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MarketScreener Homepage  >  Equities  >  Nasdaq  >  Donegal Group Inc.    DGICB

DONEGAL GROUP INC.

(DGICB)
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DONEGAL : Management's Discussion and Analysis of Financial Condition and Results of Operations. (form 10-Q)

11/05/2020 | 09:20am EST
We recommend that you read the following information in conjunction with the
historical financial information and the footnotes to that financial information
we include in this Quarterly Report on Form
10-Q.
We also recommend you read Management's Discussion and Analysis of Financial
Condition and Results of Operations in our Annual Report on Form
10-K
for the year ended December 31, 2019.

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Critical Accounting Policies and Estimates
We combine our financial statements with those of our insurance subsidiaries and
present our financial statements on a consolidated basis in accordance with
GAAP.
Our insurance subsidiaries make estimates and assumptions that can have a
significant effect on amounts and disclosures we report in our financial
statements. The most significant estimates relate to the reserves of our
insurance subsidiaries for property and casualty insurance unpaid losses and
loss expenses. While we believe our estimates and the estimates of our insurance
subsidiaries are appropriate, the ultimate amounts of these liabilities may
differ from the estimates we provided. We regularly review our methods for
making these estimates and we reflect any adjustment we consider necessary in
our current consolidated results of operations.
Liability for Unpaid Losses and Loss Expenses
Liabilities for losses and loss expenses are estimates at a given point in time
of the amounts an insurer expects to pay
with respect to incurred policyholder claims based on facts and circumstances
the insurer knows at that point in time. At the time of establishing its
estimates, an insurer recognizes that its ultimate liability for losses and loss
expenses will exceed or be less than such estimates. Our insurance subsidiaries
base their estimates of liabilities for losses and loss expenses on assumptions
as to future loss trends, expected claims severity, judicial theories of
liability and other factors. However, during the loss adjustment period, our
insurance subsidiaries may learn additional facts regarding individual claims,
and, consequently, it often becomes necessary for our insurance subsidiaries to
refine and adjust their estimates for these liabilities. We reflect any
adjustments to the liabilities for losses and loss expenses of our insurance
subsidiaries in our consolidated results of operations in the period in which
our insurance subsidiaries make adjustments to 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 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
monitor their liabilities closely 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 and loss
expenses.
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 an increase in claims severity and a lengthening
of the claim settlement periods on bodily injury claims during the past several
years. These trend changes give rise to greater uncertainty as to the pattern of
future loss settlements on bodily injury claims. Related uncertainties regarding
future trends include the cost of medical technologies and procedures and
changes in the utilization of medical procedures. Assumptions related to our
insurance subsidiaries' external environment include the absence of significant
changes in tort law and the legal environment that increase liability exposure,
consistency in judicial interpretations of insurance coverage and policy
provisions and the rate of loss cost inflation. Internal assumptions include
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 make adjustments in their
reserves that they consider appropriate for such changes. Accordingly, our
insurance subsidiaries' ultimate liability for unpaid losses and loss expenses
will likely differ from the amount recorded at September 30, 2020. 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 $5.4 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, 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

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increase their estimated future liabilities for losses and loss expenses in
certain periods and, in other periods, their estimated future liabilities for
losses and loss expenses have exceeded their actual liabilities for losses and
loss expenses. Changes in our insurance subsidiaries' estimates of their
liability for losses and loss expenses generally reflect actual payments and
their evaluation of information received subsequent to the prior reporting
period.
Excluding the impact of severe weather events and reduced claim frequency in the
second and third quarters of 2020 due to restrictions related to
COVID-19,
our insurance subsidiaries have noted stable amounts in the number of claims
incurred and the number of claims outstanding at period ends relative to their
premium base in recent years across most of their lines of business. However,
the amount of the average claim outstanding has increased gradually over the
past several years due to various factors such as rising medical loss costs and
increased litigation trends. We have also experienced a general slowing of
settlement rates in litigated claims. Our insurance subsidiaries could have to
make further adjustments to their estimates in the future. However, on the basis
of our insurance subsidiaries' internal procedures, which analyze, among other
things, their prior assumptions, their experience with similar cases and
historical trends such as reserving patterns, loss payments, pending levels of
unpaid claims and product mix, as well as court decisions, economic conditions
and public attitudes, we believe that our insurance subsidiaries have made
adequate provision for their liability for losses and loss expenses.
Atlantic States' participation in the pool with Donegal Mutual exposes Atlantic
States 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 share proportionately any adverse risk development relating to the pooled
business. The business in the pool is homogeneous and each company has a
pro-rata
share of the entire pool. Since the predominant percentage 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.
Donegal Mutual and our insurance subsidiaries operate together as the Donegal
Insurance Group and share a combined business plan designed to achieve market
penetration and underwriting profitability objectives. The products our
insurance subsidiaries and Donegal Mutual offer are generally complementary,
thereby allowing Donegal Insurance Group to offer a broader range of products to
a given market and to expand Donegal Insurance Group's ability to service an
entire personal lines or commercial lines account. Distinctions within the
products of Donegal Mutual and our insurance subsidiaries generally relate to
specific risk profiles targeted within similar classes of business, such as
preferred tier products compared to standard tier products, but we do not
allocate all of the standard risk gradients to one company. Therefore, the
underwriting profitability of the business the individual companies write
directly will vary. However, because the pool homogenizes the risk
characteristics of the predominant percentage of the business Donegal Mutual and
Atlantic States write directly and each company shares the underwriting results
according to each company's participation percentage, each company realizes its
percentage share of the underwriting results of the pool.

