BALDWIN & LYONS INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Liquidity and Capital Resources

  The primary sources of the Company's liquidity are (1) funds generated from insurance operations including net investment income, (2) proceeds from the sale of investments and (3) proceeds from maturing investments. The Company generally experiences positive cash flow from operations resulting from the fact that premiums are collected on insurance policies in advance of the disbursement of funds in payment of claims. Operating costs of the insurance subsidiaries, other than loss and loss expense payments, generally average less than 30% of net premiums earned on a consolidated basis and the remaining amount is available for investment for varying periods of time depending on the type of insurance coverage provided. Because losses are often settled in periods subsequent to when they are incurred, operating cash flows may, at times, become negative as loss settlements on claim reserves established in prior years exceed current revenues. During 2011, cash flow from operations totaled $54.3 million compared to $49.5 million in 2010. This comparative increase in operating cash flow resulted from increases in net premiums collected and lower federal tax payments largely offset by corresponding increases in losses paid in 2011.  For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As flat yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has continued to maintain its fixed maturity portfolio at short-term levels. The average contractual life of the Company's bond and short-term investment portfolio decreased from 4.5 to 3.1 years during 2011. The average duration of the Company's fixed maturity portfolio is shorter than the contractual maturity average and much shorter than the duration of the Company's liabilities. The Company also remains an active participant in the equity securities market using capital which is in excess of amounts considered necessary to fund current operations. The long-term horizon for the Company's equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. Investments made by the Company's domestic insurance subsidiaries are regulated by guidelines promulgated by the National Association of Insurance Commissioners which are designed to provide protection for both policyholders and shareholders.  The Company's assets at December 31, 2011 included $85.4 million in short-term and cash equivalent investments which are readily convertible to cash without market penalty and an additional $152.0 million of fixed maturity investments (at par) maturing in less than one year. The Company believes that these liquid investments, plus the expected cash flow from current operations, are more than sufficient to provide for projected claim payments and operating cost demands. In the event competitive conditions produce inadequate premium rates and the Company chooses to further restrict volume, the liquidity of its investment portfolio would permit management to continue to pay claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time. In addition, the Company's reinsurance program is structured to avoid significant cash outlays that accompany large losses.  Net premiums written by the Company's insurance subsidiaries for 2011 equaled approximately 56% of the combined statutory surplus of these subsidiaries. Premium writings of 100% to 200% of surplus are generally considered acceptable by regulatory authorities. Further, the statutory capital of each of the insurance subsidiaries substantially exceeds minimum risk based capital requirements set by the National Association of Insurance Commissioners. Accordingly, the Company has the ability to significantly increase its business without seeking additional capital to meet regulatory guidelines.  At December 31, 2011, $84.7 million, or 27% of shareholders' equity, represented net assets of the Company's insurance subsidiaries which, at that time, could not be transferred in the form of dividends, loans or advances to the parent company because of minimum statutory capital requirements. However, management believes that these restrictions pose no material liquidity concerns for the Company. The financial strength and stability of the subsidiaries permit ready access by the parent company to short-term and long-term sources of credit. The Company maintains a $30 million unsecured line of credit and has $10.0 million of drawings outstanding on this line at December 31, 2011, the proceeds of which were used principally for treasury stock repurchases, dividend payments and other corporate expenditures.                                         - 23 -

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  Results of Operations  2011 Compared to 2010  Direct premiums written for 2011 totaled $274.1 million, an increase of $24.4 million (10%) from 2010. The increase is primarily attributable to $23.7 million (13%) in premiums generated by fleet transportation products and $9.5 million in premiums generated by professional liability business. Premiums ceded to reinsurers on direct business increased $8.2 million (11%) during 2011 to $84.1 million, as the consolidated percentage of premiums ceded to direct premiums written remained relatively level at 30.7% for 2011 compared to 30.4 % for 2010.  Written premiums assumed from other insurers and reinsurers totaled $60.4 million during 2011, an increase of $14.3 million (31%) from 2010. The increase is related almost entirely to the expansion of the Company's professional liability reinsurance business which was launched in 2010. Premium ceded related to the reinsurance assumed business remained level with the 3% average rate from 2010.  

After giving effect to changes in unearned premiums, net premiums earned totaled $244.6 million for 2011 compared to $214.7 million for 2010, an increase of 13.9%. These changes are in line with expectations and result from product expansion and continuing marketing efforts in the Property and Casualty Insurance segment and from the continued growth of professional liability reinsurance within the Reinsurance segment.

  Pre-tax investment income of $10.7 million during 2011 was 5% lower than the 2010 total as pre-tax yields were down nearly 8% on average, reflecting continuing depressed worldwide available rates, principally on short-term investments. After tax investment income decreased by a similar 6% during 2011, compared to the prior year.  Net losses on investments, before taxes, totaled $17.8 million in 2011 compared to net gains on investments of $16.5 million during 2010. The net losses in 2011 are attributable to $21.9 million in limited partnerships net losses partially offset by $4.1 million in fixed maturity and equity security net direct trading gains. Limited partnership ventures utilized by the Company are primarily engaged in the trading of public and private securities, including foreign securities and, to a lesser extent, small venture capital activities and real estate development. The aggregate of the Company's share of losses in these entities represented a 29% decline in value for 2011 compared to an appreciation in value of 12% for 2010. To the extent that accounting rules require the limited partnerships to include realized and unrealized gains or losses in their net income, the Company's proportionate share of net income will include the results as reported to the Company by the various general partners. During 2011, approximately $20.6 million (94%) of the net loss was attributable to a reduction in unrealized gains and only 6% resulted from realized transactions. Recoveries of $1.3 million on previously impaired available-for-sale securities that were sold in 2011 are included in the fixed maturity and equity security net gains stated above.  Losses and loss expenses incurred during 2011 increased $69.6 million (48%) to $215.6 million with virtually all of the increase attributable to catastrophe losses of $66.6 million with the remainder attributable to increased premium volume. The 2011 consolidated loss and loss expense ratio was 88.1% compared to 68.0% for 2010. The Company's loss and loss expense ratios for major product lines are summarized in the following table.                                     2011        2010 Fleet transportation               68.8 %      58.8 % 

