DGICA 10-Q Quarter ended Sept. 30, 2018

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2018

OR

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

For the transition period from to .

Commission file number 0-15341

Donegal Group Inc.

(Exact name of registrant as specified in its charter)

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

1195 River Road, P.O. Box 302, Marietta, PA 17547

(Address of principal executive offices) (Zip code)

(717) 426-1931

(Registrant’s telephone number, including area code)

Not applicable

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

Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

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

Large accelerated filer		☐		Accelerated filer		☒
Non-accelerated filer		☐		Smaller reporting company		☐
				Emerging growth company		☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 22,788,003 shares of Class A Common Stock, par value $0.01 per share, and 5,576,775 shares of Class B Common Stock, par value $0.01 per share, outstanding on October 31, 2018.

DONEGAL GROUP INC.

INDEX TO FORM 10-Q REPORT

				Page
PART I		FINANCIAL INFORMATION
Item 1.		Financial Statements			1
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			22
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			31
Item 4.		Controls and Procedures			31
PART II		OTHER INFORMATION
Item 1.		Legal Proceedings			32
Item 1A.		Risk Factors			32
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			32
Item 3.		Defaults upon Senior Securities			32
Item 4.		Removed and Reserved			32
Item 5.		Other Information			32
Item 6.		Exhibits			33
Signatures					34

PART I. FINANCIAL INFORMATION

Item 1.

Financial Statements.

Donegal Group Inc. and Subsidiaries

Consolidated Balance Sheets

		September 30, 2018				December 31, 2017
		(Unaudited)
Assets
Investments
Fixed maturities
Held to maturity, at amortized cost		$	400,233,054			$	366,655,077
Available for sale, at fair value			525,027,434				538,946,050
Equity securities, at fair value			57,972,976				50,445,243
Investment in affiliate			39,960,649				38,773,420
Short-term investments, at cost, which approximates fair value			5,096,047				11,049,915
Total investments			1,028,290,160				1,005,869,705
Cash			55,258,656				37,833,435
Accrued investment income			7,166,660				6,553,121
Premiums receivable			160,318,764				160,406,432
Reinsurance receivable			322,467,746				298,342,563
Deferred policy acquisition costs			64,566,885				60,289,860
Deferred tax asset, net			10,059,549				7,128,843
Prepaid reinsurance premiums			141,536,708				135,032,641
Property and equipment, net			4,825,788				7,280,415
Accounts receivable – securities			1,101,615				180,525
Federal income taxes receivable			19,595,519				10,935,105
Goodwill			5,625,354				5,625,354
Other intangible assets			958,010				958,010
Other			2,475,943				1,483,769
Total assets		$	1,824,247,357			$	1,737,919,778
Liabilities and Stockholders’ Equity
Liabilities
Unpaid losses and loss expenses		$	779,979,677			$	676,671,727
Unearned premiums			530,543,671				503,456,541
Accrued expenses			24,381,505				28,033,776
Reinsurance balances payable			3,191,746				4,116,159
Borrowings under lines of credit			60,000,000				59,000,000
Cash dividends declared to stockholders			—				3,841,820
Subordinated debentures			5,000,000				5,000,000
Due to affiliate			3,737,282				7,314,368
Other			1,873,448				1,789,283
Total liabilities			1,408,707,329				1,289,223,674
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 25,733,219 and 25,564,481 shares and outstanding 22,730,631 and 22,561,893 shares			257,333				255,645
Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 5,649,240 shares and outstanding 5,576,775 shares			56,492				56,492
Additional paid-in capital			259,667,062				255,401,558
Accumulated other comprehensive loss			(18,943,910	)			(2,684,275	)
Retained earnings			215,729,408				236,893,041
Treasury stock, at cost			(41,226,357	)			(41,226,357	)
Total stockholders’ equity			415,540,028				448,696,104
Total liabilities and stockholders’ equity		$	1,824,247,357			$	1,737,919,778

See accompanying notes to consolidated financial statements.