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Our insurance subsidiaries' unpaid liability for losses and loss expenses by
major line of business at September 30, 2020 and December 31, 2019 consisted of
the following:

                                                         September 30,         December 31,

                                                             2020                  2019
                                                                   (in thousands)
Commercial lines:
Automobile                                              $       143,055$      126,224
Workers' compensation                                           117,583              109,060
Commercial multi-peril                                          116,498              102,424
Other                                                            13,279                9,115

Total commercial lines                                          390,415              346,823

Personal lines:
Automobile                                                      124,976              132,191
Homeowners                                                       20,074               23,494
Other                                                             6,284                4,398

Total personal lines                                            151,334              160,083

Total commercial and personal lines                             541,749     

506,906

Plus reinsurance recoverable                                    400,181     

362,768

Total liability for unpaid losses and loss expenses $ 941,930

$ 869,674




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

                              Adjusted Loss and Loss                                        Adjusted Loss and Loss
Percentage Change in Loss     Expense Reserves Net of           Percentage Change           Expense Reserves Net of           Percentage Change
and Loss Expense Reserves         Reinsurance at           in Stockholders' Equity at           Reinsurance at           in Stockholders' Equity at
   Net of Reinsurance           September 30, 2020            September 30, 2020(1)            December 31, 2019            December 31, 2019(1)
                                                               (dollars in thousands)
         (10.0)%                $             487,574                             8.5 %       $             456,215                             8.9 %
         (7.5)                                501,118                             6.4                       468,888                             6.7
         (5.0)                                514,662                             4.2                       481,561                             4.4
         (2.5)                                528,205                             2.1                       494,233                             2.2
          Base                                541,749                              -                        506,906                              -
          2.5                                 555,293                            (2.1 )                     519,579                            (2.2 )
          5.0                                 568,836                            (4.2 )                     532,251                            (4.4 )
          7.5                                 582,380                            (6.4 )                     544,924                            (6.7 )
          10.0                                595,924                           (8.5)                       557,597                           (8.9)




(1) Net of income tax effect.


Non-GAAP
Information
We prepare our consolidated financial statements on the basis of GAAP. Our
insurance subsidiaries also prepare financial statements based on statutory
accounting principles state insurance regulators prescribe or permit ("SAP").
SAP financial measures are considered
non-GAAP
financial measures under applicable SEC rules because the SAP financial measures
include or exclude certain items that the most comparable GAAP financial
measures do not ordinarily include or exclude. Our calculation of
non-GAAP
financial measures may differ from similar measures other companies use, so
investors should exercise caution when comparing our
non-GAAP
financial measures to the
non-GAAP
financial measures other companies use.


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Because our insurance subsidiaries do not prepare GAAP financial statements, we
evaluate the performance of our personal lines and commercial lines segments
utilizing SAP financial measures that reflect the growth trends and underwriting
results of our insurance subsidiaries. The SAP financial measures we utilize are
net premiums written and statutory combined ratio.
Net Premiums Written
We define net premiums written as the amount of full-term premiums our insurance
subsidiaries record for policies effective within a given period less premiums
our insurance subsidiaries cede to reinsurers. Net premiums earned is the most
comparable GAAP financial measure to net premiums written. Net premiums earned
represent the sum of the amount of net premiums written and the change in net
unearned premiums during a given period. Our insurance subsidiaries earn
premiums and recognize them as revenue over the terms of their policies, which
are one year or less in duration. Therefore, increases or decreases in net
premiums earned generally reflect increases or decreases in net premiums written
in the preceding
12-month
period compared to the comparable period one year earlier.
The following table provides a reconciliation of our net premiums earned to our
net premiums written for the three and nine months ended September 30, 2020 and
2019:

