Donegal Group
Annual Report 2015

Plain-text annual report

DONEGAL GROUP There When It Matters Most. 2015 ANNUAL REPORT DONEGAL GROUP Donegal Group Inc. is an insurance holding company that offers property and casualty insurance through its wholly owned insurance subsidiaries. Our insurance subsidiaries and Donegal Mutual Insurance Company have interrelated operations and conduct business together as the Donegal Insurance Group. The Donegal Insurance Group, which is rated A (Excellent) by A.M. Best Company, offers full lines of personal and commercial insurance products through a network of independent insurance agencies in 21 states. As an effective acquirer of small to medium-sized “main street” property and casualty insurers, we have grown profitably over the last three decades. We employ a multi-faceted strategy that includes prudent organic and acquisition growth, conservative underwriting, pricing discipline, state-of-the-art technological capabilities, efficient operations and conservative investing. Our strategy is designed to allow us to achieve our longstanding goal to outperform the property and casualty insurance industry in terms of service, profitability and book value growth. Achieving that goal provides value to the policyholders of our insurance subsidiaries and to our stockholders. There When It Matters Most. FINANCIAL HIGHLIGHTS YEAR ENDED DECEMBER 31, 2 0 1 5 2 0 1 4 2 0 1 3 2 0 1 2 2 0 1 1 INCOME STATEMENT DATA Premiums earned Investment income, net Realized investment gains Total revenues $ 605,640,728 $ 556,497,535 $ 515,291,944 $ 475,002,222 $ 431,470,184 20,949,698 18,344,382 18,795,239 20,168,919 20,858,179 1,934,424 3,134,081 2,423,442 6,859,439 12,281,267 636,387,263 586,547,742 547,110,065 514,982,585 475,017,619 Income (loss) before income taxes (benefit) 27,592,268 16,282,817 32,710,265 27,858,260 (6,739,313) 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 DA TA AT YEAR END Total investments Total assets Debt obligations Stockholders’ equity Book value per share 6,602,235 1,743,799 6,388,273 4,765,640 (7,192,266) 20,990,033 14,539,018 26,321,992 23,092,620 452,953 0.78 0.77 0.54 0.69 0.69 0.47 0.56 0.55 0.53 0.49 0.49 0.46 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 $ 900,822,274 $ 832,941,077 $ 791,808,307 $ 806,429,032 $ 785,308,991 1,537,834,415 1,458,654,644 1,385,410,502 1,336,889,187 1,290,793,478 86,000,000 58,500,000 63,000,000 72,465,000 74,965,000 408,388,568 416,134,643 396,877,111 400,034,094 383,451,592 15.66 15.40 15.02 15.63 15.01 $ 650 $ 600 $ 550 $ 500 $ 30 $ 20 $ 10 $ 450 $ 400 $ 350 $ 300 1 $ 450 11 12 13 14 15 $ 0 11 12 13 14 15 $ 250 11 12 13 14 15 TOTAL REVENUES [ in millions ] NET INCOME [ in millions ] STOCKHOLDERS’ EQUITY [ in millions ]  TO OUR STOCKHOLDERS Donegal Group achieved strong performance across nearly all lines of business in 2015. The favorable results reinforce our commitment to our regional business approach and conservative underwriting philosophy, while also confirming that we are making meaningful progress toward our long-term objective of outperforming the property and casualty insurance industry in terms of service, profitability and book value growth. There When It Matters Most. 2 Our insurance subsidiaries offer a steadfast commitment to our independent insurance agents and policyholders to be there when it matters most. We continued to expand our marketing presence in the regional insurance markets we currently serve. Our total net premiums earned increased by 8.8 percent, once again representing a combination of solid organic growth and the ongoing benefits of the premium rate increases we have implemented in the past several years. The higher premiums drove the 8.5 percent growth in our total revenues for 2015 to $636.4 million, compared to $586.5 million for 2014. Our 2015 net income was $21.0 million, or 77 cents per share of our Class A common stock on a diluted basis, compared to $14.5 million, or 55 cents per share of our Class A common stock on a diluted basis, for 2014. Our statutory combined ratio for 2015 was 97.4 percent, which represented significant improvement from our 2014 statutory combined ratio of 100.5 percent. We attribute our higher level of underwriting profitability in 2015 to lower-than-average weather-related losses and excellent results in our commercial lines segment. Our insurance subsidiaries offer a steadfast commitment to our independent insurance agents and policyholders to be there when it matters most. We believe that commitment was integral to our continued expansion in 2015, with organic growth across all regions representing the majority of the 8.6 percent increase in our net premiums written for 2015. Throughout 2015, growth in our net premiums written also reflected an additional $19.6 million of net writings from our Michigan Insurance Company (“MICO”) subsidiary. We completed the incremental acquisition strategy we planned when we acquired MICO in December 2010 by terminating MICO’s external quota-share reinsurance agreement effective January 1, 2015. Our 2015 consolidated results benefited from MICO retaining a larger portion of its underwriting results, which were more profitable than the underwriting results MICO experienced in the preceding four years. MICO’s increased profitability resulted from more favorable weather conditions and a lower incidence of larger casualty losses compared to prior years, as well as expense savings MICO has achieved as a result of its integration into the operations of the Donegal Insurance Group. We appreciate the ongoing support of all our agents, from some who have recently begun to represent the Donegal Insurance Group to their customers to the many agents who have represented our family of companies for decades. Our commitment to the independent agency distribution system means that our success is dependent on the relationships we build and maintain with each of our agents. We demonstrate our value to our agents by providing them with quality insurance products, responsive service and state-of-the-art technology tools that make it easy for our agents and policyholders to do business with us. 3 We execute our business plan with the objective of continued profitable growth in our regional insurance markets in 2016. We best fulfill our commitment to be there when it matters most by providing responsive claims service to our policyholders. We strive to manage claims efficiently, and routinely receive excellent satisfaction ratings in response to post-claim surveys that we send to our policyholders to monitor the quality of our claims service. We continue to strive to enhance further that efficiency and service quality by our expanding use of automation tools, working with selected vendors to provide value- added services to claimants, providing additional resources and training for our claims personnel and implementing claim cost containment programs. During 2015, Donegal Mutual began implementing a new policy billing system and a new personal lines rating system, both of which will replace legacy mainframe-based systems and provide an enhanced level of service to our agents and policyholders. Our book value rose to $15.66 per share of our common stock at December 31, 2015, compared to $15.40 at December 31, 2014. That growth primarily reflected our net income during 2015, partially offset by a decrease in the market value of our available-for-sale fixed-maturity investment portfolio that resulted from increases in market interest rates during the year. We appreciate the confidence in our business strategy that you have demonstrated by investing in Donegal Group. We execute our business plan with the objective of continued profitable growth in our regional insurance markets in 2016. As we annually strive for prudent growth and increased underwriting profitability, we believe our efforts will result in long-term value for our stockholders. 4 Donald H. Nikolaus CHAIRMAN OF THE BOARD OF DIRECTORS Kevin G. Burke PRESIDENT AND CHIEF EXECUTIVE OFFICER There When It Matters Most. 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, 2015 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. $229,069,047. Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 20,570,874 shares of Class A common stock and 5,576,775 shares of Class B common stock outstanding on March 16, 2016. 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 21, 2016 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. Properties Legal Proceedings Item 4. Mine Safety Disclosures Executive Officers of the Registrant 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 Financial Condition and Results of Operations 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 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 Accounting Fees and Services PART IV Item 15. Exhibits, Financial Statement Schedules Page 1 23 34 34 34 34 35 36 39 40 54 57 93 93 94 96 96 96 96 96 97 (i) PART I Item 1. Business. Introduction 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 21 Mid-Atlantic, Midwestern, New England and Southern states. As used in this Form 10-K Report, 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, 2015, Donegal Mutual held approximately 48% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. Donegal Mutual’s ownership provides Donegal Mutual with approximately 74% 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 an intercompany 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 pursue opportunities 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 our insurance subsidiaries 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 74% of the aggregate voting power of our common stock, has proven its effectiveness and success over the 29 years of our existence. Over that time period, 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 15 banking offices, substantially 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 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. -1- Available Information You may obtain our Annual Reports on Form 10-K, including this Form 10-K 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 on our website our Code of Business Conduct and Ethics and the charters of the executive committee, the audit committee, the compensation committee and the nominating committee of our board of directors. 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 Report. History and Organizational Structure In the mid-1980’s, Donegal Mutual, as a mutual insurance company, recognized the desirability 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. Accordingly, Donegal Mutual determined to implement a downstream holding company structure as one of its business strategies. Thus, 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 formation of Atlantic States and the establishment of 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 Atlantic States. Donegal Mutual and Atlantic States share the underwriting results in proportion to their respective participation in the underwriting pool. Since we established Atlantic States in 1986, Donegal Mutual and our insurance subsidiaries have conducted business together as the Donegal Insurance Group. As the Donegal Insurance Group, Donegal Mutual and our insurance subsidiaries share a combined business plan to enhance market penetration and underwriting profitability objectives. 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 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 has increased proportionately. The size of the underwriting pool has also 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. 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, including any change in the percentage participation of Atlantic States in the underwriting pool. In addition to Atlantic States, our insurance subsidiaries are 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 -2- Insurance Company, or Southern Mutual, and Donegal Mutual’s placement of its assumed business from Southern Mutual into the underwriting pool. The following chart depicts our organizational structure, including 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 our Class B common stock, our public (1) stockholders hold approximately 26% of the aggregate voting power of our Class A common stock and our Class B common stock and Donegal Mutual holds approximately 74% of the aggregate voting power of our Class A common stock and our 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 they maintain. 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 each subsidiaries’ respective percentage of the total net written premiums of the Donegal Insurance Group. Charges for these services to Atlantic States and our other insurance subsidiaries totaled $108.5 million, $98.6 million and $94.0 million for 2015, 2014 and 2013, respectively. Our insurance subsidiaries have various reinsurance arrangements with Donegal Mutual. These agreements include: • • • excess of loss reinsurance agreements with Le Mars, MICO, Peninsula, Sheboygan and Southern; catastrophe reinsurance agreements with Atlantic States, Le Mars and Southern; and quota-share reinsurance agreements with Le Mars, MICO and Peninsula. 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 amount of surplus. 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. -3- 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 availability of an additional workers’ compensation tier for 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. 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 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; • our board of directors must approve the new agreement or the change in an existing agreement; and • Donegal Mutual’s board of directors must approve the new agreement or the change in an existing agreement. 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 several years 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 to the terms of the agreements. 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 2016 in the ordinary course of our business. Our members on the coordinating committee, as of the date of this Form 10-K Report, are Robert S. Bolinger and Richard D. Wampler, II. 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 21, 2016 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 allow us to acquire all of their outstanding stock; 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; -4- • • 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 first quarter of 2016, our board of directors and the board of directors of Donegal Mutual each undertook a review of the relationships between 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 $605.6 million in 2015, a compound annual growth rate of 7.8%. 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 2011 through 2015 are shown in the following table: Our GAAP combined ratio (1) Our SAP combined ratio Industry SAP combined ratio (2) 2015 2014 2013 2012 2011 99.0% 101.7% 98.8% 101.6% 110.6% 97.4 98.0 100.5 97.4 97.4 96.4 99.8 102.5 107.9 106.5 (1) Our GAAP combined ratio for 2011 was adversely affected by accounting adjustments related to the acquisition of MICO. (2) As reported (projected for 2015) 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. A detailed review of our business strategies follows: • Achieving underwriting profitability. Our insurance subsidiaries focus on achieving a combined ratio of less than 100%. 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; -5- • 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. • 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 the product offerings of our insurance subsidiaries enables our insurance subsidiaries to compete effectively for independent agents with other insurers whose product offerings may 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. • 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; annual premium volume up to $100.0 million; and -6- • fair and reasonable transaction terms. We believe that our relationship 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. 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 we make any public disclosure regarding a proposed acquisition until Donegal Mutual or we have entered into a definitive acquisition agreement. -7- 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 with that financing, 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 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: • availability of a customer call center for claims reporting; -8- • • • 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 maintain discipline in their pricing by effecting rate increases to sustain 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, our insurance subsidiaries are generally able to achieve 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 expense control. 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 32.6% in 2015. 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 $956,000 in 2015. 