1

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

		Three Months Ended September 30,
		2018				2017
Revenues:
Net premiums earned		$	187,661,705			$	177,283,816
Investment income, net of investment expenses			6,620,491				5,979,834
Net realized investment gains (includes ($20,512) and $561,429 accumulated other comprehensive income reclassifications)			3,463,504				561,429
Lease income			119,934				113,409
Installment payment fees			1,305,778				1,373,892
Equity in earnings of Donegal Financial Services Corporation			732,768				403,647
Total revenues			199,904,180				185,716,027
Expenses:
Net losses and loss expenses			140,726,106				114,386,379
Amortization of deferred policy acquisition costs			31,110,000				29,008,000
Other underwriting expenses			24,528,860				31,790,251
Policyholder dividends			1,050,200				1,376,115
Interest			651,768				466,262
Other expenses, net			560,260				176,970
Total expenses			198,627,194				177,203,977
Income before income tax expense			1,276,986				8,512,050
Income tax expense (includes ($4,308) and $196,500 income tax (benefit) expense from reclassification items)			70,630				1,403,476
Net income		$	1,206,356			$	7,108,574
Income per common share:
Class A common stock – basic		$	0.04			$	0.27
Class A common stock – diluted		$	0.04			$	0.26
Class B common stock – basic and diluted		$	0.04			$	0.24

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

		Three Months Ended September 30,
		2018				2017
Net income		$	1,206,356			$	7,108,574
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on securities:
Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($609,572) and $561,247			(2,293,154	)			1,042,317
Reclassification adjustment for losses (gains) included in net income, net of income tax (benefit) expense of ($4,308) and $196,500			16,204				(364,929	)
Other comprehensive (loss) income			(2,276,950	)			677,388
Comprehensive (loss) income		$	(1,070,594	)		$	7,785,962

2

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

		Nine Months Ended September 30,
		2018				2017
Revenues:
Net premiums earned		$	555,140,395			$	521,454,835
Investment income, net of investment expenses			19,341,012				17,385,103
Net realized investment gains (includes ($52,828) and $4,207,710 accumulated other comprehensive income reclassifications)			4,062,475				4,207,710
Lease income			365,930				383,183
Installment payment fees			3,959,936				3,813,663
Equity in earnings of Donegal Financial Services Corporation			2,152,738				1,023,212
Total revenues			585,022,486				548,267,706
Expenses:
Net losses and loss expenses			433,063,019				356,825,751
Amortization of deferred policy acquisition costs			91,354,000				85,391,000
Other underwriting expenses			82,343,932				88,538,755
Policyholder dividends			3,565,971				3,422,672
Interest			1,682,200				1,212,895
Other expenses, net			1,604,595				1,036,223
Total expenses			613,613,717				536,427,296
(Loss) income before income tax (benefit) expense			(28,591,231	)			11,840,410
Income tax (benefit) expense (includes ($11,094) and $1,472,698 income tax (benefit) expense from reclassification items)			(10,829,654	)			1,945,666
Net (loss) income		$	(17,761,577	)		$	9,894,744
(Loss) earnings per common share:
Class A common stock – basic		$	(0.64	)		$	0.37
Class A common stock – diluted		$	(0.64	)		$	0.36
Class B common stock – basic and diluted		$	(0.59	)		$	0.33

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

		Nine Months Ended September 30,
		2018				2017
Net (loss) income		$	(17,761,577	)		$	9,894,744
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on securities:
Unrealized holding (loss) gain during the period, net of income tax (benefit) expense of ($3,025,784) and $2,215,869			(11,382,714	)			4,115,189
Reclassification adjustment for losses (gains) included in net (loss) income, net of income tax (benefit) expense of ($11,094) and $1,472,698			41,734				(2,735,012	)
Other comprehensive (loss) income			(11,340,980	)			1,380,177
Comprehensive (loss) income		$	(29,102,557	)		$	11,274,921

See accompanying notes to consolidated financial statements.

3

Donegal Group Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Equity

(Unaudited)