                                       Three Months Ended September 30,              Nine Months Ended September 30,
                                         2020                    2019                  2020                   2019
                                                                       (in thousands)
Net premiums earned                 $       184,926$       189,821$        556,552$        566,658
Change in net unearned premiums              (4,146 )                (5,951 )              16,168                 14,930

Net premiums written                $       180,780$       183,870$        572,720$        581,588



Statutory Combined Ratio
The combined ratio is a standard measurement of underwriting profitability for
an insurance company. The combined ratio does not reflect investment income, net
investment gains or losses, federal income taxes or other
non-operating
income or expense. A combined ratio of less than 100% generally indicates
underwriting profitability.
The statutory combined ratio is a
non-GAAP
financial measure that is based upon amounts determined under SAP. We calculate
our statutory combined ratio as the sum of:

• the statutory loss ratio, which is the ratio of calendar-year net

         incurred losses and loss expenses to net premiums earned;


• the statutory expense ratio, which is the ratio of expenses incurred for

net commissions, premium taxes and underwriting expenses to net premiums

         written; and


• the statutory dividend ratio, which is the ratio of dividends to holders

of workers' compensation policies to net premiums earned.



The calculation of our statutory combined ratio differs from the calculation of
our GAAP combined ratio. In calculating our GAAP combined ratio, we do not
deduct installment payment fees from incurred expenses, and we base the expense
ratio on net premiums earned instead of net premiums written. Differences
between our GAAP loss ratio and our statutory loss ratio result from
anticipating salvage and subrogation recoveries for our GAAP loss ratio but not
for our statutory loss ratio.

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Combined Ratios
The following table presents comparative details with respect to our GAAP and
statutory combined ratios for the three and nine months ended September 30, 2020
and 2019:

                                              Three Months Ended September 30,                  Nine Months Ended September 30,
                                               2020                      2019                   2020                      2019
GAAP Combined Ratios (Total Lines)
Loss ratio
(non-weather)                                        56.3 %                    61.6 %                 54.1 %                    60.8 %
Loss ratio (weather-related)                          9.1                       7.3                    7.6                       7.2
Expense ratio                                        31.9                      30.5                   33.2                      31.5
Dividend ratio                                        1.0                       1.2                    1.0                       1.2

Combined ratio                                       98.3 %                   100.6 %                 95.9 %                   100.7 %

Statutory Combined Ratios
Commercial lines:
Automobile                                          109.9 %                   113.9 %                110.5 %                   114.3 %
Workers' compensation                                86.8                      85.4                   85.9                      82.0
Commercial multi-peril                              109.2                      98.7                   98.1                      94.4
Other                                                93.5                      76.6                   79.5                      79.3
Total commercial lines                              102.4                      97.9                   97.3                      95.8
Personal lines:
Automobile                                           89.0                     103.3                   88.6                     103.9
Homeowners                                           97.7                     109.4                   99.3                     106.0
Other                                                84.0                      73.6                   76.5                      77.7
Total personal lines                                 91.9                     103.9                   91.6                     103.3
Total commercial and personal lines                  97.7                     100.8                   94.7                      99.5