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 result in policy issuance 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 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 -9- 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 small percentage (4.1% at December 31, 2015) 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 Commercial multi-peril Workers’ compensation Other Total commercial lines Total business Year Ended December 31, 2015 2014 2013 Amount % Amount % Amount % $ 214,610 34.1% $ 204,174 35.3% $ 196,363 36.8% 119,541 18,176 352,327 76,729 94,219 98,079 7,483 276,510 19.0 2.9 56.0 12.2 15.0 15.6 1.2 44.0 113,576 16,989 334,739 65,552 83,413 88,739 6,758 244,462 19.6 2.9 57.8 11.3 14.4 15.3 1.2 42.2 106,420 15,915 318,698 58,165 74,516 77,589 4,463 214,733 20.0 3.0 59.8 10.9 14.0 14.5 0.8 40.2 $ 628,837 100.0% $ 579,201 100.0% $ 533,431 100.0% 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 primarily standard and preferred risks; adhere to disciplined 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 2,400 independent insurance agencies. At December 31, 2015, the Donegal Insurance Group actively wrote business in 21 states (Alabama, Delaware, Georgia, Indiana, Iowa, Maine, Maryland, Michigan, Nebraska, New Hampshire, New York, North Carolina, Ohio, 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 our insurance subsidiaries 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 2015: Pennsylvania Michigan Maryland Virginia Georgia Delaware Ohio Wisconsin Iowa Nebraska Tennessee South Dakota Other Total 36.6% 16.1 8.8 8.8 6.0 5.6 3.5 3.5 2.5 2.2 2.2 1.1 3.1 100.0% Our insurance subsidiaries employ a number of policies and procedures that we believe enable them to attract, retain and motivate their independent agents. We believe that the consistency of the product offerings of our insurance subsidiaries enables our insurance subsidiaries to compete 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 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 during the preceding calendar year. -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 and mobile applications. 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 investigate 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 claims 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, 2015. 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 $3.2 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 of future liabilities have exceeded their actual liabilities. Changes in our insurance subsidiaries’ estimates 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 in their liability for losses and loss expenses of prior years of $7.2 million, $14.5 million and $10.4 million in 2015, 2014 and 2013, 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 2015 development represented 2.5% of the December 31, 2014 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability, commercial multiple peril and commercial automobile lines of business in accident years prior to 2015. The majority of the 2015 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. The 2014 development represented 5.4% of the December 31, 2013 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability, commercial multiple peril and commercial automobile lines of business in accident years prior to 2014. The majority of the 2014 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. 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. 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 -14- 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 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, 2015. 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 $15.3 million, $14.2 million and $13.1 million at December 31, 2015, 2014 and 2013, 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, 2015 2014 2013 Gross liability for unpaid losses and loss expenses at beginning of year $ 538,258 $ 495,619 $ 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 245,957 292,301 230,014 265,605 7,200 398,367 236,835 131,779 368,614 322,054 256,151 14,469 388,401 229,939 131,766 361,705 292,301 245,957 Gross liability for unpaid losses and loss expenses at end of year $ 578,205 $ 538,258 $ 391,167 373,932 332,770 458,827 207,891 250,936 10,358 343,128 201,782 126,677 328,459 265,605 230,014 495,619 The following table sets forth the development of the liability for net unpaid losses and loss expenses of our insurance subsidiaries from 2005 to 2015. 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 ten years because we expect the re-estimated net losses and loss expenses to be $20.9 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, 2015 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. -15- 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 indicates that at December 31, 2015 payments equal to $148.9 million of the currently re-estimated ultimate liability for net losses and loss expenses of $152.1 million had been made. 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) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Year Ended December 31, Net liability at end of year for unpaid losses and loss expenses Net liability re- estimated as of: $173,009 $163,312 $150,152 $161,307 $180,262 $217,896 $243,015 $250,936 $265,605 $292,301 $322,054 One year later 159,393 153,299 152,836 171,130 177,377 217,728 250,611 261,294 280,074 299,501 Two years later 153,894 150,934 154,435 167,446 177,741 217,355 255,612 268,877 281,782 Three years later 151,792 150,078 152,315 166,756 178,403 218,449 257,349 270,473 Four years later 150,183 148,745 151,120 166,852 179,909 218,514 256,460 Five years later 150,087 148,407 151,287 166,788 179,961 218,202 Six years later 150,555 149,031 151,739 166,964 179,858 Seven years later 151,161 149,487 151,790 167,425 Eight years later 151,243 149,700 152,240 Nine years later 151,563 150,241 Ten years later 152,110 Cumulative (excess) deficiency Cumulative amount of liability paid through: (20,899) (13,071) 2,088 6,118 (404) 306 13,445 19,537 16,177 7,200 One year later $ 71,718 $ 72,499 $ 71,950 $ 79,592 $ 84,565 $ 96,202 $119,074 $126,677 $131,766 $131,779 Two years later 107,599 104,890 105,576 116,035 123,204 148,140 181,288 191,208 194,169 Three years later 125,926 121,711 124,659 136,837 147,165 178,073 217,138 225,956 Four years later 133,805 132,698 135,392 148,243 161,363 195,948 234,392 Five years later 139,935 138,878 140,280 155,331 169,452 203,633 Six years later 143,309 141,752 143,778 160,324 173,153 Seven years later 145,492 143,784 146,491 162,531 Eight years later 146,894 145,290 148,235 Nine years later 147,757 146,557 Ten years later 148,939 (in thousands) 2007 2008 2009 2010 2011 2012 2013 2014 2015 Year Ended December 31, 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 $226,432 $239,809 $263,599 $383,317 $442,408 $458,827 $495,619 $538,258 $578,205 76,280 78,502 83,337 165,421 199,393 207,891 230,014 245,957 256,151 150,152 161,307 180,262 217,896 243,015 250,936 265,605 292,301 322,054 230,189 250,509 201,808 363,806 459,035 483,226 492,540 512,458 77,949 83,084 21,950 145,604 202,575 212,753 210,758 212,957 152,240 167,425 179,858 218,202 256,460 270,473 281,782 299,501 Gross cumulative deficiency (excess) 3,757 10,700 (61,791) (19,511) 16,627 24,399 (3,079) (25,800) -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 the losses of Donegal Mutual and our insurance subsidiaries are automatically reinsured, through a series of contracts, over a set retention (generally $1.0 million); and catastrophe reinsurance, under which Donegal Mutual and our insurance subsidiaries 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 ($1.5 million in 2015 and 2014 and $5.0 million in 2013) up to aggregate losses of $149.0 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 and after exceeding an annual aggregate deductible ($1.0 million in 2015, 2014 and 2013). 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. For policies effective through December 31, 2014, MICO maintained 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 to 40%. Effective January 1, 2013, MICO reduced the quota-share reinsurance percentage to 30%. Effective January 1, 2014, MICO reduced the quota-share reinsurance percentage to 20%. Effective January 1, 2015, MICO no longer maintains a quota-share reinsurance agreement with third-party reinsurers. Investments At December 31, 2015, 99.8% 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, 2015. -17- 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, 2015: (dollars in thousands) (1) Rating U.S. Treasury and U.S. agency securities(2) Aaa or AAA Aa or AA A BBB B Total December 31, 2015 Amount Percent $ 317,862 39.2% 24,467 266,757 143,164 57,395 2,007 3.0 32.9 17.6 7.1 0.2 $ 811,652 100.0% (1) Ratings assigned by Moody’s Investors Services, Inc. or Standard & Poor’s Corporation. (2) Includes mortgage-backed securities of $229.5 million. 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 40.9%, 50.2% and 59.0% of the fixed-maturity securities in the combined investment portfolios of our insurance subsidiaries at December 31, 2015, 2014 and 2013, respectively. -18- The following table shows the classification of our investments and the investments of our insurance subsidiaries at December 31, 2015, 2014 and 2013 (at carrying value): 2015 December 31, 2014 2013 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 $ 51,194 5.7% $ 53,619 6.4% $ 47,946 6.1% Obligations of states and political subdivisions 119,115 Corporate securities Mortgage-backed securities Total held to maturity Available for sale: 65,307 74,643 310,259 U.S. Treasury securities and obligations of U.S. government corporations and agencies 37,189 Obligations of states and political subdivisions 236,556 Corporate securities Mortgage-backed securities Total available for sale Total fixed maturities Equity securities(2) Investment in affiliate(3) Short-term investments(4) Total investments 13.2 7.2 8.3 34.4 4.1 26.3 8.1 17.2 55.7 90.1 4.1 4.3 1.5 110,999 52,226 90,548 307,392 21,259 266,242 53,945 93,704 435,150 742,542 30,822 39,284 20,293 13.3 6.3 10.9 36.9 2.5 32.0 6.5 11.2 52.2 89.1 3.7 4.7 2.5 108,435 14,875 69,114 240,370 14,334 277,547 40,672 71,099 403,652 644,022 12,423 35,685 99,678 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 72,812 154,836 501,393 811,652 37,261 38,477 13,432 $ 900,822 100.0% $ 832,941 100.0% $ 791,808 100.0% (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 $322.8 million at December 31, 2015, $322.2 million at December 31, 2014 and $238.8 million at December 31, 2013. The amortized cost of fixed maturities we classified as available for sale was $489.0 million at December 31, 2015, $414.2 million at December 31, 2014 and $390.3 million at December 31, 2013. (2) We value equity securities at fair value. Total cost of equity securities was $35.8 million at December 31, 2015, $30.0 million at December 31, 2014 and $12.2 million at December 31, 2013. (3) We value our investment in our affiliate at cost, adjusted for our share of earnings and losses of our affiliate as well as changes in equity of our affiliate due to unrealized gains and losses. (4) We value short-term investments at cost, which approximates fair value. -19- The following table sets forth the maturities (at carrying value) in the fixed maturity portfolio of our insurance subsidiaries at December 31, 2015, 2014 and 2013: (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 2015 Percent of Total Amount December 31, 2014 Percent of Total Amount 2013 Percent of Total Amount $ 20,990 2.6% $ 32,886 4.4% $ 8,257 1.3% 66,505 66,410 202,122 172,429 53,717 229,479 8.2 8.2 24.9 21.2 6.6 28.3 45,967 62,417 189,082 169,182 58,756 184,252 6.2 8.4 25.5 22.8 7.9 24.8 22,424 40,234 190,440 166,186 76,267 140,214 3.5 6.2 29.6 25.8 11.8 21.8 $ 811,652 100.0% $ 742,542 100.0% $ 644,022 100.0% (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 $229.5 million at December 31, 2015. The mortgage-backed securities consist primarily of investments in governmental agency balloon pools with stated maturities between one and 35 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, 2015, 2014 and 2013: (dollars in thousands) Invested assets(1) Investment income(2) Average yield Average tax-equivalent yield Year Ended December 31, 2015 2014 2013 $ 866,882 $ 812,375 $ 799,119 20,950 18,344 18,795 2.4% 3.1 2.3% 3.1 2.4% 3.3 (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 their 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. -20- 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, maintains a risk-based capital system, or RBC, for assessing the adequacy of the statutory capital and surplus of insurance companies that augments the states’ current fixed dollar minimum capital requirements for insurance companies. At December 31, 2015, our insurance subsidiaries and Donegal Mutual each exceeded by a substantial margin the minimum levels of statutory capital the RBC rules require. 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 with the Department 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. 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 the states 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 Donegal Mutual’s ownership of 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 -21- 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, 2015. Generally, the maximum amount that one of our insurance subsidiaries 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 $3.9 million, $11.5 million and $12.5 million in 2015, 2014 and 2013, respectively. At December 31, 2015, the amount of dividends our insurance subsidiaries could pay to us during 2016, without the prior approval of their respective domiciliary insurance commissioners, is shown in the following table. Name of Insurance Subsidiary Atlantic States Le Mars MICO Peninsula Sheboygan Southern Total Ordinary Dividend Amount $ 20,763,682 2,616,887 4,619,953 4,183,814 1,325,412 2,301,009 $ 35,810,757 Donegal Mutual Insurance Company Donegal Mutual organized as a mutual fire insurance company in Pennsylvania in 1889. At December 31, 2015, Donegal Mutual had admitted assets of $431.2 million and policyholders’ surplus of $209.4 million. At December 31, 2015, Donegal Mutual had total liabilities of $221.7 million, including reserves for net losses and loss expenses of $59.8 million and unearned premiums of $50.0 million. Donegal Mutual’s investment portfolio of $261.6 million at December 31, 2015 consisted primarily of investment-grade bonds of $21.2 million, its investment in DFSC’s common stock and its investment in our Class A common stock and our Class B common stock. At December 31, 2015, Donegal Mutual owned 9,851,025 shares, or approximately 48%, of our Class A common stock, which Donegal Mutual carried on its books at $131.1 million, and 4,647,038 shares, or approximately 83%, of our Class B common stock, which Donegal Mutual carried on its books at $61.9 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 15 banking offices, substantially all of which are located in Lancaster County, Pennsylvania, and approximately $507.8 million in assets at December 31, 2015. 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. 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 -22- supervision of financial institutions is to protect depositors, the financial institutions and the financial system as a whole rather than the stockholders of financial institutions or their holding companies. 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 and our respective subsidiaries. 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 Report and the documents we incorporate by reference in this Form 10-K 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 2015 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 and 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 condition or results of operations. Such factors may include those we describe under “Risk Factors.” The forward-looking statements contained in this Form 10-K 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 eleven 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 our insurance subsidiaries and Donegal Mutual. Our objective, over the long-term, is for these agreements to have approximately an 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 • We 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 subsequently convert into a stock insurance company and ultimately become one of our wholly owned subsidiaries. -23- 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. Each share of our Class B common stock has one vote per share and generally votes as a single class with our Class A common stock. Donegal Mutual has the right to vote approximately 74% 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 stockholders other than Donegal Mutual vote their shares. The interests of Donegal Mutual in maintaining this greater-than-majority voting 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 of us, 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 another person’s acquisition of control of us. Donegal Mutual’s majority voting control of us, 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 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 rules of the NASDAQ Global Select Market otherwise require, 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 may make it more difficult for a third party to acquire control of us. -24- 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 each 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 commissioners of those states and obtaining the prior approval of the proposed acquisition of a 10% or greater interest in us by each of the state insurance commissioners based on statutory standards designed to protect the safety and soundness of us and our insurance subsidiaries. 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, as we are, 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 for such acquisition. 