Nine Months Ended September 30, 2018

		Class A Shares				Class B Shares				Class A Amount				Class B Amount				Additional Paid-In Capital				Accumulated Other Comprehensive Loss				Retained Earnings				Treasury Stock				Total Stockholders’ Equity
Balance, December 31, 2017			25,564,481				5,649,240			$	255,645			$	56,492			$	255,401,558			$	(2,684,275	)		$	236,893,041			$	(41,226,357	)		$	448,696,104
Issuance of common stock			120,394				—				1,204				—				1,703,806				—				—				—				1,705,010
Share-based compensation			48,344				—				484				—				2,113,728				—				—				—				2,114,212
Net loss			—				—				—				—				—				—				(17,761,577	)			—				(17,761,577	)
Cash dividends declared			—				—				—				—				—				—				(7,872,741	)			—				(7,872,741	)
Grant of stock options			—				—				—				—				447,970				—				(447,970	)			—				—
Reclassification of equity unrealized gains			—				—				—				—				—				(4,918,655	)			4,918,655				—				—
Other comprehensive loss			—				—				—				—				—				(11,340,980	)			—				—				(11,340,980	)
Balance, September 30, 2018			25,733,219				5,649,240			$	257,333			$	56,492			$	259,667,062			$	(18,943,910	)		$	215,729,408			$	(41,226,357	)		$	415,540,028

See accompanying notes to consolidated financial statements.

4

Donegal Group Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

		Nine Months Ended September 30,
		2018				2017
Cash Flows from Operating Activities:
Net (loss) income		$	(17,761,577	)		$	9,894,744
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation, amortization and other non-cash items			5,288,171				4,791,010
Net realized investment gains			(4,062,475	)			(4,207,710	)
Equity in earnings of Donegal Financial Services Corporation			(2,152,738	)			(1,023,212	)
Changes in assets and liabilities:
Losses and loss expenses			103,307,950				37,685,539
Unearned premiums			27,087,130				49,850,687
Premiums receivable			87,668				(4,035,543	)
Deferred acquisition costs			(4,277,025	)			(5,568,430	)
Deferred income taxes			83,985				(113,508	)
Reinsurance receivable			(24,125,183	)			(20,551,553	)
Prepaid reinsurance premiums			(6,504,067	)			(13,554,734	)
Accrued investment income			(613,539	)			(656,215	)
Due to affiliate			(3,577,086	)			14,960,562
Reinsurance balances payable			(924,413	)			1,312,472
Current income taxes			(8,660,414	)			(995,307	)
Accrued expenses			(3,652,271	)			(5,018,331	)
Other, net			310,988				(101,676	)
Net adjustments			77,616,681				52,774,051
Net cash provided by operating activities			59,855,104				62,668,795
Cash Flows from Investing Activities:
Purchases of fixed maturities, held to maturity			(42,834,707	)			(43,710,213	)
Purchases of fixed maturities, available for sale			(88,940,126	)			(105,011,666	)
Purchases of equity securities, available for sale			(11,255,867	)			(9,030,858	)
Maturity of fixed maturities:
Held to maturity			9,485,969				14,580,714
Available for sale			84,617,730				75,856,616
Sales of fixed maturities, available for sale			1,388,934				9,634,968
Sales of equity securities, available for sale			7,843,437				10,782,859
Net purchases of property and equipment			(132,290	)			(740,608	)
Net sales (purchases) of short-term investments			5,953,868				(1,360,359	)
Net cash used in investing activities			(33,873,052	)			(48,998,547	)
Cash Flows from Financing Activities:
Cash dividends paid			(11,714,561	)			(11,079,326	)
Issuance of common stock			2,157,730				4,363,003
Borrowings under line of credit			1,000,000				—
Net cash used in financing activities			(8,556,831	)			(6,716,323	)
Net increase in cash			17,425,221				6,953,925
Cash at beginning of period			37,833,435				24,587,214
Cash at end of period		$	55,258,656			$	31,541,139
Cash paid during period – Interest		$	937,470			$	1,016,678
Net cash paid during period – Taxes		$	—			$	3,050,000

See accompanying notes to consolidated financial statements.

5

DONEGAL GROUP INC. AND SUBSIDIARIES

(Unaudited)

Notes to Consolidated Financial Statements

1 -	Organization

Donegal Mutual Insurance Company (“Donegal Mutual”) organized us as 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 property and casualty insurance exclusively through 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. 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 September 30, 2018, Donegal Mutual held approximately 43% of our outstanding Class A common stock and approximately 84% of our outstanding Class B common stock. This ownership provides Donegal Mutual with approximately 72% 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, Donegal Mutual and our insurance subsidiaries 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 entire personal lines or commercial lines accounts. Distinctions within the products Donegal Mutual and our insurance subsidiaries offer relate generally to specific risk profiles targeted within similar classes of business, such as preferred tier products versus standard tier products, but we do not allocate all of the standard risk gradients to any specific company within the Donegal Insurance Group. Therefore, the underwriting profitability of the business the individual companies write directly will vary. However, because 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 underwriting pool.