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Results of Operations - Three Months Ended September 30, 2020 Compared to Three
Months Ended September 30, 2019
Net Premiums Earned.
Our insurance subsidiaries' net premiums earned for the third quarter of 2020
were $184.9 million, a decrease of $4.9 million, or 2.6%, compared to
$189.8 million for the third quarter of 2019, primarily reflecting decreases in
net premiums written during 2020 and 2019.
Net Premiums Written.
Our insurance subsidiaries' net premiums written for the three months ended
September 30, 2020 were $180.8 million, a decrease of $3.1 million, or
1.7%, from the $183.9 million of net premiums written for the third quarter of
2019. Commercial lines net premiums written increased $4.1 million, or 4.3%, for
the third quarter of 2020 compared to the third quarter of 2019. We attribute
the increase in commercial lines net premiums written primarily to increased
writings of new commercial accounts and net premium rate increases. Personal
lines net premiums written decreased $7.2 million, or 8.0%, for the third
quarter of 2020 compared to the third quarter of 2019. We attribute the decrease
in personal lines net premiums written primarily to net attrition as a result of
measures our insurance subsidiaries have implemented to improve underwriting
profitability, partially offset by the impact of premium rate increases our
insurance subsidiaries have implemented.
Investment Income.
Our net investment income was $7.4 million for the third quarter of 2020 and
2019.
Net Investment Gains (Losses).
Net investment gains for the third quarter of 2020 were $3.3 million, compared
to net investment losses of $369,041 for the third quarter of 2019. The net
investment gains for the third quarter of 2020 resulted primarily from
unrealized gains within our equity securities portfolio at September 30, 2020.
We did not recognize any impairment losses in our investment portfolio during
the third quarter of 2020 or 2019.
Losses and Loss Expenses.
Our insurance subsidiaries' loss ratio, which is the ratio of incurred losses
and loss expenses to premiums earned, was 65.4% for the third quarter of 2020, a
decrease from our insurance subsidiaries' loss ratio of 68.9% for the third
quarter of 2019. We attribute this decrease primarily to various actions we
implemented to improve profitability and reduced frequency of personal
automobile claims as a result of lower traffic density during the third quarter
of 2020. Weather-related losses of $16.9 million for the third quarter of 2020,
or 9.1
percentage points of the loss ratio, increased from $13.9 million, or 7.3
percentage points of the loss ratio, for the third quarter of 2019.
Weather-related loss activity for the third quarter of 2020 was comparable to
our previous five-year average of $15.9 million for third quarter
weather-related losses. On a statutory basis, our insurance subsidiaries'
commercial lines loss ratio was
68.2% for the third quarter of 2020, compared to 65.2% for the third quarter of
2019, primarily due to a weather-related increase in the commercial
multiple-peril loss ratio. The personal lines statutory loss ratio of our
insurance subsidiaries decreased to 61.1% for the third quarter of 2020,
compared to 73.4% for the third quarter of 2019. We attribute this decrease
primarily to decreases in the homeowners and personal automobile loss ratios.
Our insurance subsidiaries experienced unfavorable loss reserve development of
approximately $542,000 during the third quarter of 2020, compared to favorable
loss reserve development of $1.0 million during the third quarter of 2019.
Underwriting Expenses.
The expense ratio for an insurance company is the ratio of policy acquisition
costs and other underwriting expenses to premiums earned. The expense ratio of
our insurance subsidiaries was 31.9% for the third quarter of 2020, compared to
30.5% for the third quarter of 2019. The increase in the expense ratio primarily
reflected an increase in technology systems-related expenses, higher commercial
growth incentive costs for our agents and increased underwriting-based incentive
costs for our agents and employees during the third quarter of 2020 compared to
the third quarter of 2019. The increase in technology systems-related expenses
was primarily due to an increased allocation of costs from Donegal Mutual
to our insurance subsidiaries following the successful implementation of the
first phase of our ongoing systems modernization project in February 2020.
Combined Ratio.
The combined ratio represents the sum of the loss ratio, the expense ratio and
the dividend ratio, which is the ratio of policyholder dividends incurred to
premiums earned. Our insurance subsidiaries' combined ratios were 98.3% and
100.6% for the third quarter ended September 30, 2020 and 2019, respectively. We
attribute the decrease in the combined ratio primarily to a decrease in the loss
ratio for the third quarter of 2020 compared to the third quarter of 2019.
Interest Expense.
Our interest expense for the third quarter of 2020 was $219,039, compared to
$443,179 for the third quarter of 2019.
We attribute the decrease primarily to a
pre-payment
penalty of $176,000 incurred during the third quarter of 2019 related to
Atlantic States' early repayment of a cash advance with the FHLB of Pittsburgh.