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 21 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 their respective exposure to catastrophes through their underwriting processes 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 2,400 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 one or more of 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 -25- 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: • • • • 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 may limit 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 2016 without prior regulatory approval is approximately $35.8 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 of the other insurer; the need to supplement management of the other insurer with additional experienced personnel; conditions imposed by regulatory agencies that make the realization of cost-savings through integration of the operations of the other insurer with our operations more difficult; -26- • • the need of the other insurer for additional capital that we did not anticipate at the time of the acquisition or affiliation; and the use of more of our management’s time in improving the operations of the other insurer 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. -27- 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 investment 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 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 our financial plans, growth, marketing and other objectives and those of 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, 2015, our insurance subsidiaries had approximately $115.3 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, 2015, MICO had approximately $53.5 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. -28- 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, either of which could adversely affect them. 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 results of operations 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 of banking organizations; 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. The growth and profitability of our insurance subsidiaries depend, in part, on the effective maintenance and ongoing development of Donegal Mutual’s information technology systems. Our insurance subsidiaries utilize Donegal Mutual’s information technology systems to conduct their insurance business, including policy quoting and issuance, claims processing, processing of incoming premium payments and other important functions. As a result, the ability of our insurance subsidiaries to grow their business and conduct profitable operations depends on Donegal Mutual’s ability to maintain its existing information technology systems and to develop new technology systems that will support the business of Donegal Mutual and our insurance subsidiaries in a cost-efficient manner and provide information technology capabilities equivalent to those of our competitors. The allocation among our insurance subsidiaries and Donegal Mutual of the costs of developing and maintaining Donegal Mutual’s information technology systems may impact adversely our insurance subsidiaries’ expense ratio and underwriting profitability, and such costs may exceed Donegal Mutual’s and our expectations. In addition, while Donegal Mutual is committed to developing and maintaining information technology systems that will allow Donegal Mutual and our insurance subsidiaries to compete effectively, Donegal Mutual’s information technology systems may not deliver the benefits Donegal Mutual and we expect and may fail to keep pace with our competitors’ information technology systems. As a result, Donegal Mutual and our insurance subsidiaries may not have the ability to grow their business and meet their profitability objectives. Our insurance subsidiaries rely on Donegal Mutual’s information technology systems, and the disruption or failure of these systems or the compromise of the security of those systems that results in the theft or misuse of confidential information could materially impact adversely the business of Donegal Mutual and our insurance subsidiaries. Our insurance subsidiaries’ business operations depend significantly upon the availability and successful operation of Donegal Mutual’s information technology systems in order to process new and renewal business, service their policies, process and settle claims and facilitate processing of premium payments. In addition, in the normal course of their operations, Donegal Mutual and our insurance subsidiaries collect, utilize and maintain confidential information regarding individuals and businesses. While Donegal Mutual has established various security measures to protect its information technology systems and confidential data, unanticipated computer viruses, malware, power outages, unauthorized access or other cyberattacks could disrupt those systems or result in the misappropriation or loss of confidential data. Disruption in the availability of Donegal Mutual’s information technology systems could impact the ability of Donegal Mutual and our insurance subsidiaries to underwrite and process their policies timely, process and settle claims promptly and provide expected levels of customer service to agents and policyholders. -29- While Donegal Mutual has identified threats to the security of its information technology systems, Donegal Mutual and we are unaware of any significant breach of the security measures Donegal Mutual maintains. A significant breach of the security of Donegal Mutual’s information technology systems that results in the misappropriation or misuse of confidential information could damage the business reputation of Donegal Mutual and our insurance subsidiaries and could expose Donegal Mutual and our insurance subsidiaries to litigation. The financial impact to Donegal Mutual, us and our insurance subsidiaries of a significant breach could be material. 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 for personal lines insurance products where allowed by state law. 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 insurance 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; • 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. -30- 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 of investment securities; 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 are subject to 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. 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 our insurance subsidiaries incur. 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 between the occurrence of an insured loss and 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 of pending and unreported claims. The process of estimating reserves is inherently judgmental and can be influenced by a number of factors, including the following: -31- • • • • • 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 our insurance subsidiaries recognize a deficiency in reserves. Accordingly, an increase in reserves may adversely impact the business, liquidity, financial condition and results of operations of our insurance subsidiaries. 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 realize 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; 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; -32- • • 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, 2015 was approximately 21,447 shares and approximately 115 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 majority voting control 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 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. -33- 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 235,000 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. Mine Safety Disclosures. Not applicable. -34- Executive Officers of the Registrant The following table sets forth information regarding the executive officers of Donegal Mutual and the Registrant as of December 31, 2015, each of whom has served with us for more than 10 years: Name Donald H. Nikolaus Age Kevin G. Burke Jeffrey D. Miller Cyril J. Greenya Sanjay Pandey Position 73 President and Chief Executive Officer of Donegal Mutual since 1981; President and Chief Executive Officer of us from 1986 to 2015. Chairman of our board of directors since April 2012. 50 President and Chief Executive Officer of us since 2015; Executive Vice President and Chief Operating Officer of Donegal Mutual since 2014; Senior Vice President of Human Resources of Donegal Mutual and us from 2005 to 2014; Vice President of Human Resources of Donegal Mutual and us from 2001 to 2005; other positions from 2000 to 2001. 51 Executive Vice President and Chief Financial Officer of Donegal Mutual and us since 2014; Senior Vice President and Chief Financial Officer of Donegal Mutual and us from 2005 to 2014; Vice President and Controller of Donegal Mutual and us from 2000 to 2005; other positions from 1995 to 2000. 71 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 1997. 49 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 62 Senior Vice President, Claims, of Donegal Mutual and us since 1997; other positions from 1986 to 1997. Daniel J. Wagner 55 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 2000. -35- 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 declared per share and the stock price range for both classes of stock for each quarter during 2015 and 2014: Quarter 2015 - Class A 1st 2nd 3rd 4th 2015 - Class B 1st 2nd 3rd 4th 2014 - Class A 1st 2nd 3rd 4th 2014 - Class B 1st 2nd 3rd 4th High Low Cash Dividend Declared Per Share $ 16.47 15.99 15.48 14.87 $ 14.53 $ — 14.29 0.1350 13.45 0.1350 13.05 0.2700 $ 27.00 20.95 21.60 18.72 $ 18.95 $ — 18.00 0.1175 18.54 0.1175 16.00 0.2350 $ 15.96 $ 13.84 $ — 15.90 16.18 16.10 14.05 0.1315 15.00 0.1315 14.96 0.2630 $ 26.01 $ 21.14 $ — 27.75 24.90 23.88 18.26 0.1160 21.00 0.1160 21.00 0.2320 At the close of business on March 16, 2016, we had approximately 1,891 holders of record of our Class A common stock and approximately 316 holders of record of our Class B common stock. We declared dividends of $0.54 per share on our Class A common stock and $0.47 per share on our Class B common stock in 2015, compared to $0.526 per share on our Class A common stock and $0.464 per share on our Class B common stock in 2014. -36- Between October 1, 2015 and December 31, 2015, 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 or 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, 2015 Class A — — Class B — — Class A — $— Class B — $— Class A — — Class B — — Month #2 November 1-30, 2015 Class A — — Class B — — Class A — $— Class B — $— Class A — — Class B — — Month #3 December 1-31, 2015 Class A — 3,675,000 Class B — 400,000 Class A — $16.50 Class B — $23.50 Class A — — Class B — — (1) (1) Total Class A — 3,675,000 Class B — 400,000 Class A — $16.50 Class B — $23.50 Class A — — Class B — — (1) On December 22, 2015, we repurchased 2,000,000 shares of our Class A common stock in a private transaction that was unrelated to our share repurchase program. As part of the same transaction, Donegal Mutual purchased 1,675,000 shares of our Class A common stock and 400,000 shares of our Class B common stock. -37- 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, 2010 and ending on December 31, 2015, 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, 2010, assuming reinvestment of all dividends. 2010 2011 2012 2013 2014 2015 Donegal Group Inc. Class A $100.00 $101.52 $104.25 $122.26 $127.18 $116.09 Donegal Group Inc. Class B Russell 2000 Index Peer Group 100.00 100.00 100.00 95.63 94.55 92.82 107.39 108.38 117.61 144.07 148.49 168.17 133.54 153.73 180.24 105.02 144.95 209.88 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 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. -38- Item 6. Selected Financial Data. Year Ended December 31, 2015 2014 2013 2012 2011 Income Statement Data Premiums earned $ 605,640,728 $ 556,497,535 $ 515,291,944 $ 475,002,222 $ 431,470,184 Investment income, net 20,949,698 18,344,382 18,795,239 20,168,919 20,858,179 Realized investment gains 1,934,424 3,134,081 2,423,442 6,859,439 12,281,267 636,387,263 586,547,742 547,110,065 514,982,585 475,017,619 Total revenues Income (loss) before income taxes (benefit) 27,592,268 16,282,817 32,710,265 27,858,260 Income taxes (benefit) 6,602,235 1,743,799 6,388,273 4,765,640 Net income 20,990,033 14,539,018 26,321,992 23,092,620 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 0.78 0.77 0.54 0.69 0.69 0.47 0.56 0.55 0.53 0.49 0.49 0.46 1.04 1.02 0.51 0.94 0.94 0.46 0.92 0.91 0.49 0.83 0.83 0.44 (6,739,313) (7,192,266) 452,953 0.02 0.02 0.48 0.01 0.01 0.43 Total investments Total assets Debt obligations Stockholders’ equity Book value per share $ 900,822,274 $ 832,941,077 $ 791,808,307 $ 806,429,032 $ 785,308,991 1,537,834,415 1,458,654,644 1,385,410,502 1,336,889,187 1,290,793,478 86,000,000 58,500,000 63,000,000 72,465,000 74,965,000 408,388,568 416,134,643 396,877,111 400,034,094 383,451,592 15.66 15.40 15.02 15.63 15.01 -39- Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 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, 2015, Donegal Mutual held approximately 48% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 74% 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 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 3,222 and 846 shares of our Class A common stock under this program during 2015 and 2014, respectively. As of December 31, 2015, we had no remaining authority to purchase 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 purchased 57,658 shares of our Class A common stock under this program during 2015. We did not purchase any shares of our Class A common stock under this program during 2014. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through December 31, 2015. On December 18, 2015, we and Donegal Mutual entered into a Stock Purchase and Standstill Agreement (the “Purchase Agreement”) with Gregory M. Shepard (“Mr. Shepard”). Under the terms of the Purchase Agreement, we purchased 2,000,000 shares of our Class A common stock from Mr. Shepard on December 22, 2015 for a price of $33.0 million, or $16.50 per share, representing a premium of approximately $5.8 million from the market price of our Class A common stock on the date of the Purchase Agreement. We reported this premium in excess of the market price as an expense in our consolidated statements of income and comprehensive income that we include in this Form 10-K Report. We borrowed $33.0 million under our existing line of credit with M&T Bank to fund the purchase. The Purchase Agreement contains a number of typical “standstill” provisions pursuant to which Mr. Shepard and any affiliate of Mr. Shepard agree not to take a number of “control-seeking” actions with respect to us for a period of 25 years from the date of the Purchase Agreement. -40- 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 results of operations for the period in which we make an adjustment. 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 to the insurer. 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, 2015. 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 $3.2 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 -41- 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 in their liability for losses and loss expenses of prior years of $7.2 million, $14.5 million and $10.4 million in 2015, 2014 and 2013, 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 2015 development represented 2.5% of the December 31, 2014 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability, commercial multiple peril and commercial automobile lines of business in accident years prior to 2015. 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 at December 31, 2015. 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, 2015 and 2014 consisted of the following: Commercial lines: Automobile Workers’ compensation Commercial multi-peril Other 2015 2014 (in thousands) $ 53,938 99,212 54,395 3,119 $ 44,270 89,995 48,499 2,679 Total commercial lines 210,664 185,443 Personal lines: Automobile Homeowners Other 93,923 15,816 1,651 90,207 15,053 1,598 Total personal lines 111,390 106,858 Total commercial and personal lines 322,054 292,301 Plus reinsurance recoverable Total liability for losses and loss expenses 256,151 $ 578,205 245,957 $ 538,258 -42- 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, 2015 Percentage Change in Equity at December 31, 2015(1) (dollars in thousands) Adjusted Loss and Loss Expense Reserves Net of Reinsurance at December 31, 2014 Percentage Change in Equity at December 31, 2014(1) -10.0% $289,849 5.1% $263,071 4.6% -7.5 -5.0 -2.5 Base 2.5 5.0 7.5 10.0 297,900 305,951 314,003 322,054 330,105 338,157 346,208 354,259 (1) Net of income tax effect. 3.8 2.6 1.3 — -1.3 -2.6 -3.8 -5.1 270,378 277,686 284,993 292,301 299,609 306,916 314,224 321,531 3.4 2.3 1.1 — -1.1 -2.3 -3.4 -4.6 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, 2015, the actuaries developed a range from a low of $293.3 million to a high of $353.7 million and with a most-likely number of $322.1 million. The actuaries’ range of estimates for commercial lines in 2015 was $191.9 million to $231.3 million, and the actuaries selected the most-likely number of $210.7 million. The actuaries’ range of estimates for personal lines in 2015 was $101.4 million to $122.4 million, and the actuaries selected the most-likely number of $111.4 million. For the year ended December 31, 2014, the actuaries developed a range from a low of $266.3 million to a high of $320.9 million and with a most-likely number of $292.3 million. The actuaries’ range of estimates for commercial lines in 2014 was $169.0 million to $203.5 million, and the actuaries selected the most-likely number of $185.4 million. The actuaries’ range of estimates for personal lines in 2014 was $97.3 million to $117.4 million, and the actuaries selected the most-likely number of $106.9 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. -43- The following table presents 2015 and 2014 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, 2015 2014 2,682 6,136 6,124 2,694 2,609 6,165 6,092 2,682 $ 35,262 $ 8,782 36,753 7,602 We make estimates concerning the valuation of our investments and the recognition of other-than-temporary declines in the value of our investments. For equity securities, when we consider a decline in the value of an individual investment to be other than temporary, we write down the investment to its fair value and reflect the amount of the write-down as a realized loss in our results of operations. We individually monitor all investments for other-than-temporary declines in value. Generally, 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 17 equity securities that were in an unrealized loss position at December 31, 2015. 