Private passenger automobile 72.2 85.0 Commercial multi-peril

             50.8        47.0 Professional liability             68.6         N/M Property reinsurance              202.9        94.9 Casualty reinsurance               60.6        68.0 

Residual market and all other 144.3 127.7 All lines

                          88.1        68.0     The fleet transportation loss ratio was impacted by factors such as fluctuations in premium volume, the levels of self-insured retentions and the high policy limits which allow for more volatility in losses. The property reinsurance loss ratio was higher in 2011 as the result of a historically unprecedented number of significant world-wide catastrophe losses. Losses from large catastrophic events during 2011 totaled $66.6 million compared to $25.2 million during 2010, itself a historically severe year for international catastrophic events.                                         - 24 - --------------------------------------------------------------------------------   The Company produced an overall savings on the handling of prior year claims during 2011 of $9.7 million. This net savings is included in the computation of loss ratios shown in the previous table, as is the $8.8 million savings produced during 2010 on prior year claims. The $7.4 million net savings attributable to the property and casualty insurance business was distributed among all of the Company's products, with the majority attributable to the Company's fleet transportation and personal automobile businesses, and is generally consistent with recent prior years. Because of the high limits provided by the Company to its fleet transportation insureds, the length of time necessary to settle larger, more complex claims and the volatility of the fleet transportation liability insurance business, the Company believes it is important to take a conservative posture in its reserving process. As claims are settled in years subsequent to their occurrence, the Company's claim handling process has, historically, tended to produce savings from the reserves provided. Changes in both gross premium volumes and the Company's reinsurance structure for its fleet transportation business can have a significant impact on future loss developments and, as a result, loss and loss expense ratios and prior year reserve development may not be consistent year to year.  Other operating expenses for 2011, before credits for allowances from reinsurers, increased $6.0 million (8%) to $84.8 million. This increase is due primarily to a $6.2 million increase in commission expense partially offset by decreases in salary related expenses and taxes, licenses and fees. The higher commissions reflect expansion of the Company's distribution channels to additional non-affiliated agents.  Reinsurance ceded credits were $1.4 million (14%) higher in 2011, resulting from increased gross premiums written on business ceded to other companies under quota share reinsurance treaties which provide commissions to the Insurance Subsidiaries. After consideration of these expense offsets, operating expenses increased $4.6 million, or 7% from the prior year, well below the increase in net premiums earned, as noted above.  A portion of the Company's fleet transportation business is produced by the direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Rather, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are included in operating expenses. In general, commissions paid by the insurance subsidiaries to the parent company exceed related acquisition costs incurred in the production of the property and casualty insurance business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 30.2% in 2011 and 31.0% in 2010. Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains (losses) on investments) was 28.1% for 2011 compared with 29.5% for 2010 with the decreases in both cases attributable to the fact that expenses grew at a slower pace than premium volume.  The effective federal tax rate on the consolidated pre-tax loss for 2011 was 37.8%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.  Due to an unprecedented amount of significant catastrophic losses coupled with significant net investment losses, the Company experienced net loss for 2011 of $28.2 million compared to net income of $25.0 million for 2010. Diluted earnings per share loss of $1.90 were recorded in 2011 compared to per share income of $1.69 in 2010.   2010 Compared to 2009  Direct premiums written for 2010 totaled $249.7 million, an increase of $40.6 million (19%) from 2009. The increase is primarily attributable to $25.2 million (16%) in premiums generated by fleet transportation products and $12.7 million (67%) in premiums generated by new product lines including commercial property and business owners' liability business. Premiums ceded to reinsurers on direct business increased $17.3 million (29%) during 2010 to $75.9 million as the consolidated percentage of premiums ceded to direct premiums written increased to 30.4% for 2010 from 28.0 % for 2009. This increase is reflective of overall product expansion within fleet transportation business, increased use of reinsurance for certain products and the Company's expansion into commercial property and business owners' liability business.  Written premiums assumed from other insurers and reinsurers totaled $46.1 million during 2010, an increase of $5.1 million (12%) from 2009. The increase reflects the Company's launch of a professional liability assumed business. Premium ceded related to the reinsurance assumed business declined from 4% in 2009 to 3% in 2010 reflecting slightly better pricing for the coverage.  After giving effect to changes in unearned premiums, net premiums earned totaled $214.7 million for 2010 compared to $181.3 million for 2009. These changes are in line with expectations and result from product expansion and continuing                                         - 25 - --------------------------------------------------------------------------------

marketing efforts in the Property and Casualty Insurance segment and from program changes, effective January 1, 2010, in the Reinsurance segment including the introduction of professional liability reinsurance.