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Income Taxes.
We recorded income tax expense of $2.5 million for the third quarter of 2020,
representing an effective tax rate of 17.4%. We recorded income tax expense of
$1.1 million for the third quarter of 2019, representing an effective tax rate
of 17.7%. The income tax expense and effective tax rate for the third quarter of
2020 and 2019 represented an estimate based on our projected annual taxable
income.
Net Income and Income Per Share.
Our net income for the third quarter of 2020 was $11.8 million, or $.41
per diluted share of Class A common stock and $.37 per share of Class B common
stock, compared to $5.2 million, or $.18 per diluted share of Class A common
stock and $.16 per share of Class B common stock, for the third quarter of 2019.
We had 24.1 million and 23.0 million Class A shares outstanding at September 30,
2020 and 2019, respectively. We had 5.6 million Class B shares outstanding at
the end of both periods.
Results of Operations - Nine Months Ended September 30, 2020 Compared to Nine
Months Ended September 30, 2019
Net Premiums Earned.
Our insurance subsidiaries' net premiums earned for the first nine months of
2020 were $556.6 million, a decrease of $10.1 million, or 1.8%, compared to
$566.7 million for the first nine months of 2019, primarily reflecting decreases
in net premiums written during 2020 and 2019.
Net Premiums Written.
Our insurance subsidiaries' net premiums written for the nine months ended
September 30, 2020 were $572.7 million, a decrease of $8.9 million, or 1.5%,
from the $581.6 million of net premiums written for the first nine months of
2019. Commercial lines net premiums written increased $16.2 million, or 5.2%,
for the first nine months of 2020 compared to the first nine months of 2019. We
attribute the increase in commercial lines net premiums written primarily to
increased writings of new commercial accounts and net premium rate increases.
Personal lines net premiums written decreased $25.1 million, or 9.3%, for the
first nine months of 2020 compared to the first nine months of 2019. We
attribute the decrease in personal lines net premiums written primarily to net
attrition as a result of measures our insurance subsidiaries have implemented to
improve underwriting profitability, partially offset by the impact of premium
rate increases our insurance subsidiaries have implemented.
Investment Income.
Our net investment income increased slightly to $22.0 million for the first nine
months of 2020, compared to $21.7 million for the first nine months of 2019. We
attribute the increase primarily to an increase in average invested assets,
offset partially by a decrease in the average investment yield.
Net Investment (Losses) Gains.
Net investment losses for the first nine months of 2020 were $940,488, compared
to net investment gains of $19.3 million for the first nine months of 2019. The
net investment losses for the first nine months of 2020 resulted primarily from
realized losses on sales of equity securities, offset partially by unrealized
gains in the fair value of equity securities held at September 30, 2020. The net
investment gains for the first nine months of 2019 included $12.7 million from
the sale of DFSC and $5.5 million related to unrealized gains within our equity
securities portfolio and a limited partnership that invests in equity
securities. We did not recognize any impairment losses in our investment
portfolio during the first nine months of 2020 or 2019.
Losses and Loss Expenses.
Our insurance subsidiaries' loss ratio, which is the ratio of incurred losses
and loss expenses to premiums earned, was 61.7% for the first nine months of
2020, a decrease from our insurance subsidiaries' loss ratio of 68.0% for the
first nine months of 2019. We attribute this decrease primarily to various
actions we implemented to improve profitability and reduced frequency of
personal automobile claims as a result of lower driving activity during the
second quarter of 2020 and lower traffic density during the third quarter of
2020. Weather-related losses of $42.5 million for the first nine months of 2020,
or 7.6 percentage points of the loss ratio, increased from $40.6 million, or 7.2
percentage points of the loss ratio, for the first nine months of 2019.
Weather-related loss activity for the first nine months of 2020 was comparable
to our previous five-year average of $41.6 million for first nine months
weather-related losses. On a statutory basis, our insurance subsidiaries'
commercial lines loss ratio was
63.1% for the first nine months of 2020, compared to 63.2% for the first nine
months of 2019, primarily due to a decrease in the commercial automobile loss
ratio. The personal lines statutory loss ratio of our insurance subsidiaries
decreased to 59.8% for the first nine months of 2020, compared to 72.7% for the
first nine months of 2019. We attribute this decrease primarily to decreases in
the homeowners and personal automobile loss ratios. Our insurance subsidiaries
experienced favorable loss reserve development of approximately $10.3 million
and $7.9 million during the first nine months of 2020 and 2019, respectively.
Underwriting Expenses.
The expense ratio for an insurance company is the ratio of policy acquisition
costs and other underwriting expenses to premiums earned. The expense ratio of
our insurance subsidiaries was 33.2% for the first nine months of 2020, compared
to 31.5% for the first nine months of 2019. The increase in the expense ratio
primarily reflected $2.0 million in reserves we established during the first
nine months of 2020 for potential credit losses related to uncollectible
premiums due to the effect of
COVID-19
economic disruption, an increase in technology systems-related expenses, higher
commercial growth

