UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2008

o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

National Interstate Corporation

Ohio (State or other jurisdiction of incorporation or organization)		34-1607394 (I.R.S. Employer Identification No.)

3250 Interstate Drive
Richfield, Ohio 44286-9000
(330) 659-8900
(Address and telephone number of principal executive offices)

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

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

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller Reporting Company o

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

The number of shares outstanding of the registrant’s sole class of common shares as of October 29, 2008 was 19,394,244.

 

 

National Interstate Corporation
Table of Contents

		Page
Part I — Financial Information			1
Item 1. Financial Statements			1
Consolidated Balance Sheets			1
Consolidated Statements of Income			2
Consolidated Statements of Shareholders’ Equity			3
Consolidated Statements of Cash Flows			4
Notes to Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
Item 3. Quantitative and Qualitative Disclosures about Market Risk			23
Item 4. Controls and Procedures			24
Part II — Other Information			25
Item 1. Legal Proceedings			25
Item 1A. Risk Factors			25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3. Defaults Upon Senior Securities			25
Item 4. Submission of Matters to a Vote of Security Holders			25
Item 5. Other Information			25
Item 6. Exhibits			25
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

National Interstate Corporation and Subsidiaries

		September 30,				December 31,
		2008				2007
		(Unaudited)
ASSETS
Investments:
Fixed maturities available-for-sale, at fair value (amortized cost — $442,204 and $376,019, respectively)		$	432,937			$	376,300
Equity securities available-for-sale, at fair value (cost — $57,079 and $57,800, respectively)			46,376				52,640
Short-term investments, at cost which approximates fair value			85				20,907
Total investments			479,398				449,847
Cash and cash equivalents			64,750				43,069
Securities lending collateral (cost — $85,758 and $141,316, respectively)			78,007				139,305
Accrued investment income			4,954				4,783
Premiums receivable, net of allowance for doubtful accounts of $450 and $462, respectively			118,754				84,708
Reinsurance recoverables on paid and unpaid losses			138,516				98,091
Prepaid reinsurance premiums			39,585				24,325
Deferred policy acquisition costs			22,066				17,578
Deferred federal income taxes			19,257				11,993
Property and equipment, net			19,876				19,502
Funds held by reinsurer			2,949				3,337
Prepaid expenses and other assets			2,363				2,096
Total assets		$	990,475			$	898,634
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Unpaid losses and loss adjustment expenses		$	388,715			$	302,088
Unearned premiums and service fees			185,577				145,296
Long-term debt			15,000				15,464
Amounts withheld or retained for account of others			48,413				38,739
Reinsurance balances payable			17,441				7,596
Securities lending obligation			86,900				141,316
Accounts payable and other liabilities			27,572				24,363
Commissions payable			10,810				7,332
Assessments and fees payable			5,230				3,634
Total liabilities			785,658				685,828
Shareholders’ equity:
Preferred shares — no par value
Authorized — 10,000 shares
Issued — 0 shares			—				—
Common shares — $0.01 par value
Authorized — 50,000 shares
Issued — 23,350 shares, including 4,055 and 4,145 shares, respectively, in treasury			234				234
Additional paid-in capital			47,680				45,566
Retained earnings			184,406				178,190
Accumulated other comprehensive loss			(21,765	)			(5,321	)
Treasury shares			(5,738	)			(5,863	)
Total shareholders’ equity			204,817				212,806
Total liabilities and shareholders’ equity		$	990,475			$	898,634

See notes to consolidated financial statements.