Pre-tax investment income of $11.3 million reflects a decrease during 2010 compared to 2009 as pre-tax yields were down 21% on average reflecting continuing depressed worldwide available rates, principally on short-term investments. After tax investment income decreased by 26% during 2010, compared to the prior year.

  Net gains on investments, before taxes, totaled $16.5 million in 2010 compared to net gains on investments of $30.8 million last year. The gains in 2010 are attributable to $8.3 million in fixed maturity and equity security net direct trading gains and $8.2 million in limited partnerships net gains. Limited partnership ventures utilized by the Company are primarily engaged in the trading of public and private securities, including foreign securities and, to a lesser extent, small venture capital activities and real estate development. The aggregate of the Company's share of earnings in these entities represented a return of 12% for 2010 compared to a return of 57% for 2009. To the extent that accounting rules require the limited partnerships to include realized and unrealized gains or losses in their net income, the Company's proportionate share of net income will include the results as reported to the Company by the various general partners. Recoveries of $1.6 million on previously impaired available-for-sale securities that were sold in 2010 are included in the fixed maturity and equity security net gains stated above.  Losses and loss expenses incurred during 2010 increased $46.6 million (47%) to $146.0 million with the majority of the increase attributable to increases in catastrophe losses, including major earthquakes and windstorms, of $25.2 million with the remainder attributable to increased premium volume. The 2010 consolidated loss and loss expense ratio was 68.0% compared to 54.8% for 2009. The Company's loss and loss expense ratios for major product lines are summarized in the following table.                                    2010       2009 Fleet transportation             58.8 %     56.0 % Private passenger automobile     85.0       70.6 Commercial multi-peril           47.0       63.9 Reinsurance                      94.9       40.9 All lines                        68.0       54.8     The fleet transportation loss ratio was impacted by factors such as fluctuations in premium volume, the levels of self-insured retentions and the Company's higher net retention under reinsurance treaties in recent years allow for more volatility in losses. The increase in the private passenger automobile loss ratio is due primarily to higher current year losses. The Reinsurance loss ratio was higher in 2010 as the result of increases in catastrophe losses, including major earthquakes and windstorms.  The Company produced an overall savings on the handling of prior year claims during 2010 of $8.8 million. This net savings is included in the computation of loss ratios shown in the previous table, as is the $9.6 million savings produced during 2009 on prior year claims. The $6.6 million net savings attributable to direct business was distributed among all of the Company's products, with the majority attributable to the Company's fleet transportation businesses, and is generally consistent with recent prior years. Because of the high limits provided by the Company to its fleet transportation insureds, the length of time necessary to settle larger, more complex claims and the volatility of the fleet transportation liability insurance business, the Company believes it is important to take a conservative posture in its reserving process. As claims are settled in years subsequent to their occurrence, the Company's claim handling process has, historically, tended to produce savings from the reserves provided. Changes in both gross premium volumes and the Company's reinsurance structure for its fleet transportation business can have a significant impact on future loss developments and, as a result, loss and loss expense ratios and prior year reserve development may not be consistent year to year.  

Other operating expenses for 2010, before credits for allowances from reinsurers, increased $4.4 million (6%) to $78.8 million. This increase is due primarily to a $3.9 million increase in commission expense. The higher commissions reflect expansion of the Company's distribution channels to additional non-affiliated agents. Other increases related primarily to investments in the Company's IT structure in support of existing, new and potential product lines.

  Reinsurance ceded credits were $4.7 million (88%) higher in 2010, resulting from the Company ceding a higher percentage of the gross premium to other companies under reinsurance treaties, principally for workers' compensation coverages. After                                       - 26 - --------------------------------------------------------------------------------

consideration of these expense offsets, operating expenses remained flat decreasing $.3 million, or less than 1% from the prior year.

  A portion of the Company's fleet transportation business is produced by direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Instead, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are included in operating expenses. In general, commissions paid by the insurance subsidiaries to the parent company exceed related acquisition costs incurred in the production of the property and casualty insurance business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 31.0% in 2010 and 35.8% in 2009. Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains (losses) on investments) was 29.5% for 2010 compared with 34.2% for 2009.  The effective federal tax rate on consolidated income for 2010 was 28.1%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.  As a result of the factors mentioned above, and primarily the increase in catastrophic losses and a decline in realized investment gains, the Company experienced net income for 2010 of $25.0 million compared to net income of $44.8 million for 2009. Diluted earnings per share income of $1.69 were recorded in 2010 compared to $3.04 in 2009.  

Critical Accounting Policies

The Company's significant accounting policies which are material and/or subject to significant degrees of judgment are highlighted below.

Investment Valuation

All marketable securities are included in the Company's balance sheet at current fair market value.