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incentive costs for our agents and increased underwriting-based incentive costs
for our agents and employees. The increase in technology systems-related
expenses was primarily due to an increased allocation of costs from Donegal
Mutual
to our insurance subsidiaries following the successful implementation of the
first phase of our ongoing systems modernization project in February 2020.
Combined Ratio.
The combined ratio represents the sum of the loss ratio, the expense ratio and
the dividend ratio, which is the ratio of policyholder dividends incurred to
premiums earned. Our insurance subsidiaries' combined ratios were 95.9% and
100.7% for the nine months ended September 30, 2020 and 2019, respectively. We
attribute the decrease in the combined ratio to a decrease in the loss ratio for
the first nine months of 2020 compared to the first nine months of 2019.
Interest Expense.
Our interest expense for the first nine months of 2020 was $871,461, compared to
$1.3 million for the first nine months of 2019.
We attribute the decrease primarily to lower average interest rates for
borrowings under our lines of credit, offset partially by higher average
borrowings during the first nine months of 2020 compared to the first nine
months of 2019.
Income Taxes.
We recorded income tax expense of $6.6 million for the first nine months of
2020, representing an effective tax rate of 14.7%. Income tax expense for the
first nine months of 2020 included a $1.6 million income tax benefit related to
the carryback of 2018 net operating losses to past tax years with higher
statutory income tax rates than are currently in effect, as allowed under the
Coronavirus Aid, Relief and Economic Security Act that was enacted in March
2020. We recorded income tax expense of $5.7 million for the first nine months
of 2019, representing an effective tax rate of 14.7%. The income tax expense and
effective tax rate for the first nine months of 2020 and 2019 primarily
represented an estimate based on our projected annual taxable income.
Net Income and Income Per Share.
Our net income for the first nine months of 2020 was $38.2 million, or $1.33
per diluted share of Class A common stock and $1.21 per share of Class B common
stock, compared to $33.0 million, or $1.17 per diluted share of Class A common
stock and $1.06 per share of Class B common stock, for the first nine months of
2019. We had 24.1 million and 23.0 million Class A shares outstanding at
September 30, 2020 and 2019, respectively. We had 5.6 million Class B shares
outstanding at the end of both periods.
Liquidity and Capital Resources
Liquidity is a measure of an entity's ability to secure enough cash to meet its
contractual obligations and operating needs as such obligations and needs arise.
Our major sources of funds from operations are the net cash flows we generate
from our insurance subsidiaries' underwriting results, investment income and
investment maturities.
Our operations have historically generated sufficient net positive cash flow to
fund our commitments and add to our investment portfolio, thereby increasing
future investment returns and enhancing our liquidity. The impact of the pooling
agreement between Donegal Mutual and Atlantic States has historically been
cash-flow positive because of the consistent underwriting profitability of the
pool. Donegal Mutual and Atlantic States settle their respective obligations to
each other under the pool monthly, thereby resulting in cash flows substantially
similar to the cash flows that would result from each company writing the
business directly. We have not experienced any unusual variations in the timing
of claim payments associated with the loss reserves of our insurance
subsidiaries. We maintain significant liquidity in our investment portfolio in
the form of readily marketable fixed maturities, equity securities and
short-term investments. We structure our fixed-maturity investment portfolio
following a "laddering" approach, so that projected cash flows from investment
income and principal maturities are evenly distributed from a timing
perspective, thereby providing an additional measure of liquidity to meet our
obligations should an unexpected variation occur in the future. Our operating
activities provided net cash flows in the first nine months of 2020 and 2019 of
$68.5 million and $48.4 million, respectively.
At September 30, 2020, we had no outstanding borrowings under our line of credit
with M&T and had the ability to borrow up to $20.0 million at interest rates
equal to the then-current LIBOR rate plus 2.00%. At September 30, 2020, Atlantic
States had $85.0 million in outstanding advances with the FHLB of Pittsburgh,
consisting of a $35.0 million advance that carries a fixed interest rate of
1.74% and a $50.0 million advance that carries a fixed interest rate of 0.83%.
In March 2020, Atlantic States issued $50.0 million of debt to the FHLB of
Pittsburgh in exchange for a cash advance in the same amount. Atlantic States
obtained this contingent liquidity funding in light of uncertainty surrounding
the economic impact of the
COVID-19
pandemic.