Donegal Mutual completed the merger of Mountain States Mutual Casualty Company (“Mountain States”) with and into Donegal Mutual effective May 25, 2017. Donegal Mutual was the surviving company in the merger, and Mountain States’ insurance subsidiaries, Mountain States Indemnity Company and Mountain States Commercial Insurance Company, became insurance subsidiaries of Donegal Mutual upon completion of the merger. Upon completion of the merger, Donegal Mutual assumed all of the policy obligations of Mountain States and began to market its products together with those of its insurance subsidiaries as the Mountain States Insurance Group in four Southwestern states. For an indefinite period of time, Donegal Mutual will exclude the business of the Mountain States Insurance Group from the pooling agreement with Atlantic States. As a result, our consolidated results of operations exclude the results of Donegal Mutual’s operations in those Southwestern states.

On April 3, 2018, we announced plans to consolidate the branch office operations of Peninsula into our home office operations effective July 2, 2018 to achieve economies of scale and enhance service levels for policyholders of Peninsula. We recorded a restructuring charge in the second quarter of 2018 for employee termination costs associated with the Peninsula consolidation of approximately $1.9 million. We paid approximately $835,000 of these costs in the third quarter of 2018 and

6

had an accrual of approximately $1.1 million remaining at September 30, 2018. We entered into a definitive purchase arrangement for the sale of Peninsula’s branch office real estate, and expect to receive net proceeds of $1.2 million during the fourth quarter of 2018. We recorded an impairment charge of $1.0 million in other expenses in the third quarter of 2018 related to this real estate transaction and included the $1.2 million fair value of the real estate we held for sale in other assets at September 30, 2018.

On June 11, 2018, we and Donegal Mutual entered into an agreement whereby DFSC will merge with and into Northwest Bancshares, Inc. (“Northwest”) in exchange for payment by Northwest to us and Donegal Mutual of approximately $85.0 million in a combination of cash and Northwest common stock. Immediately prior to the closing of the transaction, DFSC will pay a dividend of approximately $30.0 million to us and Donegal Mutual. As the owner of 48.2% of DFSC’s common stock, we will receive a dividend payment from DFSC of approximately $14.5 million and consideration from Northwest that will range in value from $38.9 million to $43.0 million. Subject to receipt of various regulatory approvals and satisfaction of other customary closing conditions, we anticipate that the transaction will close during the first quarter of 2019.

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 Securities and Exchange Commission (“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, 2018 or 2017. We have purchased a total of 57,658 shares of our Class A common stock under this program from its inception through September 30, 2018.

2 -	Basis of Presentation

Our financial information for the interim periods included in this Form 10-Q Report is unaudited; however, our financial information we include in this Form 10-Q Report reflects all adjustments, consisting only of normal recurring adjustments that, in the opinion of our management, are necessary for a fair presentation of our financial position, results of operations and cash flows for those interim periods. Our results of operations for the nine months ended September 30, 2018 are not necessarily indicative of the results of operations we expect for the year ending December 31, 2018.

We recommend you read the interim financial statements we include in this Form 10-Q Report in conjunction with the financial statements and the notes to our financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2017.

3 -	Earnings Per Share

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

7

		Three Months Ended September 30,
		2018								2017
		Class A				Class B				Class A				Class B
		(in thousands, except per share data)
Basic income per share:
Numerator:
Allocation of net income		$	1,006			$	200			$	5,787			$	1,322
Denominator:
Weighted-average shares outstanding			22,717				5,577				21,756				5,577
Basic income per share		$	0.04			$	0.04			$	0.27			$	0.24
Diluted income per share:
Numerator:
Allocation of net income		$	1,006			$	200			$	5,787			$	1,322
Denominator:
Number of shares used in basic computation			22,717				5,577				21,756				5,577
Weighted-average shares effect of dilutive securities:
Director and employee stock options			178				—				461				—
Number of shares used in diluted computation			22,895				5,577				22,217				5,577
Diluted income per share		$	0.04			$	0.04			$	0.26			$	0.24
		Nine Months Ended September 30,
		2018								2017
		Class A				Class B				Class A				Class B
		(in thousands, except per share data)
Basic (loss) earnings per share:
Numerator:
Allocation of net (loss) income		$	(14,472	)		$	(3,290	)		$	8,066			$	1,829
Denominator:
Weighted-average shares outstanding			22,673				5,577				21,669				5,577
Basic (loss) earnings per share		$	(0.64	)		$	(0.59	)		$	0.37			$	0.33
Diluted (loss) earnings per share:
Numerator:
Allocation of net (loss) income		$	(14,472	)		$	(3,290	)		$	8,066			$	1,829
Denominator:
Number of shares used in basic computation			22,673				5,577				21,669				5,577
Weighted-average shares effect of dilutive securities:
Director and employee stock options			—				—				778				—
Number of shares used in diluted computation			22,673				5,577				22,447				5,577
Diluted (loss) earnings per share		$	(0.64	)		$	(0.59	)		$	0.36			$	0.33