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, 2015. 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 2015, 2014 or 2013. We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 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 $ 10,168,014 $ 50,819 $ Obligations of states and political subdivisions 19,437,469 483,022 — $ — Corporate securities Mortgage-backed securities Equity securities Totals — — 957,678 168,806 — 69,481,645 1,615,369 11,323,819 105,299,953 875,658 7,538,257 9,245,342 772,848 — $ 213,632,423 $ 3,797,716 $18,862,076 $ 1,126,484 -44- We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2014 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 $ 6,821,013 $ 18,511 $ 937,448 $ Obligations of states and political subdivisions 4,145,920 15,356 1,309,285 1,482 3,686 Corporate securities Mortgage-backed securities Equity securities Totals 26,854,423 499,697 2,397,635 35,866 13,360,859 71,730 9,025,795 132,134 7,511,808 815,628 — — $ 58,694,023 $ 1,420,922 $13,670,163 $ 173,168 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 we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. We generally obtain two prices 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 the expectations of our investment personnel 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, 2015, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at December 31, 2015, we did not identify any material 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 2015, 2014 or 2013. 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 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 2016 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 -45- have generally been accompanied by increased price competition among property and casualty insurers. If our insurance 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. 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, 2015 2014 2013 $ 214,610 $ 204,174 $ 196,363 119,541 18,176 352,327 76,729 98,079 94,219 7,483 113,576 16,989 334,739 65,552 88,739 83,413 6,758 106,420 15,915 318,698 58,165 77,589 74,516 4,463 276,510 244,462 214,733 Total net premiums written $ 628,837 $ 579,201 $ 533,431 Components of GAAP combined ratio: Loss ratio Expense ratio Dividend ratio GAAP combined ratio Revenues: Premiums earned: Personal lines Commercial lines GAAP premiums earned Net investment income Realized investment gains Equity in earnings of DFSC Other Total revenues 65.8% 32.6 0.6 69.8% 31.4 0.5 99.0% 101.7% 66.6% 31.8 0.4 98.8% $ 344,355 261,286 $ 325,442 231,056 $ 312,309 202,983 605,641 20,950 1,934 1,277 6,585 556,498 18,344 3,134 1,243 7,329 515,292 18,795 2,423 2,908 7,692 $ 636,387 $ 586,548 $ 547,110 -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 Premium paid on purchase of treasury stock Other Income before income tax Income tax Net income Year Ended December 31, 2015 2014 2013 $ (6,414) $ 9,259 2,845 3,344 6,189 20,950 1,934 1,277 (5,780) 3,022 27,592 (6,602) 20,990 $ $ (6,383) $ (9,434) (15,817) 6,312 (9,505) 18,344 3,134 1,243 — 3,067 16,283 (1,744) 14,539 $ 1,654 (524) 1,130 5,175 6,305 18,795 2,423 2,908 — 2,279 32,710 (6,388) 26,322 Statutory Combined Ratios We evaluate our insurance operations by monitoring certain key measures of growth and profitability. In addition to using GAAP-based performance measurements, we also utilize certain non-GAAP financial measures that we believe are valuable in managing our business and for comparison to our peers. These non-GAAP measures are underwriting income (loss), 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, we do not deduct installment payment fees from incurred expenses, and we base the expense ratio 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, 2015, 2014 and 2013: Commercial lines: Automobile Workers’ compensation Commercial multi-peril Total commercial lines Personal lines: Automobile Homeowners Total personal lines Total commercial and personal lines Year Ended December 31, 2015 2014 2013 109.5% 115.0% 104.9% 87.6 90.8 92.8 104.3 97.6 100.9 97.4 91.1 102.9 99.8 102.8 97.8 101.0 100.5 96.9 92.9 95.7 103.2 93.0 98.8 97.4 -47- Results of Operations YEAR ENDED DECEMBER 31, 2015 COMPARED TO YEAR ENDED DECEMBER 31, 2014 Net Premiums Written Our insurance subsidiaries’ 2015 net premiums written increased 8.6% to $628.8 million, compared to $579.2 million for 2014. 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, 2015, MICO terminated its external quota-share reinsurance with third-party reinsurers. Commercial lines net premiums written increased $32.0 million, or 13.1%, for 2015 compared to 2014. The increase included $11.9 million related to the reduction in the amount of premium MICO reinsured in 2015, with the remainder attributable to premium rate increases and increased writings of new accounts in the commercial automobile, commercial multi-peril and workers’ compensation lines of business. Personal lines net premiums written increased $17.6 million, or 5.3%, for 2015 compared to 2014. The increase included $7.7 million resulting from the reduction in the amount of premium MICO reinsured in 2015, with the remainder primarily attributable to premium rate increases. Net Premiums Earned Our insurance subsidiaries’ net premiums earned increased to $605.6 million for 2015, an increase of $49.1 million, or 8.8%, over 2014, reflecting increases in net premiums written during 2014 and 2015. 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 2015, our net investment income increased to $20.9 million, an increase of $2.6 million, or 14.2%, over 2014. We attribute the increase primarily to an increase in average invested assets and a decrease in our allocation of expenses to our investment function. 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 2015. Net Realized Investment Gains Our net realized investment gains in 2015 and 2014 were $1.9 million and $3.1 million, respectively. The net realized investment gains in 2015 and 2014 resulted from normal turnover within our investment portfolio. We did not recognize any impairment losses during 2015 or 2014. Equity in Earnings of DFSC Our equity in the earnings of DFSC in 2015 and 2014 was $1.3 million and $1.2 million, respectively. Losses and Loss Expenses Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, was 65.8% in 2015, compared to 69.8% in 2014. Our insurance subsidiaries’ commercial lines loss ratio decreased to 62.3% in 2015, compared to 72.0% in 2014. This decrease resulted primarily from the workers’ compensation loss ratio decreasing to 56.7% in 2015, compared to 64.7% in 2014, and the commercial multi-peril loss ratio decreasing to 58.2% in 2015, compared to 73.5% in 2014. The personal lines loss ratio was 68.5% in 2015, virtually unchanged from 68.2% in 2014. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $7.2 million during 2015 in their reserves for prior accident years, improved from unfavorable loss reserve development of approximately $14.5 million during 2014. The change in loss reserve development patterns occurred primarily within our insurance subsidiaries’ private passenger automobile liability, workers’ compensation and commercial automobile lines of business. -48- Underwriting Expenses Our insurance subsidiaries’ expense ratio, which is the ratio of policy acquisition and other underwriting expenses to premiums earned, was 32.6% in 2015, compared to 31.4% in 2014. We attribute the increase to higher underwriting-based incentives in 2015. Combined Ratio Our insurance subsidiaries’ combined ratio was 99.0% and 101.7% in 2015 and 2014, 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. We attribute the decrease in our combined ratio primarily to the decrease in our loss ratio. Interest Expense Our interest expense in 2015 decreased to $1.1 million, compared to $1.5 million in 2014. The decrease was related to our utilization in 2015 of borrowings under Atlantic States’ line of credit with the FHLB of Pittsburgh to repay borrowings under our line of credit with M&T that carried a higher interest rate. Income Taxes Our income tax expense was $6.6 million in 2015, compared to $1.7 million in 2014. Our effective tax rate for 2015 was 23.9%, compared to 10.7% for 2014. The increase in our 2015 effective tax rate was primarily due to tax-exempt interest income representing a smaller proportion of income before income tax expense and non-deductible expenses we incurred in 2015 compared to 2014. Net Income and Earnings Per Share Our net income in 2015 was $21.0 million, or $.77 per share of Class A common stock on a diluted basis and $.69 per share of Class B common stock, compared to $14.5 million, or $.55 per share of Class A common stock on a diluted basis and $.49 per share of Class B common stock, in 2014. We had 20.5 million and 21.4 million Class A shares outstanding at December 31, 2015 and 2014, 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 $7.7 million in 2015. We attribute the decrease primarily to our repurchase of 2.0 million shares of our Class A common stock in a private transaction in December 2015. Book value per share increased to $15.66 at December 31, 2015, compared to $15.40 a year earlier. Our return on average equity was 5.1% for 2015, compared to 3.6% for 2014. YEAR ENDED DECEMBER 31, 2014 COMPARED TO YEAR ENDED DECEMBER 31, 2013 Net Premiums Written Our insurance subsidiaries’ 2014 net premiums written increased 8.6% to $579.2 million, compared to $533.4 million for 2013. 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, 2014, MICO reduced its external quota-share reinsurance percentage from 30% to 20%. Commercial lines net premiums written increased $29.7 million, or 13.8%, for 2014 compared to 2013. The increase included $5.6 million related to the reduction in the amount of premium MICO reinsured in 2014, with the remainder attributable to premium rate increases and increased writings of new accounts in the commercial automobile, commercial multi-peril and workers’ compensation lines of business. Personal lines net premiums written increased $16.0 million, or 5.0%, for 2014 compared to 2013. The increase included $4.1 million resulting from the reduction in the amount of premium MICO reinsured in 2014, with the remainder primarily attributable to premium rate increases. -49- Net Premiums Earned Our insurance subsidiaries’ net premiums earned increased to $556.5 million for 2014, an increase of $41.2 million, or 8.0%, over 2013, reflecting increases in net premiums written during 2013 and 2014. 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 2014, our net investment income was $18.3 million, representing a slight decrease from 2013. An increase in our average invested assets from $799.1 million in 2013 to $812.4 million in 2014 was offset by a decrease in our annualized average rate of return to 2.3% in 2014, compared to 2.4% in 2013. 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 2014. Net Realized Investment Gains Our net realized investment gains in 2014 and 2013 were $3.1 million and $2.4 million, respectively. The net realized investment gains in 2014 and 2013 resulted from normal turnover within our investment portfolio. We did not recognize any impairment losses during 2014 or 2013. Equity in Earnings of DFSC Our equity in the earnings of DFSC in 2014 and 2013 was $1.2 million and $2.9 million, respectively. The decrease in DFSC’s earnings during 2014 compared to 2013 resulted from a lesser benefit from acquisition accounting adjustments and a charge to terminate a lease obligation related to UCB’s former main office. Losses and Loss Expenses Our insurance subsidiaries’ loss ratio, which is the ratio of incurred losses and loss expenses to premiums earned, was 69.8% in 2014, compared to 66.6% in 2013. Our insurance subsidiaries’ commercial lines loss ratio increased to 72.0% in 2014, compared to 67.1% in 2013. This increase resulted primarily from the commercial automobile loss ratio increasing to 83.2% in 2014, compared to 73.0% in 2013, and the commercial multi-peril loss ratio increasing to 73.5% in 2014, compared to 61.5% in 2013. The personal lines loss ratio increased to 68.2% in 2014, compared to 66.3% in 2013, primarily as a result of a increase in the homeowners loss ratio to 60.4% in 2014, compared to 57.7% in 2013, primarily as a result of an increase in weather-related claims. Our insurance subsidiaries experienced unfavorable loss reserve development of approximately $14.5 million during 2014 in their reserves for prior accident years, compared to unfavorable loss reserve development of approximately $10.4 million during 2013. The change in loss reserve development patterns occurred primarily within our insurance subsidiaries’ 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 31.4% in 2014, compared to 31.8% in 2013. Combined Ratio Our insurance subsidiaries’ combined ratio was 101.7% and 98.8% in 2014 and 2013, 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. We attribute the increase in our combined ratio primarily to the increase in our loss ratio. -50- Interest Expense Our interest expense in 2014 decreased slightly to $1.5 million, compared to $1.6 million in 2013. Income Taxes Our income tax expense was $1.7 million in 2014, compared to $6.4 million in 2013. Our effective tax rate for 2014 was 10.7%, compared to 19.5% for 2013. The decrease in our 2014 effective tax rate was primarily due to tax-exempt interest income representing a larger proportion of income before income tax expense in 2014 compared to 2013. Net Income and Earnings Per Share Our net income in 2014 was $14.5 million, or $.55 per share of Class A common stock on a diluted basis and $.49 per share of Class B common stock, compared to $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, in 2013. We had 21.4 million and 20.8 million Class A shares outstanding at December 31, 2014 and 2013, 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 increased by $19.3 million in 2014. We attribute the increase primarily to net after-tax unrealized gains within our available-for-sale fixed maturity investment portfolio during 2014. Book value per share increased to $15.40 at December 31, 2014, compared to $15.02 a year earlier. Our return on average equity was 3.6% for 2014, compared to 6.6% for 2013. 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, our cash flows are substantially similar to the 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 approach 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 2015, 2014 and 2013 were $66.4 million, $44.5 million and $46.0 million, respectively. In June 2015, 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 2018. 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, 2015, we had $46.0 million in outstanding borrowings and had the ability to borrow an additional $14.0 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, 2015, the interest rate on our outstanding borrowings was 2.68%. 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 2015. 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, 2015 or 2014. -51- 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 subordinated debentures. In July 2015, Atlantic States issued secured debt in the principal amount of $20.0 million to the FHLB of Pittsburgh in exchange for cash advances in the amount of $20.0 million. Atlantic States then loaned $20.0 million to us. We used the proceeds of our loan from Atlantic States to repay borrowings under our line of credit with M&T. The interest rate on the advances was .38% at December 31, 2015. The following table shows expected payments for our significant contractual obligations at December 31, 2015: (in thousands) Net liability for unpaid losses and loss expenses of our insurance subsidiaries Subordinated debentures Borrowings under lines of credit Total contractual obligations Total Less than 1 year 1-3 years 4-5 years After 5 years $ 322,054 $ 150,297 $ 145,702 $ 12,247 $ 13,808 5,000 — — 81,000 35,000 46,000 — — 5,000 — $ 408,054 $ 185,297 $ 191,702 $ 12,247 $ 18,808 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. Donegal Mutual and Atlantic States do not anticipate any further changes in the pool participation levels in the foreseeable future. However, 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, 2015, our annual interest cost associated with our borrowings under our lines of credit is approximately $1.4 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 $810,000. The cash dividends we declared to our stockholders totaled $14.5 million, $13.7 million and $13.0 million in 2015, 2014 and 2013, 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 also 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, 2015. Amounts available for distribution to us as dividends from our insurance subsidiaries without prior approval of insurance regulatory authorities in 2016 are $20.8 million from Atlantic States, $2.3 million from Southern, $2.6 million from Le Mars, $4.2 million from Peninsula, $1.3 million from Sheboygan and $4.6 million from MICO, or a total of approximately $35.8 million. -52- Investments At December 31, 2015 and 2014, our investment portfolio of primarily investment-grade bonds, common stock, short-term investments and cash totaled $929.0 million and $868.5 million, respectively, representing 60.4% and 59.5%, respectively, of our total assets. See “Business - Investments” for more information. December 31, 2015 2014 Percent of Percent of Amount Total Amount Total (dollars in thousands) Fixed maturities: Total held to maturity $ 310,259 34.4% $ 307,392 36.9% Total available for sale Total fixed maturities Equity securities Investment in affiliate Short-term investments 501,393 811,652 37,261 38,477 13,432 55.7 90.1 4.1 4.3 1.5 435,150 742,542 30,822 39,284 20,293 52.2 89.1 3.7 4.7 2.5 Total investments $ 900,822 100.0% $ 832,941 100.0% The carrying value of our fixed maturity investments represented 90.1% and 89.1% of our total invested assets at December 31, 2015 and 2014, respectively. Our fixed maturity investments consisted of high-quality marketable bonds, of which 99.8% and 99.7% were rated at investment-grade levels at December 31, 2015 and 2014, respectively. At December 31, 2015, the net unrealized gain on our available-for-sale fixed maturity investments, net of deferred taxes, amounted to $8.0 million, compared to $13.6 million at December 31, 2014. At December 31, 2015, the net unrealized gain on our equity securities, net of deferred taxes, amounted to $972,264, compared to $543,526 at December 31, 2014. 