                                       30

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Table of Contents The following table shows our expected payments for significant contractual obligations at September 30, 2020:

                                                                         1-3
                                    Total       Less than 1 year        years        4-5 years       After 5 years
                                                                   (in thousands)
Net liability for unpaid losses
and loss expenses of our
insurance subsidiaries            $ 541,749     $         244,246     $ 255,615$    20,374$        21,514
Subordinated debentures               5,000                    -             -               -                5,000
Borrowings under lines of
credit                               85,000                50,000            -           35,000                  -

Total contractual obligations     $ 631,749     $         294,246     $ 255,615$    55,374$        26,514



We estimate the date of payment for the net liability for unpaid losses and loss
expenses of our insurance subsidiaries based on historical experience and
expectations of future payment patterns. We show the liability net of
reinsurance recoverable on unpaid losses and loss expenses to reflect expected
future cash flows related to such liability. Amounts Atlantic States assumes
pursuant to the pooling agreement with Donegal Mutual represent a substantial
portion of our insurance subsidiaries' gross liability for unpaid losses and
loss expenses, and amounts Atlantic States cedes pursuant to the pooling
agreement represent a substantial portion of our insurance subsidiaries'
reinsurance recoverable on unpaid losses and loss expenses. We include cash
settlement of Atlantic States' assumed liability from the pool in monthly
settlements of pooled activity, as we net amounts ceded to and assumed from the
pool. Although Donegal Mutual and we do not anticipate any changes in the pool
participation levels in the foreseeable future, any such change would be
prospective in nature and therefore would not impact the timing of expected
payments by Atlantic States for its percentage share of pooled losses occurring
in periods prior to the effective date of such change.
We discuss in Note 7 - Borrowings our estimate of the timing of the amounts
payable for the borrowings under our lines of credit based on their contractual
maturities. The borrowings under our lines of credit carry interest rates that
we discuss in Note 7 - Borrowings.
We discuss in Note 7 - Borrowings our estimate of the timing of the amounts
payable for the subordinated debentures based on their contractual maturity. The
subordinated debentures carry an interest rate of 5%, and any repayment of
principal or payment of interest on the subordinated debentures requires prior
approval of the Michigan Department of Insurance and Financial Services. Our
annual interest cost associated with the subordinated debentures is $250,000.
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 shares of our
Class A common stock at prices prevailing from time to time in the open market
subject to the provisions of applicable rules of the SEC and in privately
negotiated transactions. We did not purchase any shares of our Class A common
stock under this program during the nine months ended September 30, 2020 or
2019. We have purchased a total of 57,658 shares of our Class A common stock
under this program from its inception through September 30, 2020.
On October 15, 2020, our board of directors declared quarterly cash dividends of
15.0 cents per share of our Class A common stock and 13.25
cents per share of our Class B common stock, payable on November 16, 2020 to our
stockholders of record as of the close of business on November 2, 2020. We are
not subject to any restrictions on our payment of dividends to our stockholders,
although there are state law restrictions on the payment of dividends by our
insurance subsidiaries to us. Dividends from our insurance subsidiaries are our
principal source of cash for payment of dividends to our stockholders. Our
insurance subsidiaries are subject to regulations that restrict the payment of
dividends from statutory surplus and may require prior approval of their
domiciliary insurance regulatory authorities. Our insurance subsidiaries are
also subject to risk based capital ("RBC") requirements that limit their ability
to pay dividends to us. Our insurance subsidiaries' statutory capital and
surplus at December 31, 2019 exceeded the amount of statutory capital and
surplus necessary to satisfy regulatory requirements, including the RBC
requirements, by a significant margin. Our insurance subsidiaries paid
$14.0 million in dividends to us during the first nine months of 2020. Amounts
remaining available for distribution to us as dividends from our insurance
subsidiaries without prior approval of their domiciliary insurance regulatory
authorities in 2020 are $20.9 million from Atlantic States, $0 from Southern,
$1.0 million from Peninsula and $576,859 from MICO, or a total of approximately
$22.5 million.
At September 30, 2020, we had no material commitments for capital expenditures.