  Approximately 72% of the Company's assets are composed of investments at December 31, 2011. Approximately 91% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The remaining 9% of investments are composed primarily of minority interests in several limited partnerships. These limited partnerships are engaged in the trading of public and non-public equity securities and debt, hedging transactions, real estate development and venture capital investment. These partnerships, themselves, do not have readily-determinable market values. Rather, the values recorded are those provided to the Company by the respective partnerships based on the underlying assets of the partnerships. While the majority of the underlying assets at December 31, 2011 are publicly-traded securities, those which are not publically traded have been valued by the respective partnerships using their experience and judgment.  Under FASB guidance, if a fixed maturity security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the decline in value is deemed to be other-than-temporary and is recorded to net realized losses on investments in the consolidated statements of operations.  For impaired fixed maturity securities that the Company does not intend to sell or it is more likely than not that the Company will not have to sell such securities, but the Company expects that it will not fully recover the amortized cost basis, the credit component of the other-than-temporary impairment is recognized in net realized losses on investments in the consolidated statements of operations and the non-credit component of the other-than-temporary impairment is recognized directly in shareholder's equity (accumulated other comprehensive income).  In determining if and when an equity security's decline in market value below cost is other-than-temporary, we first make an objective analysis of each individual equity security where current market value is less than cost. For any equity security where the unrealized loss exceeds 20% of original or adjusted cost, and where that decline has existed for a period of at least six months, the decline is treated as an other-than-temporary impairment, without any subjective evaluation as to possible future recovery. For individual issues where the decline in value is less than 20% but the amount of the decline is considered significant, we will also evaluate the market conditions, trends of earnings, price multiples and other key measures for the securities to determine if it appears that the decline is other-than-temporary. In those instances, the Company also considers its intent and ability to hold equity investments until recovery can be reasonably expected. For any decline which is considered to be other-than-temporary, we recognize an impairment loss in the current period earnings as an investment loss. Declines which are considered to be temporary are recorded as a reduction in shareholders' equity, net of related federal income tax credits.                                        - 27 - --------------------------------------------------------------------------------    It is important to note that all available for sale securities included in the Company's financial statements are valued at current fair market values. The evaluation process for determination of other-than-temporary decline in value of investments, as described above, does not change these valuations but, rather, determines when a decline in value will be recognized in the income statement (other-than-temporary decline) as opposed to a charge to shareholders' equity (temporary decline). Another aspect of this accounting policy which is important to understand is that any subsequent recovery in value of investments which have incurred other-than-temporary impairment adjustments are accounted for as unrealized gains until the security is actually disposed of or sold. At December 31, 2011, unrealized gains include $6.8 million of appreciation on investments previously adjusted for other-than-temporary impairment, compared to $8.2 million of impairment write-downs at that date. This evaluation process is subject to risks and uncertainties since it is not always clear what has caused a decline in value of an individual security or since some declines may be associated with general market conditions or economic factors which relate to an industry, in general, but not necessarily to an individual issue. The Company has attempted to minimize many of these uncertainties by adopting a largely objective evaluation process as described above. However, to the extent that certain declines in value are reported as unrealized at December 31, 2011, it is possible that future earnings charges will result should the declines in value increase or persist or should the security actually be disposed of while market values are less than cost. At December 31, 2011, the total gross unrealized loss included in the Company's investment portfolio was approximately $4.5 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other-than-temporary at December 31, 2011, there would have been no impact on total shareholders' equity or book value since the decline in value of these securities was already recognized as a reduction to shareholders' equity at December 31, 2011.   

Reinsurance Recoverable

  Reinsurance ceded transactions were as follows for the years ended December 31 (dollars in thousands):                                                         2011          2010          2009

Premium ceded (reduction to premium earned) $ 85,493$ 73,119$ 60,818 Losses ceded (reduction to losses incurred)

             56,600        17,581        22,025 Commissions from reinsurers (reduction to operating expenses)                                     11,503        10,081         5,352   

A discussion of the Company's reinsurance strategies is presented in Item 1, Business, on page 3.

  Amounts recoverable under the terms of reinsurance contracts comprise approximately 16% of total Company assets as of December 31, 2011. In order to be able to provide the high limits required by the Company's insureds, we share a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts. Some reinsurance contracts provide that a loss be shared among the Company and its reinsurers on a predetermined pro-rata basis ("quota-share") while other contracts provide that the Company keep a fixed amount of the loss, similar to a deductible, with reinsurers taking all losses above this fixed amount ("excess of loss"). Some risks are covered by a combination of quota-share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms of the various contracts and follows the underlying estimation process for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded as recoverable from reinsurers. Estimation uncertainties are greatest for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by the Company's insurance policies for fleet transportation liability, workers' compensation and professional liability risks provide more variability in the estimation process than lines of business with lower coverage limits.  It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in charges or credits to losses incurred. This is because any change in estimated recovery follows the estimate of the underlying loss. Thus, it is the computation of the gross underlying loss that is critical.  As with any receivable, credit risk exists in the recoverability of reinsurance. This may be even more pronounced than in normal receivable situations since recoverable amounts are not generally due until the loss is settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet its financial commitments under the terms of the contracts, the Company would be responsible to satisfy the reinsurer's portion of the loss. The                                        - 28 - --------------------------------------------------------------------------------    financial condition of each of the Company's reinsurers is initially determined upon the execution of a given treaty and only reinsurers with the superior credit ratings available are utilized. However, as noted above, reinsurers are often not called upon to satisfy their obligations for several years and changes in credit worthiness can occur in the interim period. Reviews of the current financial strength of each reinsurer are made frequently and, should impairment in the ability of a reinsurer be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges are included in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit loss rather than a deficiency associated with the loss reserving process.   