8

We did not include outstanding options to purchase 6,731,481 shares of Class A common stock in our computation of diluted earnings per share for the three months ended September 30, 2018 because the exercise price of the options exceeded the average market price of our Class A common stock during the period. We did not include any effect of dilutive securities in the computation of diluted earnings per share for the nine months ended September 30, 2018 because we sustained a net loss for this period.

We did not include outstanding options to purchase 5,178,629 and 1,382,400 shares of Class A common stock in our computation of diluted earnings per share for the three and nine months ended September 30, 2017 because the exercise price of the options exceeded the average market price of our Class A common stock during the applicable periods.

4 -	Reinsurance

Atlantic States and Donegal Mutual have participated in a pooling agreement since 1986 under which they pool substantially all of their direct premiums written, and Atlantic States and Donegal Mutual then share the underwriting results of the pool in accordance with the terms of the pooling agreement. Atlantic States has an 80% share of the results of the pool, and Donegal Mutual has a 20% share of the results of the pool.

Our insurance subsidiaries and Donegal Mutual purchase certain third-party reinsurance on a combined basis. Le Mars, MICO, Peninsula and Sheboygan also separately purchase third-party reinsurance that provides that insurance subsidiary with reinsurance coverage that we believe is commensurate with its respective size and risk exposures. Our insurance subsidiaries use several different reinsurers, all of which have an A.M. Best rating of A- (Excellent) or better or, with respect to foreign reinsurers, have a financial condition that, in the opinion of our management, is equivalent to a company with at least an A- rating from A.M. Best. The following information describes the external reinsurance our insurance subsidiaries have in place for 2018:

•

excess of loss reinsurance, under which Donegal Mutual and our insurance subsidiaries recover, through a series of reinsurance agreements, losses 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 (generally $5.0 million) up to aggregate losses of $170.0 million per occurrence.

Our insurance subsidiaries and Donegal Mutual also purchase facultative reinsurance to cover exposures in excess of the covered limits of their third-party reinsurance agreements.

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

Effective March 1, 2018, Donegal Mutual and certain of our insurance subsidiaries modified their third-party reinsurance coverage related to umbrella liability policies to increase the maximum loss retention of Donegal Mutual and our insurance subsidiaries from $250,000 to $1.0 million. Donegal Mutual and certain of our insurance subsidiaries also made various adjustments to the terms of their intercompany catastrophe reinsurance agreements effective January 1, 2018. We have made no other significant changes to our third-party reinsurance or the reinsurance agreements between our insurance subsidiaries and Donegal Mutual during the nine months ended September 30, 2018.

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5 -	Investments

The amortized cost and estimated fair values of our fixed maturities at September 30, 2018 were as follows:

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(in thousands)
Held to Maturity
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	76,078			$	5			$	2,120			$	73,963
Obligations of states and political subdivisions			156,055				6,890				1,721				161,224
Corporate securities			125,879				258				4,338				121,799
Mortgage-backed securities			42,221				—				1,033				41,188
Totals		$	400,233			$	7,153			$	9,212			$	398,174

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(in thousands)
Available for Sale
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	44,192			$	4			$	1,668			$	42,528
Obligations of states and political subdivisions			81,704				1,696				726				82,674
Corporate securities			135,889				178				3,285				132,782
Mortgage-backed securities			276,973				37				9,967				267,043
Totals		$	538,758			$	1,915			$	15,646			$	525,027