                                       31
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  Table of Contents
Equity Price Risk
Our portfolio of marketable equity securities, which we carry on our
consolidated balance sheets at estimated fair value, has exposure to the risk of
loss resulting from an adverse change in prices. We manage this risk by having
our investment personnel perform an analysis of prospective investments and
regular reviews of our portfolio of equity securities.
Credit Risk
Our portfolio of fixed-maturity securities and, to a lesser extent, our
portfolio of short-term investments is subject to credit risk, which we define
as the potential loss in market value resulting from adverse changes in the
borrower's ability to repay its debt. We manage this risk by having our
investment personnel perform an analysis of prospective investments and regular
reviews of our portfolio of fixed-maturity securities. We also limit the
percentage and amount of our total investment portfolio that we invest in the
securities of any one issuer.
Our insurance subsidiaries provide property and casualty insurance coverages
through independent insurance agencies. We bill the majority of this business
directly to the insured, although we bill a portion of our commercial business
through licensed insurance agents to whom our insurance subsidiaries extend
credit in the normal course of business.
Because the pooling agreement does not relieve Atlantic States of primary
liability as the originating insurer, Atlantic States is subject to a
concentration of credit risk arising from the business it cedes to Donegal
Mutual. Our insurance subsidiaries maintain reinsurance agreements with Donegal
Mutual and with a number of other major unaffiliated authorized reinsurers.
Impact of Inflation
We establish property and casualty insurance premium rates before we know the
amount of unpaid losses and loss expenses or the extent to which inflation may
impact such losses and expenses. Consequently, our insurance subsidiaries
attempt, in establishing rates, to anticipate the potential impact of inflation.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Our market risk generally represents the risk of gain or loss that may result
from the potential change in the fair value of the securities we hold in our
investment portfolio as a result of fluctuations in prices and interest rates
and, to a lesser extent, our debt obligations. We manage our interest rate risk
by maintaining an appropriate relationship between the average duration of our
investment portfolio and the approximate duration of our liabilities, i.e.,
policy claims of our insurance subsidiaries and our debt obligations.
Other than interest rate and pricing fluctuations related to the
COVID-19
pandemic, there have been no material changes to our quantitative or qualitative
market risk exposure from December 31, 2019 through September 30, 2020.
Item 4. 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). Based on such evaluation, our Chief Executive Officer
and our Chief Financial Officer have concluded that, at September 30, 2020, our
disclosure controls and procedures were effective in recording, processing,
summarizing and reporting, on a timely basis, information we are required to
disclose in the reports that we file or submit under the Exchange Act, and our
disclosure controls and procedures were also effective to ensure that
information we disclose in the reports we file or submit under the Exchange Act
is accumulated and communicated to our management, including our Chief Executive
Officer and our Chief Financial Officer, to allow timely decisions regarding
required disclosure.

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  Table of Contents
Changes in Internal Control Over Financial Reporting
During 2020, Donegal Mutual implemented new infrastructure and applications
systems that Donegal Mutual and our insurance subsidiaries began to utilize for
the issuance of new and renewal workers' compensation policies effective
beginning in the second quarter of 2020. Such changes resulted in changes to
procedures related to our financial reporting. Prior to the implementation of
the new systems, we identified and designed new internal controls that we
incorporated into our internal controls over financial reporting. Following the
implementation, we validated these new controls according to our established
processes. The implementation of the new systems represented the first phase of
a multi-year systems modernization initiative Donegal Mutual is implementing to
achieve various benefits for Donegal Mutual and our insurance subsidiaries,
including streamlined workflows and innovative business solutions. We are not
implementing these changes in internal controls to respond to any actual or
perceived significant deficiencies in our internal control over financial
reporting.
Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
We base all statements contained in this Quarterly Report on Form
10-Q
that are not historic facts on our current expectations. Such statements are
forward-looking in nature (as defined in the Private Securities Litigation
Reform Act of 1995) and necessarily involve risks and uncertainties.
Forward-looking statements we make may be identified by our use of words such as
"will," "expects," "intends," "plans," "anticipates," "believes," "seeks,"
"estimates" and similar expressions. Our actual results could vary materially
from our forward-looking statements. The factors that could cause our actual
results to vary materially from the forward-looking statements we have
previously made include, but are not limited to, prolonged economic challenges
resulting from the
COVID-19
pandemic and related business shutdown, adverse and catastrophic weather events,
our ability to maintain profitable operations, the adequacy of the loss and loss
expense reserves of our insurance subsidiaries, the availability and successful
operation of the information technology systems our insurance subsidiaries
utilize, the successful development of new information technology systems to
allow our insurance subsidiaries to compete effectively, business and economic
conditions in the areas in which we and our insurance subsidiaries operate,
interest rates, competition from various insurance and other financial
businesses, terrorism, the availability and cost of reinsurance, legal and
judicial developments including those related to
COVID-19
business interruption coverage exclusions, adverse litigation and other industry
trends that could increase our loss costs, changes in regulatory requirements,
changes in our A.M. Best rating, our ability to integrate and manage
successfully the companies we may acquire from time to time and the other risks
that we describe from time to time in our filings with the SEC. We disclaim any
obligation to update such statements or to announce publicly the results of any
revisions that we may make to any forward-looking statements to reflect the
occurrence of anticipated or unanticipated events or circumstances after the
date of such statements.

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