Loss and Loss Expense Reserves

  The Company's loss and loss expense reserves for each segment are shown in the following table on both a gross (before consideration of reinsurance) and on a net of reinsurance basis at December 31, 2011 and 2010 (dollars in thousands).                                      Direct and Assumed                  Net   Line of Business (Segment)        2011          2010          2011          2010  Property and casualty insurance   $ 330,683     $ 296,367     $ 199,219     $ 170,476 Reinsurance                          90,873        48,153        90,873        48,153                                    $ 421,556     $ 344,520     $ 290,092     $ 218,629     The Company's reserves for losses and loss expenses ("reserves") are determined based on complex estimation processes using historical experience, current economic information and, when necessary, available industry statistics. Reserves are evaluated in three basic categories (1) "case basis", (2) "incurred but not reported" and (3) "loss adjustment expense" reserves. Case basis reserves are established for specific known loss occurrences at amounts dependent upon various criteria such as type of coverage, severity and the underlying policy limits, as examples. Case basis reserves are generally estimated by experienced claims adjusters using established Company guidelines and are subject to review by claims management. Incurred but not reported reserves, which are established for those losses which have occurred, but have not yet been reported to the Company, are not linked to specific claims but are computed on a "bulk" basis. Common actuarial methods are employed in the establishment of incurred but not reported loss reserves using company historical loss data, consideration of changes in the Company's business and study of current economic trends affecting ultimate claims costs. Loss adjustment expense reserves, or reserves for the costs associated with the investigation and settlement of a claim, are also bulk reserves representing the Company's estimate of the costs associated with the claims handling process. Loss adjustment expense reserves include amounts ultimately allocable to individual claims as well as amounts required for the general overhead of the claims handling operation that are not specifically allocable to individual claims. Historical analyses of the ratio of loss adjusting expenses to losses paid on prior closed claims and review of current economic trends affecting loss settlement costs are used to estimate the loss adjustment reserve needs related to the established loss reserves. Each of these reserve categories contain elements of uncertainty which assure variability when compared to the ultimate costs to settle the underlying claims for which the reserves are established. The reserving process requires management to continuously monitor and evaluate the life cycle of claims based on the class of business and the nature of claims. The Company's claims range from the very routine private passenger automobile "fender bender" to the highly complex and costly third party bodily injury claim involving large tractor-trailer rigs. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in many of the Company's policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. Note C to the consolidated financial statements includes additional information relating to loss and loss adjustment expense reserve development.   

The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting periods.

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A detailed analysis and discussion for each of the above basic reserve categories follows.

Reserves for known losses (Case reserves)

  The Company's reserves for known claims are determined on an individual case basis and can range from the routine private passenger "fender bender" valued at a few hundred dollars to the very complex long-haul trucking claim involving multiple vehicles, severe injuries and extensive property damage costing several millions of dollars to settle. Each known claim, regardless of complexity, is handled by a claims adjuster experienced with claims of this nature and a "case" reserve, appropriate for the individual loss occurrence, is established. For very routine "short-tail" claims such as private passenger physical damage, the Company records an initial reserve that is based upon historical loss settlements adjusted for current trends. As information regarding the loss occurrence is gathered in the claim handling process, the initial reserve is adjusted to reflect the anticipated ultimate cost to settle the claim. For more complex claims which can tend toward being "long-tail" in nature, an experienced claims adjuster will review the facts and circumstances surrounding the loss occurrence to make a determination of the reserve to be established. Many of the more complex claims involve litigation and necessitate an evaluation of potential jury awards in addition to the factual information to determine the value of each claim. Each claim is frequently monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.  

Reserves for incurred but not reported losses

  The Company uses both standard actuarial techniques common to most insurance companies as well as techniques developed by the Company in consideration of its specialty business products. For its short-tail lines of business, the Company uses predominantly the incurred or paid loss development factor methods. The Company has found that the use of accident quarter loss development triangles, rather than those based upon accident year, are most responsive to claim settlement trends and fluctuations in premium exposures for its short-tail lines. A minimum of 12 running accident quarters is used to project the reserve necessary for incurred but not reported losses for its short-tail lines.  The Company also uses the loss development factor approach for its long-tail lines of business. A minimum of 15 accident years is included in the loss development triangles used to calculate link ratios and the selected loss development factors used to determine the reserves for incurred but not reported losses. A minimum of 20 accident years is used for long-tail workers' compensation reserve projections. Significant emphasis is placed on the use of tail factors for the Company's long-tail lines of business.  For the Company's fleet transportation risks, which are covered by frequently changing reinsurance agreements and which contain wide-ranging self-insured retentions ("SIR") as low as $25,000 per loss occurrence and as high as several million dollars per occurrence, traditional actuarial methods are supplemented by other methods in consideration of the Company's exposures to loss. In situations where the Company's reinsurance structure, the insured's SIR selections, policy volume, and other factors are changing, current accident period loss exposures may not be homogenous with historical loss data to allow for reliable projection of future developed losses. Therefore, the Company supplements the above-described actuarial methods with loss ratio reserving techniques developed from our databases to arrive at the reserve for losses incurred but not reported for the calendar/accident period under review. Management relies on its extensive historical pricing and loss history databases to produce reserve factors unique to this specialty business. As losses for a given calendar/accident period develop with the passage of time, management evaluates such development on a quarterly basis and adjusts reserve factors, as necessary, to reflect current judgment with regard to the anticipated ultimate incurred losses. This process continues until all losses are settled for each period subject to this method.  