National Interstate Corporation and Subsidiaries

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Revenues:
Premiums earned		$	75,058			$	66,187			$	214,521			$	189,742
Net investment income			5,417				5,690				16,849				16,421
Net realized gains (losses) on investments			(8,376	)			(319	)			(10,824	)			(47	)
Other			605				1,564				2,199				3,384
Total revenues			72,704				73,122				222,745				209,500
Expenses:
Losses and loss adjustment expenses			51,995				39,844				144,097				112,564
Commissions and other underwriting expenses			18,529				13,803				46,685				36,348
Other operating and general expenses			3,241				2,795				9,786				8,990
Expense on amounts withheld			1,001				997				3,261				2,641
Interest expense			133				393				704				1,160
Total expenses			74,899				57,832				204,533				161,703
Income (loss) before federal income taxes			(2,195	)			15,290				18,212				47,797
Provision for federal income taxes			2,033				5,145				8,499				15,327
Net income (loss)		$	(4,228	)		$	10,145			$	9,713			$	32,470
Net income (loss) per common share — basic		$	(0.22	)		$	0.53			$	0.50			$	1.69
Net income (loss) per common share — diluted		$	(0.22	)		$	0.52			$	0.50			$	1.67
Weighted average of common shares outstanding — basic			19,293				19,199				19,281				19,189
Weighted average of common shares outstanding — diluted			19,293				19,459				19,375				19,401
Cash dividends per common share		$	0.06			$	0.05			$	0.18			$	0.15

See notes to consolidated financial statements.

National Interstate Corporation and Subsidiaries

		Common				Additional Paid-In				Retained				Accumulated Other				Treasury
		Stock				Capital				Earnings				Comprehensive Loss				Stock				Total
Balance at January 1, 2008		$	234			$	45,566			$	178,190			$	(5,321	)		$	(5,863	)		$	212,806
Net income											9,713												9,713
Unrealized depreciation of investment securities, net of tax benefit of $4,387															(16,444	)							(16,444	)
Comprehensive loss																							(6,731	)
Dividends on common stock											(3,497	)											(3,497	)
Issuance of 89,723 treasury shares upon exercise of options and restricted stock issued, net of forfeitures							706												125				831
Tax benefit realized from exercise of stock options							396																396
Stock compensation expense							1,012																1,012
Balance at September 30, 2008		$	234			$	47,680			$	184,406			$	(21,765	)		$	(5,738	)		$	204,817
Balance at January 1, 2007		$	234			$	43,921			$	138,450			$	(2,915	)		$	(5,927	)		$	173,763
Net income											32,470												32,470
Unrealized depreciation of investment securities, net of tax benefit of $76															(141	)							(141	)
Comprehensive income																							32,329
Dividends on common stock											(2,892	)											(2,892	)
Issuance of 45,847 treasury shares upon exercise of options and stock award grants							388												64				452
Tax benefit realized from exercise of stock options							201																201
Stock compensation expense							776																776
Balance at September 30, 2007		$	234			$	45,286			$	168,028			$	(3,056	)		$	(5,863	)		$	204,629

See notes to consolidated financial statements.

National Interstate Corporation and Subsidiaries

		Nine Months Ended September 30,
		2008				2007
Operating activities
Net income		$	9,713			$	32,470
Adjustments to reconcile net income to net cash provided by operating activities:
Net amortization of bond premiums and discounts			1,251				253
Provision for depreciation and amortization			1,017				948
Net realized losses on investment securities			10,824				47
Deferred federal income taxes			(2,877	)			(268	)
Stock compensation expense			1,012				776
Increase in deferred policy acquisition costs, net			(4,488	)			(4,621	)
Increase in reserves for losses and loss adjustment expenses			86,627				43,903
Increase in premiums receivable			(34,046	)			(26,229	)
Increase in unearned premiums and service fees			40,281				34,206
Increase in interest receivable and other assets			(80	)			(2,089	)
Increase in prepaid reinsurance premiums			(15,260	)			(10,914	)
Increase in accounts payable, commissions and other liabilities and assessments and fees payable			8,283				9,380
Increase in amounts withheld or retained for account of others			9,674				7,505
Increase in reinsurance recoverable			(40,425	)			(18,877	)
Increase in reinsurance balances payable			9,845				3,386
Other			(3	)			—
Net cash provided by operating activities			81,348				69,876
Investing activities
Purchases of fixed maturities			(342,290	)			(127,238	)
Purchases of equity securities			(3,443	)			(57,143	)
Proceeds from sale of fixed maturities			1,148				—
Proceeds from sale of equity securities			10,115				14,593
Proceeds from maturity of investments			278,896				111,672
Capital expenditures			(1,359	)			(1,578	)
Net cash used in investing activities			(56,933	)			(59,694	)
Financing activities
Decrease in securities lending collateral			54,416				11,187
Decrease in securities lending obligation			(54,416	)			(11,187	)
Additional long-term borrowings			15,000				—
Reductions of long-term debt			(15,464	)			—
Tax benefit realized from exercise of stock options			396				201
Issuance of common shares from treasury upon exercise of stock options or stock award grants			831				452
Cash dividends paid on common shares			(3,497	)			(2,892	)
Net cash used in financing activities			(2,734	)			(2,239	)
Net increase in cash and cash equivalents			21,681				7,943
Cash and cash equivalents at beginning of period			43,069				22,166
Cash and cash equivalents at end of period		$	64,750			$	30,109