At September 30, 2018, our holdings of obligations of states and political subdivisions included general obligation bonds with an aggregate fair value of $163.4 million and an amortized cost of $159.7 million. Our holdings at September 30, 2018 also included special revenue bonds with an aggregate fair value of $80.5 million and an amortized cost of $78.1 million. With respect to both categories of those bonds at September 30, 2018, we held no securities of any issuer that comprised more than 10% of our holdings of either bond category. Education bonds and water and sewer utility bonds represented 54% and 27%, respectively, of our total investments in special revenue bonds based on the carrying values of these investments at September 30, 2018. Many of the issuers of the special revenue bonds we held at September 30, 2018 have the authority to impose ad valorem taxes. In that respect, many of the special revenue bonds we held at September 30, 2018 are similar to general obligation bonds.

The amortized cost and estimated fair values of our fixed maturities at December 31, 2017 were as follows:

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(in thousands)
Held to Maturity
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	71,736			$	804			$	547			$	71,993
Obligations of states and political subdivisions			137,581				11,162				112				148,631
Corporate securities			108,025				2,860				731				110,154
Mortgage-backed securities			49,313				516				157				49,672
Totals		$	366,655			$	15,342			$	1,547			$	380,450

10

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(in thousands)
Available for Sale
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	44,759			$	20			$	730			$	44,049
Obligations of states and political subdivisions			128,478				3,942				303				132,117
Corporate securities			105,254				1,011				526				105,739
Mortgage-backed securities			259,923				445				3,327				257,041
Totals		$	538,414			$	5,418			$	4,886			$	538,946

At December 31, 2017, our holdings of obligations of states and political subdivisions included general obligation bonds

with an aggregate fair value of $190.7 million and an amortized cost of $181.4 million. Our holdings at December 31, 2017 also included special revenue bonds with an aggregate fair value of $90.0 million and an amortized cost of $84.7 million. With respect to both categories of those bonds at December 31, 2017, we held no securities of any issuer that comprised more than 10% of that category. Education bonds and water and sewer utility bonds represented 53% and 26%, respectively, of our total investments in special revenue bonds based on their carrying values at December 31, 2017. Many of the issuers of the special revenue bonds we held at December 31, 2017 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 certain fixed maturities at fair value on November 30, 2013. We segregated within accumulated other comprehensive loss the net unrealized losses of $15.1 million arising prior to the November 30, 2013 reclassifications. We are amortizing this balance over the remaining life of the related securities as an adjustment to yield in a manner consistent with the accretion of discount on the same fixed maturities. We recorded amortization of $912,229 and $909,044 in other comprehensive (loss) income during the nine months ended September 30, 2018 and 2017, respectively. At September 30, 2018 and December 31, 2017, net unrealized losses of $8.9 million and $9.8 million, respectively, remained within accumulated other comprehensive loss.

We show below the amortized cost and estimated fair value of our fixed maturities at September 30, 2018 by contractual maturity. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

		Amortized Cost				Estimated Fair Value
		(in thousands)
Held to maturity
Due in one year or less		$	8,783			$	8,768
Due after one year through five years			70,790				70,505
Due after five years through ten years			136,673				135,068
Due after ten years			141,766				142,645
Mortgage-backed securities			42,221				41,188
Total held to maturity		$	400,233			$	398,174
Available for sale
Due in one year or less		$	39,265			$	39,465
Due after one year through five years			86,468				85,156
Due after five years through ten years			116,791				114,026
Due after ten years			19,261				19,337
Mortgage-backed securities			276,973				267,043
Total available for sale		$	538,758			$	525,027

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The cost and estimated fair values of our equity securities at September 30, 2018 were as follows:

		Cost				Gross Gains				Gross Losses				Estimated Fair Value
		(in thousands)
Equity securities		$	49,416			$	9,207			$	650			$	57,973

The cost and estimated fair values of our equity securities at December 31, 2017 were as follows:

		Cost				Gross Gains				Gross Losses				Estimated Fair Value
		(in thousands)
Equity securities		$	44,219			$	6,505			$	279			$	50,445

Gross realized gains and losses from investments before applicable income taxes for the three and nine months ended September 30, 2018 and 2017 were as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
		(in thousands)								(in thousands)
Gross realized gains:
Fixed maturities		$	5			$	87			$	16			$	138
Equity securities			2,976				513				6,246				4,142
			2,981				600				6,262				4,280
Gross realized losses:
Fixed maturities			25				39				70				69
Equity securities			(508	)			—				2,130				3
			(483	)			39				2,200				72
Net realized gains		$	3,464			$	561			$	4,062			$	4,208

We recognized $3.9 million of gains and $1.6 million of losses on equity securities held at September 30, 2018 in net realized investment gains for the nine months ended September 30, 2018.