Reserves for loss adjustment expenses

  While certain of the Company's products involve case basis reserving for allocated loss adjustment expenses, the majority of such reserves are determined on a bulk basis. The Company uses historical analysis of the ratios of allocated loss adjustment expenses paid to losses paid on closed claims to arrive at the expected ultimate incurred loss adjustment expense factors applicable to each affected product. Once developed, the factors are applied to the expected ultimate incurred losses, including IBNR, on all open claims. The resulting ultimate incurred allocated loss adjustment expense is then reduced by amounts paid to date on all open claims to arrive at the reserve for allocated loss adjustment expenses to be incurred in the future for the handling of specific claims.  For those loss adjustment expenses not specific to individual claims (general claims handling expenses referred to as unallocated loss adjustment expenses) the Company uses standard industry loss adjustment expenses paid to losses paid (net of reinsurance) ratio analysis to establish the necessary reserves. The selected factors are applied to 100% of IBNR reserves                                         - 30 - --------------------------------------------------------------------------------

and to case reserves with consideration given for that portion of loss adjustment expense already paid at the reserve measurement date. Such factors are monitored and revised, as necessary, on a quarterly basis.

  The reserving process requires management to continuously monitor and evaluate the life cycle of claims based on the class of business and the nature of claims. As previously noted, our claims vary widely in scope and complexity. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in the Company's fleet transportation liability policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimations, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time.  

Sensitivity Analysis - Potential impact on reserve volatility from changes in key assumptions

  Management is aware of the potential for variation from the reserves established at any particular point in time. Redundancies or deficiencies could develop in future valuations of the currently established loss and loss expense reserve estimates under a variety of reasonably possible scenarios. The Company's reserve selections are developed to be a "best estimate" of unpaid loss at a point in time and, due to the unique nature of our exposures, particularly in the large fleet transportation excess product where insured's policies of insurance combine large self-insured retentions with high policy limits, ranges of reserve estimates are not established during the reserving process. However, basic assumptions that could potentially impact future volatility of our valuations of current loss and loss expense reserve estimates include, but are not limited to, the following:                · Consistency in the individual case reserving processes      · The selection of loss development factors in the establishment of bulk     reserves for incurred but reported losses and loss expenses                               · Projected future loss trend   

· Expected loss ratios for the current book of business, particularly the

Company's fleet transportation products, where the number of accounts insured,

selected self-insured retentions, policy limits and reinsurance structure may

vary widely period to period

    Under reasonably possible scenarios, it is conceivable that the Company's selected loss reserve estimates could be 10%, or more, redundant or deficient. The majority of the Company's reserves for losses and loss expenses, on either a gross or a net of reinsurance basis, relates to its fleet transportation products. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company's fleet transportation products for policies subject to certain major reinsurance treaties (approximately $103.8 million, or approximately 32% of carried direct reserves for directly produced property and casualty business).  A 10 percentage point increase in the loss factors actually utilized in the Company's reserve determination at December 31, 2011 would increase gross loss reserves by approximately $33.8 million whereas a 10 percentage point decrease would decrease gross loss reserves by approximately $32.3 million. On a net basis, a 10 percentage point increase in loss ratio would increase net loss reserves by approximately $16.0 million whereas a 10 percentage point decrease would decrease net loss reserves by approximately $18.2 million. Similarly, a 20 percentage point increase would increase gross loss reserves by approximately $69.3 million whereas a decrease would decrease gross loss reserves by approximately $57.2 million. On a net basis, a 20 percentage point increase in loss ratio would increase net loss reserves by approximately $31.5 million whereas a 20 percentage point decrease would decrease net loss reserves by approximately $27.1 million with the lower impact from loss ratio increases attributable to minimum and maximum premium rate factors included in the various reinsurance contracts.                                        - 31 -

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Federal Income Tax Considerations

  The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. Net deferred tax liabilities reported at December 31, 2011 and 2010 consisted of (dollars in thousands):                                                  2011         2010    Total deferred tax liabilities          $ 21,068     $ 29,466    Total deferred tax assets                 28,187       22,694    Net deferred tax assets (liabilities)   $  7,119     $ (6,772 )     Deferred tax assets at December 31, 2011, include approximately $18.4 million related to the timing of deductibility of loss and loss expense reserves, the majority of which relates to policy liability discounts required by the Internal Revenue Code which are perpetual in nature and, in the absence of the termination of business, will not, in the aggregate, reverse to a material degree in the foreseeable future. An additional $2.9 million relates to impairment adjustments made to investments, as required by accounting regulations. The sizable unrealized gains in the Company's investment portfolios would allow for the recovery of this deferred tax at any time. Unearned premiums discount and deferred ceding commissions represent $2.4 and $2.0 million of deferred tax assets, respectively. The balance of deferred tax assets, approximately $2.5 million, consists of various normal operating expense accruals and is not considered to be material. As a result of its analysis, management has determined that no valuation allowance is necessary at December 31, 2011.  FASB provides guidance for recognizing and measuring uncertain tax positions and prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Based on this guidance, we regularly analyze tax positions taken or expected to be taken in a tax return based on the threshold condition prescribed. Tax positions that do not meet or exceed this threshold condition are considered uncertain tax positions. We accrue interest related to these uncertain tax positions which is recognized in income tax expense. Penalties, if any, related to uncertain tax positions would be recorded in income tax expenses.   Forward-Looking Information  Any forward-looking statements in this report including, without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including, without limitation, the following: (i) the Company's plans, strategies, objectives, expectations and intentions are subject to change at any time at the discretion of the Company; (ii) the Company's business is highly competitive and the entrance of new competitors into or the expansion of the operations by existing competitors in the Company's markets and other changes in the market for insurance products could adversely affect the Company's plans and results of operations; and (iii) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission.  