See notes to consolidated financial statements.

NATIONAL INTERSTATE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of National Interstate Corporation (the “Company”) and its subsidiaries have been prepared in accordance with the instructions to Form 10-Q, which differ in some respects from statutory accounting principles permitted by state regulatory agencies.

The consolidated financial statements include the accounts of the Company and its subsidiaries, National Interstate Insurance Company (“NIIC”), Hudson Indemnity, Ltd. (“HIL”), National Interstate Insurance Company of Hawaii, Inc. (“NIIC-HI”), Triumphe Casualty Company (“TCC”), National Interstate Insurance Agency, Inc. (“NIIA”), Hudson Management Group, Ltd. (“HMG”), American Highways Insurance Agency, Inc., Safety, Claims and Litigation Services, Inc., Explorer RV Insurance Agency, Inc. and Safety, Claims and Litigation Services, LLC. Significant intercompany transactions have been eliminated.

These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The interim financial statements reflect all adjustments which are, in the opinion of management, necessary for the fair presentation of the results for the periods presented. Such adjustments are of a normal recurring nature. Operating results for the three and nine month period ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.

The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates. Certain reclassifications have been made to financial information presented for prior years to conform to the current year’s presentation.

2. Recent Accounting Pronouncements

The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to elect to measure many financial instruments and certain other items at fair value. Upon adoption of SFAS No. 159, an entity may elect the fair value option for eligible items that exist at the adoption date. Subsequent to the initial adoption, the election of the fair value option should only be made at the initial recognition of the asset or liability or upon a re-measurement event that gives rise to the new-basis of accounting. All subsequent changes in fair value for that instrument are reported in earnings. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be recorded at fair value nor does it eliminate disclosure requirements included in other accounting standards. SFAS No. 159 was effective January 1, 2008 for calendar year companies. The Company did not elect the fair value option for any of its eligible assets or liabilities at the effective date.

3. Fair Value Measurements

On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Under SFAS No. 157, the Company must determine the appropriate level in the fair value hierarchy for each fair value measurement. The fair value hierarchy in SFAS No. 157 prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.

Level 1 inputs are quoted prices (unadjusted) in active markets for identical securities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices within Level 1 that are observable for the security, either directly or indirectly. Level 2 inputs include quoted prices for similar securities in active markets, quoted prices for identical or similar securities that are not active and observable inputs other than quoted prices, such as interest rate and yield curves. Level 3 inputs are unobservable inputs for the asset or liability.