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 future impact of inflation. Our insurance subsidiaries account for inflation in the reserving function through analysis of costs and trends and reviews of historical reserving results. Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard is effective on January 1, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. -53-  In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of their significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate their liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in net income. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the new issued guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. 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 we describe 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 our 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. -54- Principal cash flows and related weighted-average interest rates by stated maturity dates for the financial instruments we held at December 31, 2015 that are sensitive to interest rates are as follows: (in thousands) Fixed-maturity and short-term investments: 2016 2017 2018 2019 2020 Thereafter Total Fair value Debt: 2016 2017 Thereafter Total Fair value Principal Cash Flows Weighted- Average Interest Rate $ 34,627 2.65% 4.13 4.54 2.96 2.93 3.47 0.38% 2.68 5.00 30,750 32,722 33,557 34,794 646,633 813,083 837,625 35,000 46,000 5,000 86,000 86,000 $ $ $ $ $ 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 mitigate this risk and 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. 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 the business Atlantic States cedes 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 Mutual Insurance Company (“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 -55- 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, 2015, West Bend’s net obligations under the reinsurance agreements were approximately $9.4 million, and the fair value of assets held in trust was approximately $9.7 million. -56- 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 58 59 60 61 62 92 -57- Donegal Group Inc. Consolidated Balance Sheets December 31, 2015 2014 Assets Investments Fixed maturities Held to maturity, at amortized cost (fair value $322,799,167 and $322,155,079 ). . . . . $ 310,258,704 501,393,559 Available for sale, at fair value (amortized cost $489,010,066 and $414,201,436) . . . . 37,260,821 Equity securities, available for sale, at fair value (cost $35,765,030 and $29,985,828). . . 38,476,708 Investment in affiliate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,432,482 Short-term investments, at cost, which approximates fair value . . . . . . . . . . . . . . . . . . . . 900,822,274 Total investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,139,144 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,991,197 Accrued investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,267,411 Premiums receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259,728,113 Reinsurance receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,108,388 Deferred policy acquisition costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,443,807 Deferred tax asset, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113,522,505 Prepaid reinsurance premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,027,143 Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,487,656 Federal income taxes recoverable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,625,354 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 958,010 1,713,413 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,537,834,415 $ 307,391,699 435,149,784 30,822,022 39,283,924 20,293,648 832,941,077 35,578,509 5,751,376 133,306,961 253,635,890 48,298,608 17,146,303 115,871,783 7,668,340 581,477 5,625,354 958,010 1,290,956 $ 1,458,654,644 Liabilities and Stockholders’ Equity Liabilities Losses and loss expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 578,205,109 429,493,203 Unearned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,460,475 Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,480,406 Reinsurance balances payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,000,000 Borrowings under lines of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,511,881 Cash dividends declared to stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000 Subordinated debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable - securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582,560 3,557,177 Due to affiliate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439,282 Drafts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,715,754 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,129,445,847 Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 538,258,406 408,646,363 19,429,627 7,841,172 53,500,000 3,467,273 5,000,000 — 2,409,347 1,950,765 2,017,048 1,042,520,001 Stockholders’ Equity Preferred stock, $.01 par value, authorized 2,000,000 shares; none issued . . . . . . . . . . . . Class A common stock, $.01 par value, authorized 40,000,000 shares, issued 23,501,805 and 22,389,369 shares and outstanding 20,499,217 and 21,447,661 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 income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,492 219,525,301 773,744 229,024,370 (41,226,357) 408,388,568 Total liabilities and stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,537,834,415 56,492 200,348,783 5,353,269 223,253,887 (13,101,682) 416,134,643 $ 1,458,654,644 — — 235,018 223,894 See accompanying notes to consolidated financial statements. -58- Donegal Group Inc. Consolidated Statements of Income and Comprehensive Income Years Ended December 31, 2014 2013 2015 Statements of Income Revenues Net premiums earned (includes affiliated reinsurance of $175,024,905, $167,070,235 and $156,938,714 - see note 3). . . . . . . . . . . . . . . . . . . . . . $ 605,640,728 20,949,698 $ 556,497,535 $ 515,291,944 18,344,382 18,795,239 Investment income, net of investment expenses . . . . . . . . . . . . . . . . . . . . . . Installment payment fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net realized investment gains (includes $1,934,424, $3,134,081 and $2,423,442 accumulated other comprehensive income reclassification) . . . Equity in earnings of DFSC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,834,897 6,473,288 6,841,778 750,287 855,546 849,795 1,934,424 1,277,229 3,134,081 1,242,910 2,423,442 2,907,867 636,387,263 586,547,742 547,110,065 Expenses Net losses and loss expenses (includes affiliated reinsurance of $100,110,773, $108,847,508 and $86,962,750 - see note 3). . . . . . . . . . . Amortization of deferred policy acquisition costs . . . . . . . . . . . . . . . . . . . . Other underwriting expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Policyholder dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premium paid on purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (includes $677,048, $1,065,588 and $823,970 income tax expense from reclassification items). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398,366,874 388,401,182 343,127,951 99,513,000 90,146,000 81,753,000 97,709,656 84,659,364 82,196,700 3,862,606 1,111,441 5,780,000 2,451,418 2,795,515 1,516,983 — 1,909,569 1,635,323 — 2,745,881 3,777,257 608,794,995 570,264,925 514,399,800 27,592,268 16,282,817 32,710,265 6,602,235 1,743,799 6,388,273 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,990,033 $ 14,539,018 $ 26,321,992 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.78 0.69 0.77 0.69 $ $ $ $ 0.56 0.49 0.55 0.49 $ $ $ $ 1.04 0.94 1.02 0.94 Statements of Comprehensive Income Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,990,033 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on securities: $ 14,539,018 $ 26,321,992 Unrealized holding (loss) gain arising during the period, net of income tax (benefit) expense of ($1,788,852), $5,193,522 and ($14,633,895) . (3,322,149) 9,734,652 (27,107,995) Reclassification adjustment for gains included in net income, net of (1,257,376) income tax of $677,048, $1,065,588 and $823,970. . . . . . . . . . . . . . . . (4,579,525) Other comprehensive (loss) income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Comprehensive income (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,410,508 (2,068,493) 7,666,159 $ 22,205,177 (1,599,472) (28,707,467) $ (2,385,475) See accompanying notes to consolidated financial statements. -59- 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 20,941,821 5,649,240 $209,419 $56,492 $176,416,585 $ 26,394,577 $ 209,670,214 $ (12,713,193) $400,034,094 844,944 8,449 12,108,468 60,198 531,159 26,321,992 (13,043,121) (60,198) 12,116,917 26,321,992 (13,043,121) — 531,159 (376,463) (376,463) (28,707,467) (28,707,467) 21,786,765 5,649,240 $217,868 $56,492 $189,116,410 $ (2,312,890) $ 222,888,887 $ (13,089,656) $396,877,111 602,604 6,026 10,497,881 429,959 304,533 14,539,018 (13,744,059) (429,959) 10,503,907 14,539,018 (13,744,059) — 304,533 (12,026) (12,026) 7,666,159 7,666,159 22,389,369 5,649,240 223,894 56,492 200,348,783 5,353,269 223,253,887 (13,101,682) 416,134,643 1,112,436 11,124 18,192,824 719,775 263,919 20,990,033 (14,499,775) (719,775) 18,203,948 20,990,033 (14,499,775) — 263,919 (28,124,675) (28,124,675) (4,579,525) (4,579,525) 23,501,805 5,649,240 $235,018 $56,492 $219,525,301 $ 773,744 $ 229,024,370 $ (41,226,357) $408,388,568 See accompanying notes to consolidated financial statements. -60- Balance, January 1, 2013 . . . . . . . . . . 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, 2013 . . . . . . . . . . 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 . . . . . . . . Balance, December 31, 2014 . . . . . . . . . . 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, 2015 . . . . . . . . . . Donegal Group Inc. Consolidated Statements of Cash Flows Years Ended December 31, 2014 2013 2015 Cash Flows from Operating Activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,990,033 Adjustments to reconcile net income to net cash provided by operating $ 14,539,018 $ 26,321,992 activities: Depreciation, amortization and other non-cash items . . . . . . . . . . . . . . . . . Net realized investment gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in earnings of DFSC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . Cash Flows from Investing Activities: Purchases of fixed maturities: 6,740,346 (1,934,424) (1,277,229) 3,523,692 (3,134,081) (1,242,910) 3,049,101 (2,423,442) (2,907,867) 39,946,703 20,846,840 3,030,848 (7,960,450) (3,809,780) 168,395 (6,092,223) (239,821) 1,147,830 (4,360,766) 2,349,278 (906,179) (2,235,228) 45,414,140 66,404,173 42,639,137 25,911,721 164,530 (9,402,332) (4,671,098) (963,679) (9,396,777) (327,845) 239,122 (10,107,636) (3,207,841) (160,525) 111,941 29,975,419 44,514,437 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 Held to maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales of fixed maturities: (31,310,026) (181,106,519) (14,759,861) (103,654,684) (89,585,027) (23,607,077) — (148,486,404) (47,156,954) Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,321,838 26,816,642 133,890,611 Maturity of fixed maturities: Held to maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales of equity securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net decrease in investment in affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net purchases of property and equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . Net sales (purchases) 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 provided by (used in) financing activities . . . . . . . . . . . . . . . . . . 28,575,153 66,744,045 8,761,474 1,783,700 (151,536) 6,861,166 (74,280,566) 15,516,870 (14,455,167) (28,124,675) — (9,500,000) 37,000,000 437,028 36,832,890 38,417,972 8,337,461 — (2,127,311) 79,384,147 (29,184,987) 13,767,271 52,675,833 43,204,703 1,139,800 (1,254,767) (75,851,568) (28,071,475) 10,700,637 (13,575,968) (12,026) (7,500,000) 3,000,000 (7,387,357) 12,550,066 (12,810,471) (376,463) — (15,465,000) (15,500,000) 21,500,000 (10,101,868) (7,439,365) Net (decrease) increase in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,578,509 Cash at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 28,139,144 7,942,093 27,636,416 $ 35,578,509 7,835,126 19,801,290 $ 27,636,416 See accompanying notes to consolidated financial statements. -61- 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 15 banking offices, substantially 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, 2015, Donegal Mutual held approximately 48% of our outstanding Class A common stock and approximately 83% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 74% 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. 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 we use them in the notes to our consolidated financial statements refer to the consolidated entity. -62- 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 then ended. Actual results could differ significantly from those estimates. We make estimates and assumptions that could 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 of investment securities 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. We account for our investment in affiliate 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. -63- 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 we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values for our fixed maturity and equity investments. We generally obtain two prices 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 the general knowledge of our investment personnel 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 the pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. 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 we report in the balance sheet for these instruments approximate their fair values. Premiums and Reinsurance Receivables and Payables - The carrying amounts we report 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 we report 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. 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 to the insurer. 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. -64- 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 primarily 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 we expect 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 its debt to us. 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. 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 -65- 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 or more 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 our 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 the reinsurance agreements of our insurance subsidiaries. Stock-Based Compensation We measure all share-based payments to our directors and the directors and employees of our subsidiaries and affiliates, 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 we grant to our directors and the 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 2015, 2014 and 2013, we realized $437,474, $304,533 and $531,159, respectively, in tax benefits upon the exercise of stock options. 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. 2 - Impact of New Accounting Standards In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. While the guidance will replace most existing GAAP revenue recognition guidance, the scope of the guidance excludes insurance contracts. The new standard is effective on January 1, 2018. The standard permits the use of either the retrospective or the -66- cumulative effect transition method. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In February 2015, the FASB issued a new standard that amends the current consolidation guidance affecting both the variable interest entity (“VIE”) and voting interest entity (“VOE”) consolidation models. The standard does not add or remove any of the characteristics in determining if an entity is a VIE or a VOE, but rather, the standard enhances assessment of some of these characteristics. The new standard is effective on January 1, 2017. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The guidance also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. The guidance instead limits disclosure to investments for which the entity has elected to measure fair value using that practical expedient. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within those annual reporting periods. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In May 2015, the FASB issued guidance that requires entities to provide additional disclosures about their liability for unpaid claims and claim adjustment expenses to increase the transparency of significant estimates. The guidance also requires entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including the reasons for the changes and the effects on the entities’ financial statements, and the timing, frequency and severity of claims. The guidance also requires entities to disclose a rollforward of the liability for unpaid claims and claim adjustment expenses for annual and interim reporting periods. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim reporting periods within annual reporting periods beginning after December 15, 2016. We do not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows. In January 2016, the FASB issued guidance that generally requires entities to measure equity investments at fair value and recognize changes in fair value in net income. The guidance also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring entities to perform a qualitative assessment to identify impairment. The FASB issued other disclosure and presentation improvements related to financial instruments within the new issued guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. As a result of this guidance, we will reflect changes in the fair value of our equity investments in our results of operations beginning January 1, 2018. In February 2016, the FASB issued guidance that requires lessees to recognize leases, including operating leases, on the balance sheet, unless a lease is considered a short-term lease. The guidance also requires entities to make new judgments to identify leases. The guidance is effective for annual and interim reporting periods beginning after December 15, 2018 and permits early adoption. We do not expect the adoption of this new guidance to have a significant impact on 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 the pooled 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. -67- The following amounts represent reinsurance Atlantic States ceded to the pool during 2015, 2014 and 2013: Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses 2015 2014 2013 $ 170,418,931 $ 158,221,567 $ 145,678,744 115,029,244 116,193,967 95,037,273 87,780,338 82,144,290 75,232,651 108,672,769 98,873,924 88,035,924 The following amounts represent reinsurance Atlantic States assumed from the pool during 2015, 2014 and 2013: Premiums earned Losses and loss expenses Unearned premiums Liability for losses and loss expenses 2015 2014 $ 396,098,036 $ 372,001,855 $ 337,548,492 2013 240,197,659 257,682,215 198,785,775 199,966,888 190,470,447 176,845,395 216,194,945 196,781,007 175,497,405 Donegal Mutual and Le Mars have a quota-share reinsurance agreement under which 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 2015, 2014 and 2013: Premiums earned Losses and loss expenses Unearned premiums Liability for losses and loss expenses 2015 2014 2013 $ 880,787 $ 4,265,196 $ 12,170,155 1,492,673 4,002,879 10,839,444 — 514,297 5,722,000 7,360,792 1,831,672 7,838,274 Donegal Mutual and MICO have a quota-share reinsurance agreement under which 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 under which 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 under the reinsurance agreements is subject to 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 2015, 2014 and 2013: Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses 2015 2014 2013 $ 37,299,760 $ 36,007,453 $ 34,992,435 19,735,479 24,951,662 25,301,470 17,172,112 16,396,417 16,032,985 29,968,948 28,172,373 25,298,464 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 ($2,000,000, $1,500,000 and $750,000 for Atlantic States, Southern and Le Mars, respectively), with a combined retention of $4,000,000 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. The set retention for Le Mars was $500,000 in 2014 and 2013. Donegal Mutual and Southern have an excess of loss reinsurance agreement in which Donegal Mutual assumes up to $500,000 of Southern’s losses in excess of $500,000. -68- The following amounts represent reinsurance that our insurance subsidiaries ceded to Donegal Mutual pursuant to these reinsurance agreements during 2015, 2014 and 2013: Premiums earned Losses and loss expenses Liability for losses and loss expenses 2015 2014 2013 $ 14,235,227 $ 14,967,796 $ 12,108,754 6,814,836 11,691,957 4,485,201 3,981,351 2,323,726 2,366,370 The following amounts represent the effect of affiliated reinsurance transactions on net premiums our insurance subsidiaries earned during 2015, 2014 and 2013: Assumed Ceded Net 2015 2014 2013 $ 396,978,823 (221,953,918) $ 175,024,905 $ 376,267,051 (209,196,816) $ 167,070,235 $ 349,718,647 (192,779,933) $ 156,938,714 The following amounts represent the effect of affiliated reinsurance transactions on net losses and loss expenses our insurance subsidiaries incurred during 2015, 2014 and 2013: Assumed Ceded Net b. Expense Sharing 2015 2014 2013 $ 241,690,332 $ 261,685,094 $ 209,625,219 (122,662,469) (152,837,586) $ 100,110,773 $ 108,847,508 $ 86,962,750 (141,579,559) 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 $108,473,146, $98,634,816 and $94,021,056 for 2015, 2014 and 2013, 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 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, 2015 and 2014, we had $24,030,780 and $28,868,418, respectively, in checking accounts with UCB, a wholly owned subsidiary of DFSC. We earned $3,317, $2,757 and $1,954 in interest on these accounts during 2015, 2014 and 2013, respectively. -69- 4 - Investments The amortized cost and estimated fair values of our fixed maturities and equity securities at December 31, 2015 and 2014 are as follows: Held to Maturity U.S. Treasury securities and obligations of U.S. government corporations and agencies 2015 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 51,193,849 $ 1,544,520 $ — $ 52,738,369 Obligations of states and political subdivisions 119,115,002 10,827,728 119,350 129,823,380 Corporate securities Mortgage-backed securities Totals 65,306,517 816,408 1,560,891 64,562,034 74,643,336 1,180,745 148,697 75,675,384 $ 310,258,704 $ 14,369,401 $ 1,828,938 $ 322,799,167 Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies 2015 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 37,080,117 $ 159,510 $ 50,819 $ 37,188,808 Obligations of states and political subdivisions 223,768,856 13,151,235 363,672 236,556,419 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 73,474,433 350,140 1,012,156 72,812,417 154,686,660 1,045,022 895,767 154,835,915 489,010,066 14,705,907 2,322,414 501,393,559 35,765,030 2,268,639 772,848 37,260,821 $ 524,775,096 $ 16,974,546 $ 3,095,262 $ 538,654,380 2014 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 53,619,146 $ 1,693,994 $ 127 $ 55,313,013 Obligations of states and political subdivisions 110,998,967 10,312,987 4,892 121,307,062 Corporate securities Mortgage-backed securities Totals 52,225,691 1,234,527 460,523 52,999,695 90,547,895 2,098,995 111,581 92,535,309 $ 307,391,699 $ 15,340,503 $ 577,123 $ 322,155,079 Available for Sale U.S. Treasury securities and obligations of U.S. government corporations and agencies 2014 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 21,152,999 $ 125,609 $ 19,866 $ 21,258,742 Obligations of states and political subdivisions 248,045,899 18,210,313 14,150 266,242,062 Corporate securities Mortgage-backed securities Fixed maturities Equity securities Totals 53,210,731 809,207 75,040 53,944,898 91,791,807 2,004,558 92,283 93,704,082 414,201,436 21,149,687 201,339 435,149,784 29,985,828 1,651,822 815,628 30,822,022 $ 444,187,264 $ 22,801,509 $ 1,016,967 $ 465,971,806 -70- At December 31, 2015, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $256.9 million and an amortized cost of $241.1 million. Our holdings also included special revenue bonds with an aggregate fair value of $109.5 million and an amortized cost of $101.8 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2015. Education bonds and water and sewer utility bonds represented 57% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2015. Many of the issuers of the special revenue bonds we held at December 31, 2015 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, 2014, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $279.7 million and an amortized cost of $259.8 million. Our holdings also included special revenue bonds with an aggregate fair value of $107.8 million and an amortized cost of $99.2 million. With respect to both categories of bonds, we held no securities of any issuer that comprised more than 10% of that category at December 31, 2014. Education bonds and water and sewer utility bonds represented 55% and 27%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2014. Many of the issuers of the special revenue bonds we held at December 31, 2014 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held are similar to general obligation bonds. 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 at November 30, 2013, summarized by type of securities, in the following table: 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 income the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassification date for fixed maturities reclassified from available for sale to held to maturity. We will amortize this balance over the remaining life of the related securities as an adjustment of yield in a manner consistent with the accretion of discount on the same fixed maturities. During 2015, we recorded amortization of $1.3 million in accumulated other comprehensive income. At December 31, 2015 and 2014, net unrealized losses of $12.3 million and $13.6 million, respectively, remained within accumulated other comprehensive income. -71- We set forth below the amortized cost and estimated fair value of fixed maturities at December 31, 2015 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 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 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 $ 2,493,562 $ 2,488,554 35,862,800 36,313,522 79,335,315 81,223,850 117,923,691 127,097,857 74,643,336 75,675,384 $ 310,258,704 $ 322,799,167 $ 18,226,200 $ 18,495,967 94,535,097 97,051,851 119,028,240 122,786,982 102,533,869 154,686,660 108,222,844 154,835,915 $ 489,010,066 $ 501,393,559 The amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2015 and 2014 amounted to $9,625,807 and $10,458,585, respectively. Our investment in affiliate represented our 48.2% investment in DFSC in the amount of $38,476,708 and $39,283,924 at December 31, 2015 and 2014, respectively. We account for our investment in DFSC using the equity method of accounting. Under this 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 its unrealized gains and losses. 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, 2015 and 2014 from the financial statements of DFSC. Balance sheets: Total assets Total liabilities Stockholders’ equity December 31, 2015 2014 $ 507,138,740 $ 505,934,003 $ 427,422,661 79,716,079 $ 424,266,891 81,667,112 Total liabilities and stockholders’ equity $ 507,138,740 $ 505,934,003 Income statements: Net income Year Ended December 31, 2015 2014 2013 $ 2,372,650 $ 2,853,576 $ 6,030,292 Other comprehensive (loss) income in our statements of comprehensive income includes net unrealized (losses) gains of ($263,991), $1.5 million and ($2.2 million) for 2015, 2014 and 2013, respectively, representing our share of DFSC’s unrealized investment gains or losses. -72- 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 2015 2014 2013 $ 23,636,468 $ 22,910,621 $ 23,621,977 707,703 181,154 33,450 528,453 139,243 34,675 122,603 98,817 41,608 24,558,775 (3,609,077) $ 20,949,698 23,612,992 (5,268,610) $ 18,344,382 23,885,005 (5,089,766) $ 18,795,239 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 2015 2014 2013 $ 2,259,045 $ 1,811,295 $ 4,774,437 1,088,467 3,347,512 1,455,076 3,266,371 1,634,315 6,408,752 105,432 1,307,656 1,413,088 37,449 94,841 3,091,538 893,772 132,290 3,985,310 $ 1,934,424 $ 3,134,081 $ 2,423,442 $(10,787,772) $ 23,893,815 581,467 $(10,128,175) $ 24,475,282 659,597 $(29,153,645) 160,652 $(28,992,993) We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2015 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 $ 10,168,014 $ 50,819 $ Obligations of states and political subdivisions 19,437,469 483,022 — $ — Corporate securities Mortgage-backed securities Equity securities Totals — — 957,678 168,806 — 69,481,645 1,615,369 11,323,819 105,299,953 875,658 7,538,257 9,245,342 772,848 — $213,632,423 $ 3,797,716 $ 18,862,076 $ 1,126,484 -73- We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2014 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 $ 6,821,013 $ 18,511 $ 937,448 $ Obligations of states and political subdivisions 4,145,920 15,356 1,309,285 26,854,423 499,697 2,397,635 13,360,859 71,730 9,025,795 7,511,808 815,628 — $ 58,694,023 $ 1,420,922 $ 13,670,163 $ 173,168 1,482 3,686 35,866 132,134 — Corporate securities Mortgage-backed securities Equity securities Totals 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 17 equity securities that were in an unrealized loss position at December 31, 2015. 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, 2015. 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 2015, 2014 or 2013. We had no sales or transfers from our held to maturity portfolio in 2015, 2014 or 2013. We had no derivative instruments or hedging activities during 2015, 2014 or 2013. 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. -74- 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 also classify a portion of our equity securities as Level 2. 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 we could realize if we sold the security in a forced transaction. In addition, the valuation of fixed maturity investments is more subjective when markets are less liquid, increasing the potential that the estimated fair value does not reflect the price at which an actual transaction would occur. We utilize nationally recognized independent pricing services to estimate fair values or obtain market quotations for substantially all of our fixed maturity and equity investments. We generally obtain two prices 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 the general knowledge of the market of our investment personnel, their research findings related to unusual fluctuations in value and their comparison of such values to execution prices for similar securities. Our investment personnel monitor the market and are familiar with current trading ranges for similar securities and pricing of specific investments. Our investment personnel review all pricing estimates that we receive from the pricing services against their expectations with respect to pricing based on fair market curves, security ratings, coupon rates, security type and recent trading activity. Our investment personnel review documentation with respect to the pricing services’ pricing methodology that they obtain periodically to determine if the primary pricing sources, market inputs and pricing frequency for various security types are reasonable. At December 31, 2015, we received two estimates per security from the pricing services, and we priced substantially all of our Level 1 and Level 2 investments using those prices. In our review of the estimates the pricing services provided at December 31, 2015, we did not identify any material discrepancies, and we did not make any adjustments to the estimates the pricing services provided. We present our cash and short-term investments at estimated fair value. The carrying values in our 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 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, 2015 and 2014. The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2015: 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 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 $ 37,188,808 $ — $ 37,188,808 $ 236,556,419 72,812,417 154,835,915 — 236,556,419 — 72,812,417 — 154,835,915 26,726,924 26,726,924 — Total investments in the fair value hierarchy 528,120,483 26,726,924 501,393,559 Investment measured at net asset value 10,533,897 — — Totals $ 538,654,380 $ 26,726,924 $ 501,393,559 $ — — — — — — — — -75- The following table presents our fair value measurements for our investments in available-for-sale fixed maturity and equity securities at December 31, 2014: 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 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 $ 21,258,742 $ — $ 21,258,742 $ 266,242,062 53,944,898 93,704,082 — 266,242,062 — 53,944,898 — 93,704,082 20,767,600 20,767,600 — Total investments in the fair value hierarchy 455,917,384 20,767,600 435,149,784 Investment measured at net asset value 10,054,422 — — Totals $ 465,971,806 $ 20,767,600 $ 435,149,784 $ — — — — — — — — 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 2015 2014 2013 $ 48,298,608 $ 43,627,510 $ 40,121,697 103,322,780 (99,513,000) $ 52,108,388 94,817,098 (90,146,000) $ 48,298,608 85,258,813 (81,753,000) $ 43,627,510 Property and equipment at December 31, 2015 and 2014 consisted of the following: Office equipment Automobiles Real estate Software Accumulated depreciation 2015 2014 Estimated Useful Life $ 9,118,021 $ 9,458,444 3-15 years 1,685,483 2,069,761 5 years 7,323,868 7,183,312 5-50 years 2,794,864 20,922,236 (13,895,093) 2,776,141 21,487,658 (13,819,318) $ 7,027,143 $ 7,668,340 5 years Depreciation expense for 2015, 2014 and 2013 amounted to $792,733, $883,674 and $783,897, 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 -76- 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. 