Impact of Inflation

  To the extent possible, the Company attempts to recover the impact of inflation to loss costs and operating expenses by increasing the premiums it charges. Within the fleet transportation business, a majority of the Company's premiums are charged as a percentage of an insured's gross revenue or payroll. As these charging bases increase with inflation, premium revenues are immediately increased. The remaining premium rates charged are adjustable only at periodic intervals and often require state regulatory approval. Such periodic increases in premium rates may lag far behind cost increases.  To the extent inflation influences yields on investments, the Company is also affected. The Company's short-term and fixed investment portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company's investments are                                        - 32 - --------------------------------------------------------------------------------   impacted. Further, as inflation affects current market rates of return, previously committed investments might increase or decline in value depending on the type and maturity of investment (see additional comments under Market Risk, following).  Inflation must also be considered by the Company in the creation and review of loss and loss adjustment expense reserves since portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses.   Market Risk  The Company operates within the property and casualty insurance industry and, accordingly, has significant invested assets which are exposed to various market risks. These market risks relate to interest rate fluctuations, equity security market prices and, to a far lesser extent, foreign currency rate fluctuations. All of the Company's invested assets, with the exception of investments in limited partnerships, are classified as available for sale.  Based on the structure of the Company's investment portfolio, the most potentially significant of the three identified market risks relates to prices in the equity security market. Though not the largest category of the Company's invested assets, equity securities have a high potential for short-term price fluctuation. The market value of the Company's equity positions at December 31, 2011 was $88.1 million or approximately 14% of invested assets. This market valuation includes $40.4 million of appreciation over the adjusted cost basis of the equity security investments. Funds invested in the equities market are not considered to be assets necessary for the Company to conduct its daily operations and, therefore, can be committed for extended periods of time. The long-term nature of the Company's equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuations, is the primary focus.  Reference is made to the discussion of limited partnership investments in Critical Accounting Policies presented on page 27 of this report. All of the market risks, attendant to equity securities, apply to the underlying assets in these partnerships, and to a greater degree because of the generally more aggressive investment philosophies utilized by the partnerships. In addition, these investments are illiquid. There is no primary or secondary market on which these limited partnerships trade and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and must seek approval from the general partner for any such disposal. Distributions of earnings from these partnerships are largely at the sole discretion of the general partners and distributions are generally not received by the Company for many years after the earnings have been reported.  Finally, through the application of the equity method of accounting, the Company's share of net income reported by the limited partnerships may include significant amounts of unrealized appreciation on the underlying investments. As such, the likelihood that reported income from limited partnership investments will be ultimately returned to the Company in the form of cash is markedly lower than the Company's other investments, where appreciation is reported only when a security is actually sold.  The Company's fixed maturity portfolio totaled $409.5 million at December 31, 2011. Approximately 68% of this portfolio is made up of U.S. Government and government agency obligations and state and municipal debt securities; 90% of the portfolio matures within 5 years; and the average contractual maturity of the Company's fixed maturity investments is approximately 3.1 years. Although the Company is exposed to interest rate risk on its fixed maturity investments, given the anticipated duration of the Company's liabilities (principally insurance loss and loss expense reserves) relative to investment maturities, even a 100 to 200 basis point increase in interest rates would not have even a moderate impact on the Company's ability to conduct daily operations or to meet its obligations and would, in fact, result in significantly higher investment income in a relatively short period of time as short term investments and maturing bonds could be reinvested in the higher yielding securities very quickly.  There is an inverse relationship between interest rate fluctuations and the fair value of the Company's fixed maturity investments. Additionally, the fair value of interest rate sensitive instruments may be affected by the financial strength of the issuer, prepayment options, relative values of alternative investments, liquidity of the investment and other general market conditions. The Company monitors its sensitivity to interest rate risk by measuring the change in fair value of its fixed maturity investments relative to hypothetical changes in interest rates.  The following tables present the estimated effects on the fair value of financial instruments at December 31 due to an instantaneous change in yield rates of varying magnitudes on a static balance sheet to determine the effect such a change in rates would have on current fair value. The analysis presents the sensitivity of the fair value of the Company's financial instruments to selected changes in market rates and prices. The range of change chosen reflects the Company's view of                                        - 33 -