Level 1 consists of publicly traded equity securities whose fair value is based on quoted prices that are readily and regularly available in an active market. Level 2 primarily consists of financial instruments whose fair value is based on quoted prices in markets that are not active and include U.S. government and government agency securities, fixed maturity investments, preferred stock and certain publicly traded common stocks that are not actively traded. Included in Level 2 are $10.3 million of securities, which are valued based upon a non-binding broker quote and validated by management by observable market data. Level 3 consists of financial instruments that are not traded in an active market, whose fair value is estimated by management based on inputs from independent financial institutions, which include non-binding broker quotes, for which the Company believes reflects fair value, but are unable to verify inputs to the valuation methodology. We obtained one quote or price per instrument from our brokers and pricing services and did not adjust any quotes or prices that we obtained.

The following table presents the Company’s investment portfolio, categorized by the level within the SFAS No. 157 hierarchy in which the fair value measurements fall at September 30, 2008:

		September 30, 2008
		Level 1				Level 2				Level 3				Fair Value
		(Dollars in thousands)
Fixed maturities:
U.S. Government and government agency obligations		$	—			$	208,695			$	—			$	208,695
State and local government obligations			—				108,207				7,069				115,276
Mortgage-backed securities			—				66,189				—				66,189
Corporate obligations			—				38,459				4,318				42,777
Total fixed maturities			—				421,550				11,387				432,937
Equity securities:
Preferred stock			10,407				1,834				7,813				20,054
Common stock			15,855				10,467				—				26,322
Total equity securities			26,262				12,301				7,813				46,376
Short-term investments			—				85				—				85
Total investments		$	26,262			$	433,936			$	19,200			$	479,398

The following table presents the underlying securities included in the Company’s securities lending collateral asset, categorized by the level within the SFAS No. 157 hierarchy in which the fair value measurements fall at September 30, 2008:

		September 30, 2008
		Level 1				Level 2				Level 3				Fair Value
						(Dollars in thousands)
Fixed maturities:
Cash and cash equivalents		$	22,852			$	2,000			$	—			$	24,852
Mortgage-backed securities			—				19,062				3,416				22,478
Corporate obligations			—				28,102				2,575				30,677
Total fixed maturities:		$	22,852			$	49,164			$	5,991			$	78,007

The following tables presents a reconciliation of the beginning and ending balances for all investments measured at fair value on a recurring basis using Level 3 inputs for the three and nine months ended September 30, 2008:

		Three Months Ended September 30, 2008
						State and local
		Corporate				government				Preferred				Securities lending
		obligations				obligations				stock				collateral
						(Dollars inthousands)
Beginning balance at June 30, 2008		$	1,403			$	7,279			$	8,348			$	3,489
Total gains or (losses):
Included in realized investment gains and (losses)			—				—				—				(495	)
Included in other comprehensive income			(10	)			(210	)			(535	)			(35	)
Purchases, issuances and settlements (1)			—				—				—				(384	)
Transfers in and/or (out) of Level 3 (2)			2,925												3,416
Ending balance at September 30, 2008		$	4,318			$	7,069			$	7,813			$	5,991
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date		$	—			$	—			$	—			$	(495	)

						State and local
		Corporate				government				Preferred				Securities lending
		obligations				obligations				stock				collateral
						(Dollars inthousands)
Beginning balance at January 1, 2008		$	1,388			$	—			$	3,812			$	4,675
Total gains or (losses):
Included in realized investment gains and (losses)			—				—				—				(1,141	)
Included in other comprehensive income			5				(210	)			(549	)			321
Purchases, issuances and settlements (1)			—				—				—				(1,280	)
Transfers in and/or (out) of Level 3 (2)			2,925				7,279				4,550				3,416
Ending balance at September 30, 2008		$	4,318			$	7,069			$	7,813			$	5,991
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date		$	—			$	—			$	—			$	(1,142	)

4. Securities Lending

The Company participates in a securities lending program whereby certain fixed maturity and equity securities from the Company’s investment portfolio are loaned to other institutions for short periods of time. The Company requires cash collateral equal to 102% of the market value of the loaned securities plus accrued interest and records the obligation to return the collateral as a liability. The collateral is subsequently invested by the lending agent generating investment income, net of applicable fees. The Company is not permitted to sell or re-pledge the collateral on the securities lending program. The Company accounts for this program as a secured borrowing and records the collateral held on the Company’s Consolidated Balance Sheets at fair value. The securities loaned remain a recorded asset of the Company. Prior to 2008, collateral could be invested in investments with maturities beyond the loan term, including asset backed securities and corporate obligations. However, in light of the recent market turmoil, beginning in 2008, new cash collateral is only invested in overnight investments.