We held fixed maturities with unrealized losses representing declines that we considered temporary at September 30, 2018 as follows:

		Less Than 12 Months								More Than 12 Months
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
		(in thousands)
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	65,701			$	1,017			$	48,064			$	2,771
Obligations of states and political subdivisions			58,935				1,586				16,385				861
Corporate securities			179,587				5,150				39,074				2,473
Mortgage-backed securities			144,615				3,200				159,788				7,800
Totals		$	448,838			$	10,953			$	263,311			$	13,905

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We held fixed maturities and equity securities with unrealized losses representing declines that we considered temporary at December 31, 2017 as follows:

		Less Than 12 Months								More Than 12 Months
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
		(in thousands)
U.S. Treasury securities and obligations of U.S. government corporations and agencies		$	24,024			$	287			$	33,987			$	990
Obligations of states and political subdivisions			10,223				120				14,127				295
Corporate securities			35,204				253				31,561				1,004
Mortgage-backed securities			100,534				817				124,062				2,667
Equity securities			4,292				279				—				—
Totals		$	174,277			$	1,756			$	203,737			$	4,956

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 measure investments at fair value and, beginning January 1, 2018, we recognize changes in fair value in our results of operations. 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 the 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 with respect to that security. 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, issuer or geographic events that have negatively impacted the value of a security and rating agency downgrades. We held 565 debt securities that were in an unrealized loss position at September 30, 2018. 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 amortize premiums and discounts on debt securities over the life of the security as an adjustment to yield using the effective interest method. We compute realized investment gains and losses using the specific identification method.

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

Our investment in affiliate represents our 48.2% ownership interest in DFSC. 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 the equity of DFSC due to 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 September 30, 2018 and December 31, 2017 and for the three and nine months ended September 30, 2018 and 2017, respectively, from the financial statements of DFSC. The financial information of DFSC at September 30, 2018 and 2017 and for the three and nine months then ended is unaudited.

		September 30, 2018				December 31, 2017
		(in thousands)
Balance sheets:
Total assets		$	543,086			$	567,935
Total liabilities		$	460,292			$	487,604
Stockholders’ equity			82,794				80,331
Total liabilities and stockholders’ equity		$	543,086			$	567,935

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		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
		(in thousands)								(in thousands)
Income statements:
Net income		$	1,519			$	837			$	4,464			$	2,122

6 -	Segment Information

We evaluate the performance of our personal lines and commercial lines segments based upon the underwriting results of our insurance subsidiaries using statutory accounting principles (“SAP”) that various state insurance departments prescribe or permit. Our management uses SAP to measure the performance of our insurance subsidiaries instead of United States generally accepted accounting principles (“GAAP”). SAP financial measures are considered non-GAAP financial measures under applicable SEC rules because they include or exclude certain items that the most comparable GAAP financial measures do not ordinarily include or exclude.

Financial data by segment for the three and nine months ended September 30, 2018 and 2017 is as follows:

		Three Months Ended September 30,
		2018				2017
		(in thousands)
Revenues:
Premiums earned:
Commercial lines		$	84,251			$	80,724
Personal lines			103,410				96,560
Premiums earned			187,661				177,284
Net investment income			6,620				5,980
Realized investment gains			3,464				561
Equity in earnings of DFSC			733				404
Other			1,426				1,487
Total revenues		$	199,904			$	185,716
Income before income tax expense:
Underwriting (loss) income:
Commercial lines		$	2,125			$	8,998
Personal lines			(12,210	)			(8,919	)
SAP underwriting (loss) income			(10,085	)			79
GAAP adjustments			332				644
GAAP underwriting (loss) income			(9,753	)			723
Net investment income			6,620				5,980
Realized investment gains			3,464				561
Equity in earnings of DFSC			733				404
Other			213				844
Income before income tax expense		$	1,277			$	8,512

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