--------------------------------------------------------------------------------   changes that the Company believes are reasonably possible over a one-year period. The Company's selection of the range of values chosen to represent changes in interest rates should not be construed as the Company's prediction of future market events, but rather an illustration of the impact of such events. The equity portfolio was compared to the S&P 500 index due to its correlation with the vast majority of the Company's current equity portfolio.  The limited partnership portfolio was compared to the S&P 500 and Indian BSE 500 indices due to their significant correlation with the vast majority of our limited partnership portfolio. As previously indicated, several other factors can impact the fair values of fixed maturity investments and, therefore, significant variations in market interest rates could produce quite different results from the hypothetical estimates presented below.  The following tables present the estimated effects on the fair value of financial instruments at December 31 due to an instantaneous change in yield rates of 100 basis points and a 10% decline in the S&P 500 and Indian BSE 500 indices (dollars in thousands).                                                                    Increase (Decrease)                                                     Fair         Interest       Equity                                                     Value       Rate Risk        Risk 2011:   U.S. government obligations                     $  73,137     $   (1,000 )   $       -   Government sponsored entities                         349             (3 )           -   Residential mortgage-backed securities             21,872           (542 )           -   Commercial mortgage-backed securities              11,300           (280 )           -   State and municipal obligations                   190,035         (2,983 )           -   Corporate securities                               91,646         (1,785 )           -   Foreign government obligations                     21,121           (652 )           -    Total fixed maturities                           409,460         (7,245 )           -   Equity securities:   Financial institutions                              9,428              -          (943 )   Industrial & Miscellaneous                         78,657              -        (7,866 )    Total equity securities                           88,085              -        (8,809 )   Limited partnerships                               54,705              -        (3,747 )   Short-term                                          3,675              -             -

Total fixed maturities and other investments $ 555,925 $ (7,245 ) $ (12,556 )

2010:

   U.S. government obligations                     $  62,998     $     (911 

) $ -

   Government sponsored entities                       3,324            (55 )           -   Residential mortgage-backed securities             37,101           (855 )           -   Commercial mortgage-backed securities              14,714           (339 )           -   State and municipal obligations                   192,706         (3,563 )           -   Corporate securities                               84,417         (1,889 )           -   Foreign government obligations                     20,294           (603 )           -    Total fixed maturities                           415,554         (8,215 )           -   Equity securities:   Financial institutions                             11,477              -        (1,148 )   Industrial & Miscellaneous                         85,180              -        (8,518 )    Total equity securities                           96,657              -        (9,666 )   Limited partnerships                               77,352              -        (9,621 )   Short-term                                          4,225              -             -

Total fixed maturities and other investments $ 593,788 $ (8,215 ) $ (19,287 )

                                          - 34 -

--------------------------------------------------------------------------------   The following tables present the estimated effects on the fair value of financial instruments at December 31 due to an instantaneous change in yield rates of 150 basis points and a 15% decline in the S&P 500 and Indian BSE 500 indices (dollars in thousands).                                                                     Increase (Decrease)                                                     Fair         Interest       Equity                                                     Value       Rate Risk        Risk 2011:   U.S. government obligations                     $  73,137     $   (1,491 )   $       -   Government sponsored entities                         349             (5 )           -   Residential mortgage-backed securities             21,872           (891 )           -   Commercial mortgage-backed securities              11,300           (461 )           -   State and municipal obligations                   190,035         (4,356 )           -   Corporate securities                               91,646         (2,657 )           -   Foreign government obligations                     21,121           (931 )           -    Total fixed maturities                           409,460        (10,792 )           -   Equity securities:   Financial institutions                              9,428              -        (1,414 )   Industrial & Miscellaneous                         78,657              -       (11,799 )    Total equity securities                           88,085              -       (13,213 )   Limited partnerships                               54,705              -        (5,620 )   Short-term                                          3,675              -             -

Total fixed maturities and other investments $ 555,925 $ (10,792 ) $ (18,833 )

2010:

   U.S. government obligations                     $  62,998     $   (1,358 

) $ -

   Government sponsored entities                       3,324            (82 )           -   Residential mortgage-backed securities             37,101         (1,259 )           -   Commercial mortgage-backed securities              14,714           (499 )           -   State and municipal obligations                   192,706         (5,228 )           -   Corporate securities                               84,417         (2,825 )           -   Foreign government obligations                     20,294           (894 )           -    Total fixed maturities                           415,554        (12,145 )           -   Equity securities:   Financial institutions                             11,477              -        (1,722 )   Industrial & Miscellaneous                         85,180              -       (12,777 )    Total equity securities                           96,657              -       (14,499 )   Limited partnerships                               77,352              -       (14,431 )   Short-term                                          4,225              -             -

Total fixed maturities and other investments $ 593,788 $ (12,145 ) $ (28,930 )

The Company's exposure to foreign currency risk is not material.

                                     - 35 - --------------------------------------------------------------------------------

Contractual Obligations

  The table below sets forth the amounts of the Company's contractual obligations at December 31, 2011.                                                                Payments Due by Period                                                 Less than 1                                         More Than 5                                     Total          year          1 - 3 Years       3 - 5 Years         Years                                                               (dollars in millions) Loss and loss expense reserves    $   421.6     $     138.3     $       118.9     $        49.3     $     115.1  Investment commitments                 10.0            10.0                 -                 -               -  Operating leases                        2.5             1.5               1.0                 -               -  Borrowings                             10.0            10.0                 -                 -               -                            Total   $   444.1     $     159.8     $       119.9     $        49.3     $     115.1     The Company's loss and loss expense reserves do not have contractual maturity dates and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of when we might expect our direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid in the preceding table. Timing of the collection of the related reinsurance recoverable, estimated to be $138.4 million at December 31, 2011, would approximate that of the above projected direct reserve payout.  

The investment commitments in the above table relate to maximum unfunded capital obligations for limited partnership investments at December 31, 2011.

Borrowings are made under a line of credit with a current expiration of September 23, 2014; however, it is expected that this line of credit will be renewed for a multiple year period prior to maturity.

                                          - 36 -

--------------------------------------------------------------------------------                              ANNUAL REPORT ON FORM 10-K