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 2015 2014 2013 $ 538,258,406 (245,957,364) 292,301,042 $ 495,619,269 (230,014,037) 265,605,232 $ 458,827,395 (207,891,560) 250,935,835 391,166,740 373,932,058 332,770,088 7,200,134 14,469,124 10,357,863 398,366,874 388,401,182 343,127,951 236,834,666 229,939,627 201,781,955 131,779,001 131,765,745 126,676,599 368,613,667 322,054,249 361,705,372 292,301,042 328,458,554 265,605,232 256,150,860 245,957,364 230,014,037 $ 578,205,109 $ 538,258,406 $ 495,619,269 Our insurance subsidiaries recognized an increase in their liability for losses and loss expenses of prior years of $7.2 million, $14.5 million and $10.4 million in 2015, 2014 and 2013, 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 those years. The 2015 development represented 2.5% of the December 31, 2014 net carried reserves and resulted primarily from higher-than- expected severity in the private passenger automobile liability, commercial multiple peril and commercial automobile lines of business in accident years prior to 2015. The majority of the 2015 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. The 2014 development represented 5.4% of the December 31, 2013 net carried reserves and resulted primarily from higher-than-expected severity in the private passenger automobile liability, commercial multiple peril and commercial automobile lines of business in accident years prior to 2014. The majority of the 2014 development related to increases in the liability for losses and loss expenses of prior years for Atlantic States and Southern. 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. 9 - Borrowings Lines of Credit In June 2015, 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 2018. 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, 2015, we had $46.0 million in outstanding borrowings and had the ability to borrow an additional $14.0 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, 2015, the interest rate on our outstanding borrowings was 2.68%. 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 2015. 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 -77- at December 31, 2015 or 2014. 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, 2015. FHLB stock purchased and owned as part of the agreement $ 201,100 Collateral pledged, at par (carrying value $2,529,748) Borrowing capacity currently available 2,552,250 2,437,379 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 subordinated debentures. In July 2015, Atlantic States issued secured debt in the principal amount of $20.0 million to the FHLB of Pittsburgh in exchange for cash advances in the amount of $20.0 million. Atlantic States then loaned $20.0 million to us. We used the proceeds of our loan from Atlantic States to repay borrowings under our line of credit with M&T. The interest rate on the advances was .38% at December 31, 2015. 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, 2015. FHLB stock purchased and owned as part of the agreement Collateral pledged, at par (carrying value $36,893,743) Borrowing capacity currently available $ 1,540,300 37,325,137 569,727 Subordinated Debentures 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 2015, 2014 and 2013. 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), 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 ($1.5 million in 2015 and 2014 and $5.0 million in 2013) up to aggregate losses of $149.0 million per occurrence. For property insurance, our insurance subsidiaries have excess of loss treaties that provide for coverage up to $5.0 million per loss. For liability insurance, our insurance subsidiaries have excess of loss treaties that provide for coverage up to $50.0 million per occurrence. For workers’ compensation insurance, our insurance subsidiaries have excess of loss treaties that provide for coverage up to $10.0 million on any one life. Our insurance subsidiaries and Donegal Mutual have property catastrophe coverage through a series of layered treaties up to aggregate losses of $154.0 million for any single event. As many as 25 reinsurers provided coverage for 2015 on any one treaty with no reinsurer taking more than 40% 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 -78- 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. For policies effective through December 31, 2014, MICO maintained 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 to 40%. Effective January 1, 2013, MICO reduced the quota-share reinsurance percentage to 30%. Effective January 1, 2014, MICO reduced the quota-share reinsurance percentage to 20%. Effective January 1, 2015, MICO no longer maintains a quota-share reinsurance agreement with third-party reinsurers. The following amounts represent ceded reinsurance transactions with unaffiliated reinsurers during 2015, 2014 and 2013: Premiums written Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses Total Reinsurance 2015 2014 2013 $ 40,997,351 $ 62,351,702 $ 69,776,461 49,758,371 30,722,807 66,418,933 78,912,356 73,504,433 58,556,283 8,570,055 17,331,076 21,398,306 113,023,942 114,929,716 114,313,279 The following amounts represent total ceded reinsurance transactions with both affiliated and unaffiliated reinsurers during 2015, 2014 and 2013: Premiums earned Losses and loss expenses Prepaid reinsurance premiums Liability for losses and loss expenses 2015 2014 2013 $ 271,712,289 $ 275,615,749 $ 266,284,366 172,302,366 231,749,942 181,218,752 113,522,505 115,871,783 112,663,942 256,150,860 245,957,364 230,014,037 The following amounts represent the effect of reinsurance on premiums written for 2015, 2014 and 2013: Direct Assumed Ceded Net premiums written 2015 2014 2013 $ 492,073,587 $ 469,274,692 $ 441,469,330 406,126,275 (269,363,012) 359,753,517 388,750,312 (267,792,144) (278,823,589) $ 628,836,850 $ 579,201,415 $ 533,430,703 The following amounts represent the effect of reinsurance on premiums earned for 2015, 2014 and 2013: Direct Assumed Ceded Net premiums earned 2015 2014 2013 $ 480,210,534 $ 455,689,137 $ 431,788,593 397,142,483 (271,712,289) 376,424,147 349,787,717 (266,284,366) (275,615,749) $ 605,640,728 $ 556,497,535 $ 515,291,944 -79- 11 - Income Taxes Our provision for income tax for 2015, 2014 and 2013 consisted of the following: Current Deferred Federal income tax provision 2015 5,621,367 $ 980,868 6,602,235 $ 2014 2,707,478 $ (963,679) 1,743,799 $ 2013 4,973,430 1,414,843 6,388,273 $ $ Our effective tax rate is different from the amount computed at the statutory federal rate of 35% for 2015, 2014 and 2013. The reasons for such difference and the related tax effects are as follows: Income before income taxes Computed “expected” taxes Tax-exempt interest Proration Other, net 2015 2014 2013 $ 27,592,268 $ 16,282,817 $ 32,710,265 9,657,294 (4,806,855) 737,644 5,698,986 (5,063,140) 766,334 1,014,152 341,619 11,448,593 (5,789,963) 868,306 (138,663) 6,388,273 Federal income tax provision $ 6,602,235 $ 1,743,799 $ The tax effects of temporary differences that give rise to significant portions of our deferred tax assets and deferred tax liabilities at December 31, 2015 and 2014 are as follows: Deferred tax assets: Unearned premium Loss reserves Net operating loss carryforward - Le Mars Alternative minimum tax credit carryforward Other Total gross deferred tax 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 2015 2014 $ 22,174,971 $ 20,548,545 6,615,751 1,402,857 6,677,129 1,534,303 10,336,593 11,880,197 2,565,340 1,451,017 43,095,512 (440,778) 42,654,734 42,091,191 (440,778) 41,650,413 18,237,936 16,904,513 416,635 4,556,356 2,882,534 4,717,063 23,210,927 24,504,110 $ 19,443,807 $ 17,146,303 We provide a valuation allowance when we believe it is more likely than not that we will not realize some portion of a deferred tax asset. At December 31, 2015 and 2014, 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 $42.7 million and $41.7 million at December 31, 2015 and 2014, 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 our implementation of tax-planning strategies. Tax years 2012 through 2015 remained open for examination at December 31, 2015. The net operating loss carryforward of $4.0 million of Le Mars will begin to expire in 2020 if not utilized and is subject to an annual limitation of approximately -80- $376,000. We also had an alternative minimum tax credit carryforward of $10.3 million at December 31, 2015 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 our Class A common stock outstanding at the time of the declaration of any dividend or other distribution payable in cash upon the shares of our 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 our Class B common stock. In the event of our merger or consolidation with or into another entity, the holders of our Class A common stock and the holders of our 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 our Class A common stock and our 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 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 3,222 and 846 shares of our Class A common stock under this program during 2015 and 2014, respectively. As of December 31, 2015, we had no remaining authority to purchase 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 purchased 57,658 shares of our Class A common stock under this program during 2015. We did not purchase any shares of our Class A common stock under this program during 2013 or 2014. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through December 31, 2015. On December 18, 2015, we and Donegal Mutual entered into a Stock Purchase and Standstill Agreement (the “Purchase Agreement”) with Gregory M. Shepard (“Mr. Shepard”). Under the terms of the Purchase Agreement, we purchased 2,000,000 shares of our Class A common stock from Mr. Shepard on December 22, 2015 for a price of $33.0 million, or $16.50 per share, representing a premium of approximately $5.8 million from the market price of our Class A common stock on the date of the Purchase Agreement. We reported this premium in excess of the market price as an expense in our consolidated statements of income and comprehensive income that we include in this Form 10-K Report. We borrowed $33.0 million under our existing line of credit with M&T Bank to fund the purchase. The Purchase Agreement contains a number of typical “standstill” provisions pursuant to which Mr. Shepard and any affiliate of Mr. Shepard agree not to take a number of “control-seeking” actions with respect to us for a period of 25 years from the date of the Purchase Agreement. At December 31, 2015, our treasury stock consisted of 3,002,588 and 72,465 shares of Class A common stock and Class B common stock, respectively. At December 31, 2014, our treasury stock consisted of 941,708 and 72,465 shares of Class A common stock and Class B common stock, respectively. -81- 13 - Stock Compensation Plans Equity Incentive Plans Since 1996, we have maintained an Equity Incentive Plan for Employees. During 2015, we adopted a 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. The plan provides for the granting of awards by our board of directors in the form of stock options, stock appreciation rights, restricted stock or any combination of the above. The plan provides that stock options may become exercisable up to five years from their date of grant, with an option price not less than fair market value on the date preceding the date of grant. We have not granted any stock appreciation rights. Since 1996, we have maintained an Equity Incentive Plan for Directors. During 2015, we adopted a plan that made 500,000 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 500 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 7,200, 6,800 and 6,800 shares of restricted stock on January 2, 2015, 2014 and 2013 under our director plan. 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 we granted during 2015 was $1.55. We calculated this fair value based upon a risk-free interest rate of 1.86%, an expected life of three years, an expected volatility of 23% and an expected dividend yield of 4%. The weighted-average grant date fair value of options we granted during 2014 was $1.69. We calculated this fair value based upon a risk-free interest rate of 1.76%, an expected life of five years, an expected volatility of 18% and an expected dividend yield of 3%. The weighted-average grant date fair value of options we granted during 2013 was $2.20. We calculated this fair value based upon a risk-free interest rate of 1.63%, an expected life of five years, an expected volatility of 23% and an expected dividend yield of 3%. We charged compensation expense for our stock compensation plans against income before income taxes of $2.6 million, $2.1 million and $599,179 for the years ended December 31, 2015, 2014 and 2013, respectively, with a corresponding income tax benefit of $896,753, $700,487 and $203,721. At December 31, 2015 and 2014, our total unrecognized compensation cost related to non-vested share-based compensation granted under our stock compensation plans was $4.0 million and $4.6 million, respectively. We expect to recognize this cost over a weighted average period of 1.3 years. During 2015, we received cash from option exercises under all stock compensation plans of $13.7 million. We realized actual tax benefits for the tax deductions from option exercises of share-based compensation of $437,474 for 2015. During 2014, we received cash from option exercises under all stock compensation plans of $6.5 million. We realized actual tax benefits for the tax deductions from option exercises of share-based compensation of $304,533 for 2014. 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. No further shares are available for future option grants for plans in effect prior to 2015. -82- Information regarding activity in our stock option plans follows: Outstanding at December 31, 2012 Granted - 2013 Exercised - 2013 Forfeited - 2013 Expired - 2013 Outstanding at December 31, 2013 Granted - 2014 Exercised - 2014 Forfeited - 2014 Expired - 2014 Outstanding at December 31, 2014 Granted - 2015 Exercised - 2015 Forfeited - 2015 Expired - 2015 Outstanding at December 31, 2015 Exercisable at: December 31, 2013 December 31, 2014 December 31, 2015 Number of Options Weighted- Average Exercise Price Per Share 6,700,825 $14.27 2,543,500 (722,322) (116,669) (1,204,000) 7,201,334 1,574,500 (474,893) (112,511) (5,000) 8,183,430 1,710,500 (983,370) (114,967) (641) 8,794,952 3,028,619 4,477,240 5,250,338 15.90 13.45 13.65 17.52 14.39 15.80 13.64 15.23 17.50 14.69 13.64 13.91 15.30 14.00 $14.57 $13.47 $13.88 $14.42 Shares available for future option grants at December 31, 2015 totaled 3,289,500 shares under all plans. The following table summarizes information about stock options outstanding at December 31, 2015: Number of Options Outstanding Weighted-Average Remaining Contractual Life Number of Options Exercisable Exercise Price $14.00 12.50 14.50 15.90 15.80 13.64 20,000 1,668,148 1,433,303 2,423,667 1,539,334 1,710,500 0.5 years 6.0 years 7.0 years 8.0 years 9.0 years 5.0 years 20,000 1,668,148 1,433,303 1,615,776 513,111 — 5,250,338 Total 8,794,952 Employee Stock Purchase Plan Since 1996, we have maintained an Employee Stock Purchase Plan. During 2011, we adopted a plan that made 300,000 shares of our Class A common stock available for issuance. The 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 Class A common stock on the last day of each subscription period (June 30 and December 31 of each year). -83- A summary of plan activity follows: January 1, 2013 July 1, 2013 January 1, 2014 July 1, 2014 January 1, 2015 July 1, 2015 Shares Issued Price 11.93 11.76 12.58 13.01 12.40 12.95 Shares 16,485 19,805 16,964 19,627 17,662 20,006 On January 1, 2016, we issued 18,387 shares at a price of $11.97 per share under this plan. Agency Stock Purchase Plan Since 1996, we have maintained an Agency Stock Purchase Plan. During 2015, we adopted a plan that made 350,000 shares of our Class A common stock available for issuance to agents of our insurance subsidiaries and Donegal Mutual. The plan permits an agent 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 2015, 2014 and 2013, we issued 84,198, 84,320 and 79,532 shares, respectively, under this plan. The expense we recognized under the plan was not material. -84- 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 Southern: Statutory capital and surplus Statutory unassigned surplus Statutory net income Le Mars: Statutory capital and surplus Statutory unassigned surplus Statutory net (loss) income 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 (loss) 2015 2014 2013 $ 207,636,824 $ 191,195,309 $ 186,606,655 149,257,062 134,473,661 131,028,806 13,352,784 6,054,186 12,596,844 61,742,861 60,061,445 62,702,432 10,459,840 8,946,329 11,701,045 2,301,009 987,335 4,195,635 26,168,865 27,251,245 27,627,914 13,367,321 (600,608) 14,571,069 (591,242) 15,032,372 790,147 41,838,137 42,065,153 41,891,487 23,813,003 24,170,534 24,089,092 1,976,093 3,240,015 1,481,670 13,254,117 1,107,421 1,719,703 11,553,018 (525,782) (707,321) 12,085,839 52,211 1,374,543 46,199,534 41,989,986 41,594,701 19,894,850 3,562,536 15,860,855 (276,023) 15,588,110 1,170,008 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, 2015 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 2016 are $20.8 million from Atlantic States, $2.3 million from Southern, $2.6 million from Le Mars, $4.2 million from Peninsula, $1.3 million from Sheboygan and $4.6 million from MICO, or a total of approximately $35.8 million. 