We examine all investments, including securities lending collateral, held by the Company for possible other-than-temporary declines in the value. In the first nine months of 2008, we recorded an other-than-temporary impairment on one fixed maturity investment within our securities lending collateral portfolio.

		September 30,				December 31,
		2008				2007
		(Dollars in thousands)
Collateral obligation		$	86,900			$	141,316
Pretax unrealized loss on fair value of collateral held			(7,751	)			(2,011	)
Other than temporary impairment charge			(1,142	)			—
Fair value of collateral held			78,007				139,305
Fair value of securities lent plus accrued interest			85,280				138,581

5. Shareholders’ Equity and Stock-Based Compensation

The Company grants options and other stock awards to officers of the Company under the Long Term Incentive Plan (“LTIP”). At September 30, 2008, there were 824,468 of the Company’s common shares reserved for issuance under the LTIP and options for 607,050 shares were outstanding. Treasury shares are used to fulfill the options exercised and other awards granted. Options and restricted shares vest pursuant to the terms of a written grant agreement. Options must be exercised no later than the tenth anniversary of the date of grant. As set forth in the LTIP, the Compensation Committee of the Board of Directors may accelerate vesting and exercisability of options.

For both the three months ended September 30, 2008 and 2007, the Company recognized stock-based compensation expense of $0.3 million, with related income tax benefits of approximately $0.1 million. For the nine months ended September 30, 2008 and 2007, the Company recognized stock-based compensation expense of $1.0 million and $0.8 million, respectively. Related income tax benefits of $0.2 million and $0.1 million were recognized for the nine months ended September 30, 2008 and 2007, respectively.

The Company paid a dividend of $0.06 and $0.05 and $0.18 and $0.15 per common share for the three and nine months ended September 30, 2008 and 2007, respectively.

6. Transactions with Related Parties

The Company’s principal insurance subsidiary, NIIC is a party to a reinsurance agreement involving an assumption of reinsurance with Great American Insurance Company (“Great American”). NIIA, a wholly owned subsidiary of the Company, is a party to an underwriting management agreement also with Great American. As of September 30, 2008, Great American owned 52.6% of the outstanding shares of the Company. The reinsurance agreement calls for the assumption by NIIC of all of the risk on Great American’s net premiums written for public transportation and recreational vehicle risks underwritten pursuant to the reinsurance agreement. NIIA provides administrative services to Great American in connection with Great American’s underwriting of these risks. In addition, NIIC and two other subsidiaries, NIIC-HI and HIL, are involved in cessions of reinsurance with Great American to reduce exposure in certain property-casualty insurance programs.

The table below summarizes the reinsurance balance and activity with Great American:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(Dollars in thousands)								(Dollars in thousands)
Assumed premiums written		$	821			$	1,288			$	4,779			$	4,901
Assumed premiums earned			1,617				1,467				4,818				4,060
Assumed losses and loss adjustment expense incurred			1,347				2,123				3,763				4,581
Ceded premiums written			576				658				3,026				3,410
Ceded premiums earned			880				1,013				2,707				2,966
Ceded losses and loss adjustment expense recoveries			452				146				849				1,186
Payable to Great American as of period end			526				725				526				725

Great American or its parent, American Financial Group, Inc., performs certain services for the Company without charge including, without limitation, actuarial services and on a consultative basis, as needed, internal audit, legal, accounting and other support services. If Great American no longer controlled a majority of the Company’s common shares, it is possible that many of these services would cease or, alternatively, be provided at an increased cost to us. This could impact our personnel resources, require us to hire additional

professional staff and generally increase our operating expenses. Management believes, based on discussions with Great American, that these services will continue to be provided by the affiliated entity in future periods and the relative impact on operating results is not material.

