agreement dated June 1, 2011. Third Amendment to Credit Agreement between Donegal Group Inc. and Manufacturers and Traders Trust Company dated June 1, 2012 and Fourth Amendment to Credit Agreement dated December 5, 2012. Fifth Amendment to Credit Agreement between Donegal Group Inc. and Manufacturers and Traders Trust Company dated June 1, 2013. Code of Business Conduct and Ethics. Subsidiaries of Registrant. 23.1 Report and Consent of Independent Registered Public Accounting Firm. 23.2 Consent of Independent Registered Public Accounting Firm. 23.3 Consent of Independent Registered Public Accounting Firm. 31.1 Rule 13a-14(a)/15(d)-14(a) Certification of Chief Executive Officer. 31.2 Rule 13a-14(a)/15(d)-14(a) Certification of Chief Financial Officer. 32.1 Section 1350 Certification of Chief Executive Officer. 32.2 Section 1350 Certification of Chief Financial Officer. Exhibit 10 1.INS Exhibit 10 1.SCH Exhibit 10 1.PRE Exhibit 10 1.CAL Exhibit 10 1.LAB XBRL Instance Document XBRL Taxonomy Extension Schema Document XBRL Taxonomy Presentation Linkbase Document XBRL Taxonomy Calculation Linkbase Document XBRL Taxonomy Label Linkbase Document -97- (n) (o) (o) (o) (p) (q) (r) Filed herewith (g) Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Filed herewith Exhibit 10 1.DEF XBRL Taxonomy Extension Definition Linkbase Document Filed herewith (a) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-Q for the quarterly period ended March 31, 2013. (b) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 2001. (c) We incorporate such exhibit by reference to the like-described exhibit in Registrant's Form 8-K Report dated April 22, 2011. (d) We incorporate such exhibit by reference to the like-described exhibit in Registrant's Form 8-K Report dated August 3, 2011. (e) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 1999. (f) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 1996. (g) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Annual Report for the year ended December 31, 2003. (h) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Annual Report for the year ended December 31, 2002. (i) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 8-K Report dated July 18, 2008. (j) We incorporate such exhibit by reference to the like-numbered exhibit in Registrant’s Form 8-K Report dated April 20, 2007. (k) We incorporate such exhibit by reference to the description of such plan in Registrant’s definitive proxy statement for its Annual Meeting of Stockholders held on April 21, 2011 filed on March 18, 2011. (l) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Annual Report for the year ended December 31, 2009. (m) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form S-4 registration statement filed June 25, 2010, Registrant’s Form 8-K Report dated September 1, 2010 and Registrant’s Form 8-K Report dated December 8, 2010. (n) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 8-K Report dated December 8, 2010. (o) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Annual Report for the year ended December 31, 2010. (p) We incorporate such exhibit by reference to the like-described exhibit filed in Registrant's Form S-3 registration statement filed on May 27, 2011. (q) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Annual Report for the year ended December 31, 2011. (r) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Annual Report for the year ended December 31, 2012. -98- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGNATURES DONEGAL GROUP INC. By: /s/ Donald H. Nikolaus Donald H. Nikolaus, President Date: March 14, 2014 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant in the capacities and on the dates indicated. Signature Title /s/ Donald H. Nikolaus President and a Director Donald H. Nikolaus (principal executive officer) /s/ Jeffrey D. Miller Jeffrey D. Miller /s/ Scott A. Berlucchi Scott A. Berlucchi /s/ Robert S. Bolinger Robert S. Bolinger /s/ Patricia A. Gilmartin Patricia A. Gilmartin Senior Vice President and Chief Financial Officer (principal financial and accounting officer) Director Director Director /s/ Philip H. Glatfelter, II Director Philip H. Glatfelter, II /s/ Jack L. Hess Jack L. Hess /s/ Kevin M. Kraft, Sr. Kevin M. Kraft, Sr. /s/ John J. Lyons John J. Lyons /s/ Jon M. Mahan Jon M. Mahan Director Director Director Director /s/ S. Trezevant Moore, Jr. Director S. Trezevant Moore, Jr. /s/ Richard D. Wampler, II Director Richard D. Wampler, II Date March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 March 14, 2014 -99- [THIS PAGE INTENTIONALLY LEFT BLANK] 2013 ANNUAL REPORT Corporate Information DONEGAL GROUP BOARD OF DIRECTORS Donald H. Nikolaus Chairman of the Board and a Director Director Scott A. Berlucchi Director Robert S. Bolinger Director Patricia A. Gilmartin Director Philip H. Glatfelter, II Director Jack L. Hess Director Kevin M. Kraft, Sr. Director John J. Lyons Director Jon M. Mahan S. Trezevant Moore, Jr. Director Director Richard D. Wampler, II OFFICERS Donald H. Nikolaus Kevin G. Burke Cyril J. Greenya Jeffrey D. Miller Sanjay Pandey Robert G. Shenk Sheri O. Smith Christina M. Springer V. Anthony Viozzi Daniel J. Wagner President and Chief Executive Ofﬁcer Senior Vice President Senior Vice President Senior Vice President and Chief Financial Ofﬁcer Senior Vice President Senior Vice President Secretary Vice President Senior Vice President and Chief Investment Ofﬁcer Senior Vice President and Treasurer ANNUAL MEETING April 17, 2014 at 10:00 a.m. at the Heritage Hotel Lancaster 500 Centerville Road Lancaster, Pennsylvania 17601 CORPORATE OFFICES 1195 River Road P.O. Box 302 Marietta, Pennsylvania 17547-0302 (800) 877-0600 E-mail Address: info@donegalgroup.com Donegal Web Site: www.donegalgroup.com TRANSFER AGENT Computershare Trust Company, N.A. P.O. Box 43078 Providence, Rhode Island 02940-3078 (800) 317-4445 Web Site: www.computershare.com Hearing Impaired: TDD: 800-952-9245 DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN The Company offers a dividend reinvestment and stock purchase plan through its transfer agent. For information contact: Donegal Group Inc. Dividend Reinvestment and Stock Purchase Plan Computershare Trust Company, N.A. P.O. Box 43078 Providence, Rhode Island 02940-3078 STOCKHOLDERS The following represent the number of common stockholders of record as of December 31, 2013: Class A common stock Class B common stock 1,921 344 11111111195 95 9595 95 RivRivRivRivRiverer er er RoaRoaRoaRoRoad, d, d, , P.OP.OP.O. B. B. Box ox ox 302302302 MarMarMarMarietietietie ta,tata,ta, PA PA PAPA 17 1717 17545454547777--03003003003 2222 777171717..424242666.1.1.1931931931 www.donegalgroup.ccomo

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