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. -85- 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 of insurance subsidiaries $ 22,311,517 $ 8,706,950 $ 21,608,847 Year Ended December 31, 2015 2014 2013 Increases (decreases): Deferred policy acquisition costs Deferred federal income taxes Salvage and subrogation recoverable Consolidating eliminations and adjustments Parent-only net (loss) income Net income as reported herein 3,809,780 (168,395) 1,082,800 (3,679,277) (2,366,392) $ 20,990,033 4,671,098 963,679 1,132,000 (11,075,829) 10,141,120 3,505,813 (1,414,843) 1,059,400 (10,648,834) 12,211,609 $ 14,539,018 $ 26,321,992 Year Ended December 31, 2015 2014 2013 Statutory capital and surplus of insurance subsidiaries $ 396,840,338 $ 374,116,156 $ 372,509,028 Increases (decreases): Deferred policy acquisition costs Deferred federal income taxes Salvage and subrogation recoverable 52,108,388 (16,930,202) 15,274,800 48,298,608 (17,639,443) 14,192,000 43,627,510 (12,251,398) 13,060,000 Non-admitted assets and other adjustments, net 2,441,591 2,236,021 Fixed maturities Parent-only equity and other adjustments Stockholders’ equity as reported herein 957,401 (42,303,748) $ 408,388,568 7,637,828 (12,706,527) $ 416,134,643 2,363,038 (1,465,363) (20,965,704) $ 396,877,111 16 - Supplementary Cash Flow Information The following table reflects net income taxes and interest we paid during 2015, 2014 and 2013: Income taxes Interest 2015 2014 2013 $ 7,100,000 $ 2,550,000 $ 5,450,000 870,675 1,252,194 1,527,037 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 dividends 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. -86- 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, 2015 2014 2013 $ $ $ 17,155 $ 11,797 $ 21,110 22,045,999 21,099,861 0.78 $ 0.56 $ 20,363,677 1.04 17,155 $ 11,797 $ 21,110 22,045,999 21,099,861 20,363,677 348,122 22,394,121 464,595 21,564,456 $ 0.77 $ 0.55 $ 398,708 20,762,385 1.02 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, 2015 2014 2013 $ $ 3,835 $ 2,742 $ 5,212 5,576,775 5,576,775 5,576,775 0.69 $ 0.49 $ 0.94 During 2014 and 2013, 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 the options we did not include: Options excluded from diluted earnings per share 2014 4,030,500 2013 2,548,500 -87- 18 - Condensed Financial Information of Parent Company December 31, Assets Condensed Balance Sheets (in thousands) 2015 2014 Investment in subsidiaries/affiliates (equity method) $ 493,600 $ 472,903 Short-term investments Cash Property and equipment Other Total assets Liabilities and Stockholders’ Equity Liabilities Cash dividends declared to stockholders Borrowings under lines of credit Other Total liabilities Stockholders’ equity Total liabilities and stockholders’ equity 32 1,153 619 649 530 1,543 948 429 $ 496,053 $ 476,353 $ 3,512 $ 81,000 3,152 87,664 3,467 53,500 3,251 60,218 408,389 416,135 $ 496,053 $ 476,353 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 Premium paid on purchase of treasury stock Interest Total expenses (Loss) income before income tax benefit and equity in undistributed net income of subsidiaries Income tax benefit (Loss) income before equity in undistributed net income of subsidiaries Equity in undistributed net income 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 income (loss) -88- 2015 2014 2013 $ 3,875 $ 11,500 $ 12,500 2,028 5,903 2,451 5,780 1,066 9,297 (3,394) 1,028 (2,366) 23,356 2,099 13,599 2,746 — 1,367 4,113 9,486 655 10,141 4,398 20,990 $ 14,539 $ 3,758 16,258 3,777 — 1,488 5,265 10,993 1,219 12,212 14,110 26,322 20,990 $ 14,539 $ 26,322 (4,579) (4,579) 16,411 7,666 7,666 $ 22,205 $ (28,707) (28,707) (2,385) $ $ $ Condensed Statements of Cash Flows (in thousands) Year Ended December 31, Cash flows from operating activities: Net income Adjustments: Equity in undistributed net income of subsidiaries Other Net adjustments Net cash (used) provided Cash flows from investing activities: Net sale (purchase) of short-term investments Net purchase of property and equipment Investment in subsidiaries Other Net cash (used) provided 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 Purchase of treasury stock Net cash provided (used) Net change in cash Cash at beginning of year Cash at end of year 2015 2014 2013 $ 20,990 $ 14,539 $ 26,322 (23,356) 539 (22,817) (1,827) 498 (23) (2,427) — (1,952) (14,454) 18,468 — (9,500) 37,000 (28,125) 3,389 (390) 1,543 (4,398) (432) (4,830) 9,709 (381) (426) (1,710) 26 (2,491) (13,575) 10,808 — (7,500) 3,000 (12) (7,279) (61) 1,604 $ 1,153 $ 1,543 $ (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 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. -89- Financial data by segment is as follows: Revenues: Premiums earned: Commercial lines Personal lines 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 Premium paid on purchase of treasury stock Other Income before income taxes 2015 2014 2013 (in thousands) $ 261,286 $ 231,056 $ 202,983 344,355 605,641 20,950 1,934 1,277 6,585 325,442 556,498 18,344 3,134 1,243 7,329 312,309 515,292 18,795 2,423 2,908 7,692 $ 636,387 $ 586,548 $ 547,110 2015 2014 2013 (in thousands) $ $ 9,259 (6,414) 2,845 3,344 6,189 20,950 1,934 1,277 (5,780) 3,022 (9,434) $ (6,383) (15,817) 6,312 (9,505) 18,344 3,134 1,243 — 3,067 (524) 1,654 1,130 5,175 6,305 18,795 2,423 2,908 — 2,279 $ 27,592 $ 16,283 $ 32,710 20 - Guaranty Fund and Other Insurance-Related Assessments Our insurance subsidiaries’ liabilities for guaranty fund and other insurance-related assessments were $1,348,427 and $1,440,845 at December 31, 2015 and 2014, respectively. These liabilities included $400,690 and $472,665 related to surcharges collected by our insurance subsidiaries on behalf of regulatory authorities for 2015 and 2014, respectively. -90- 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 (loss) income Net (loss) earnings per common share: Class A common stock - basic Class A common stock - diluted Class B common stock - basic and diluted 2015 First Quarter Second Quarter Third Quarter Fourth Quarter $ 146,529,816 $ 150,457,785 $ 153,096,075 $ 155,557,052 154,772,448 158,016,954 159,801,784 163,796,077 95,939,312 97,839,291 102,233,708 102,354,563 6,854,336 6,465,027 5,686,831 1,983,839 0.26 0.25 0.23 0.24 0.24 0.21 2014 0.21 0.21 0.18 0.07 0.07 0.07 First Quarter Second Quarter Third Quarter Fourth Quarter $ 133,548,261 $ 136,589,156 $ 142,149,561 $ 144,210,557 140,339,087 145,481,928 149,135,383 151,591,344 97,632,392 (634,414) 97,887,449 91,003,905 101,877,436 1,938,670 8,748,711 4,486,051 (0.02) (0.02) (0.02) 0.08 0.07 0.07 0.33 0.33 0.30 0.17 0.17 0.14 -91- 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, 2015 and 2014, 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, 2015. 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, 2015 and 2014 was $38,476,708 and $39,283,924, respectively, and its equity in earnings of Donegal Financial Services Corporation was $1,277,229, $1,242,910 and $2,907,867 for the years ended December 31, 2015, 2014 and 2013, 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 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, 2015 and 2014, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Donegal Group Inc.’s internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 18, 2016 expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting. Philadelphia, Pennsylvania March 18, 2016 -92- 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) as of December 31, 2015, the end of the period covered by this Form 10-K Report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as a result of the material weakness in internal control over financial reporting we describe below, our disclosure controls and procedures were not effective as of December 31, 2015. Disclosure controls and procedures are controls and other procedures that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, on a timely basis, and that the information disclosed 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 (2013) 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 not effective as of December 31, 2015 due to the material weakness we describe below. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. The identified material weakness in our internal control over financial reporting pertains to our control activities over the accounting for a significant and unusual transaction related to the purchase of a large block of our Class A common stock in December 2015. The control activities were not designed appropriately to ensure that our related accounting conclusions were sufficiently documented and reviewed for compliance with U.S. generally accepted accounting principles (“GAAP”). The material weakness resulted in a material misstatement of the cost of our treasury stock and amounts within our statement of operations that were corrected prior to the issuance of our consolidated financial statements. Notwithstanding this material weakness, our management concluded that our consolidated financial statements we include in this Form 10-K Report present fairly, in all material respects, our financial position and our results of operations and cash flows in conformity with GAAP, and KPMG LLP, our independent registered public accounting firm, has issued an unqualified opinion on our consolidated financial statements as of December 31, 2015 and 2014 and for each of the years in the three-year period ended December 31, 2015. This material weakness has no impact on our consolidated financial statements for prior years. The effectiveness of our internal control over financial reporting as of December 31, 2015 has been audited by KPMG LLP, as stated in their adverse report, which we include elsewhere in this Form 10-K Report. Management Remediation Plan To remediate the material weakness we describe above, our management is enhancing and revising the design of existing controls and procedures over our accounting for significant and unusual transactions. These controls relate to enhanced documentation of our management’s evaluation of the facts and circumstances supporting our management’s judgments and conclusions, and may include consultation with third-party experts with relevant knowledge and experience to assist our management with the evaluation of our accounting for significant and unusual transactions. -93- Changes in Internal Control over Financial Reporting There were no 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) that occurred during the fourth quarter of 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B. Other Information. None. -94- 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, 2015, based on criteria established in Internal Control - Integrated Framework (2013) 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 in Item 9A. 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. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness relating to control activities over the accounting for a significant and unusual transaction has been identified and included in management’s assessment. 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, 2015 and 2014, 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, 2015. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2015 consolidated financial statements, and this report does not affect our report dated March 18, 2016, which expressed an unqualified opinion on those consolidated financial statements. In our opinion, because of the effect of the aforementioned material weakness on the achievement of the objectives of the control criteria, Donegal Group Inc. has not maintained effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Philadelphia, Pennsylvania March 18, 2016 -95- Item 10. Directors, Executive Officers and Corporate Governance. 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 21, 2016 relating to our annual meeting of stockholders that we will hold on April 21, 2016, 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 Committee 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 Accounting Fees and Services. We incorporate the response to this Item 14 by reference to our Proxy Statement. -96- Item 15. Exhibits, Financial Statement Schedules. (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, 2015 and 2014 Consolidated Statements of Income and Comprehensive Income for each of the years in the three-year period ended December 31, 2015, 2014 and 2013 Consolidated Statements of Stockholders’ Equity for each of the years in the three-year period ended December 31, 2015, 2014 and 2013 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2015, 2014 and 2013 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) (b) Financial Statement Schedule Schedule III — Supplementary Insurance Information Consolidated Financial Statements of Donegal Financial Services Corporation Page 92 58 59 60 61 62 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 10.6 10.7 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. 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. -97- (a) (i) (c) (c) (c) (c) (c) (d) (d) 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 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. Employment Agreement dated as of July 18, 2013 among Donegal Mutual Insurance Company, Donegal Group Inc. and Sanjay Pandey. 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. Cash Incentive Bonus Plan. 10.22 10.23 Donegal Group Inc. 2015 Equity Incentive Plan for Employees. Donegal Group Inc. 2015 Equity Incentive Plan for Directors. Other Material Contracts 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. 10.24 10.25 10.26 10.27 10.28 10.29 10.30 10.31 (d) (d) (d) (s) (d) (d) (e) (e) (b) (b) (b) (b) (h) (j) (t) (t) (f) (k) (k) (k) (k) (k) (l) 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. (m) -98- 10.32 10.33 10.34 10.35 10.36 10.37 10.38 10.39 10.40 10.41 14 21 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. 2015 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. Sixth Amendment to Credit Agreement between Donegal Group Inc. and Manufacturers and Traders Trust Company dated June 1, 2014. (n) (n) (n) (o) (p) (q) (r) (s) Seventh Amendment to Credit Agreement between Donegal Group Inc. and Manufacturers and Traders Trust Company dated June 1, 2015. Filed herewith Stock Purchase and Standstill Agreement dated as of December 18, 2015 among Donegal Mutual Insurance Company, Donegal Group Inc. and Gregory M. Shepard. 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. 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 -99- (u) (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 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 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 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 description of such plan in Registrant’s definitive proxy statement for its Annual Meeting of Stockholders held on April 17, 2014 filed on March 17, 2014. (k) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 2009. (l) 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. (m) We incorporate such exhibit by reference to the like-described exhibit in 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 10-K Report for the year ended December 31, 2010. (o) We incorporate such exhibit by reference to the like-described exhibit filed in Registrant’s Form S-3 registration statement filed on April 28, 2015. (p) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 2011. (q) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 2012. (r) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 2013. (s) We incorporate such exhibit by reference to the like-described exhibit in Registrant’s Form 10-K Report for the year ended December 31, 2014. (t) 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 16, 2015 filed on March 16, 2015. (u) We incorporate such exhibit by reference to the like-described exhibit in Registrant's Form 8-K Report dated December 22, 2015. -100- 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/ Kevin G. Burke Kevin G. Burke, President and Chief Executive Officer Date: March 18, 2016 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 /s/ Kevin G. Burke Kevin G. Burke /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 Title President and Chief Executive Officer (principal executive officer) Executive 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/ Barry C. Huber Barry C. Huber /s/ Kevin M. Kraft, Sr. Kevin M. Kraft, Sr. /s/ Jon M. Mahan Jon M. Mahan Director Director Director Director /s/ S. Trezevant Moore, Jr. Director S. Trezevant Moore, Jr. /s/ Donald H. Nikolaus Donald H. Nikolaus Director /s/ Richard D. Wampler, II Director Richard D. Wampler, II -101- Date March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 March 18, 2016 [THIS PAGE INTENTIONALLY LEFT BLANK] CORPORATE INFORMATION ANNUAL MEETING April 21, 2016 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 30170 College Station, Texas 77842-3170 (800) 317-4445 Web Site: www.computershare.com Hearing Impaired: TDD: 800-952-9245 DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN We offer a dividend reinvestment and stock purchase plan through our transfer agent. For information contact: Donegal Group Inc. Dividend Reinvestment and Stock Purchase Plan Computershare Trust Company, N.A. P.O. Box 30170 College Station, Texas 77842-3170 STOCKHOLDERS The following represent the number of our common stockholders of record as of December 31, 2015: Class A common stock 1,890 317 Class B common stock BOARD OF DIRECTORS Donald H. Nikolaus Chairman of the Board and a Director Scott A. Berlucchi Director Robert S. Bolinger Director Patricia A. Gilmartin Director Philip H. Glatfelter, II Director Barry C. Huber Director Jack L. Hess Director Kevin M. Kraft, Sr. Director Director Jon M. Mahan S. Trezevant Moore, Jr. Director Richard D. Wampler, II Director OFFICERS Kevin G. Burke Jeffrey D. Miller Cyril J. Greenya Sanjay Pandey Robert G. Shenk Christina M. Springer V. Anthony Viozzi Daniel J. Wagner Jason M. Crumbling Jerry W. Demastus Sheri O. Smith Michelle M. Post President and Chief Executive Officer Executive Vice President and Chief Financial Officer Senior Vice President Senior Vice President and Chief Information Officer Senior Vice President Senior Vice President Senior Vice President and Chief Investment Officer Senior Vice President and Treasurer Vice President and Controller Vice President and Assistant Treasurer Vice President and Secretary Assistant Secretary There When It Matters Most. 1195 River Road, P.O. Box 302 Marietta, PA 17547-0302 (717) 426-1931 www.donegalgroup.com 

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