On January 17, 2008, Great American filed an Undertaking on Appeal as surety with the Superior Court of the State of California for the County of Los Angeles in the amount of $17.9 million on behalf of NIIC. This surety was purchased from Great American to secure a judgment amount associated with the Company’s pending appellate case as noted in Note 8 “Commitments and Contingencies.”

7. Reinsurance

Premiums and reinsurance activity consisted of the following:

		Three Months Ended September 30,																Nine Months Ended September 30,
		2008								2007								2008								2007
		Written				Earned				Written				Earned				Written				Earned				Written				Earned
						(Dollars in thousands)																(Dollars in thousands)
Direct		$	75,487			$	93,386			$	67,867			$	79,700			$	304,508			$	264,561			$	265,626			$	231,713
Assumed			1,964				2,748				4,190				3,878				7,739				7,934				9,244				8,952
Ceded			(15,035	)			(21,076	)			(12,786	)			(17,391	)			(72,674	)			(57,974	)			(61,837	)			(50,923	)
Net Premium		$	62,416			$	75,058			$	59,271			$	66,187			$	239,573			$	214,521			$	213,033			$	189,742

The Company cedes premiums through reinsurance agreements with reinsurers to reduce exposure in certain of its property-casualty insurance programs. Ceded losses and loss adjustment expense recoveries recorded were $8.9 million for both the three months ended September 30, 2008 and 2007 and were $22.3 million and $25.6 million for the nine months ended September 30, 2008 and 2007, respectively. The Company remains primarily liable as the direct insurer on all risks reinsured and a contingent liability exists to the extent that the reinsurance companies are unable to meet their obligations for losses assumed. The Company regularly evaluates the financial condition of its reinsurers and to minimize its exposure to significant losses from reinsurer insolvencies, seeks to do business with only reinsurers rated “Excellent” or better by A.M. Best Company or obtains collateral to secure the reinsurers obligations.

8. Commitments and Contingencies

The Company and its subsidiaries are subject at times to various claims, lawsuits and legal proceedings arising in the ordinary course of business. All legal actions relating to claims made under insurance policies are considered in the establishment of our loss and loss adjustment expense reserves. In addition, regulatory bodies, such as state insurance departments, the Securities and Exchange Commission, the Department of Labor and other regulatory bodies may make inquiries and conduct examinations or investigations concerning our compliance with insurance laws, securities laws, labor laws and the Employee Retirement Income Security Act of 1974, as amended.

Our insurance companies also have lawsuits pending in which the plaintiff seeks extra-contractual damages from us in addition to damages claimed or in excess of the available limits under an insurance policy. These lawsuits, which are in various stages of development, generally mirror similar lawsuits filed against other carriers in the industry. Although we are vigorously defending these lawsuits, the outcomes of these cases cannot be determined at this time. We have established loss and loss adjustment expense reserves for lawsuits as to which we have determined that a loss is both probable and estimable. In addition to these case reserves, we also establish reserves for claims incurred but not reported to cover unknown exposures and adverse development on known exposures. Based on currently available information, we believe that our reserves for these lawsuits are reasonable and that the amounts reserved did not have a material effect on our financial condition or results of operations. However, if any one or more of these cases results in a judgment against or settlement by us for an amount that is significantly greater than the amount so reserved, the resulting liability could have a material effect on our financial condition, cash flows and results of operations.

On August 3, 2007, the Company was informed that the jury in a case pending in the Superior Court of the State of California for the County of Los Angeles (the “Court”), had issued, on August 2, 2007, a special verdict adverse to the Company’s interests in a pending lawsuit against one of the Company’s insurance companies. The Court entered a formal judgment on October 25, 2007 and the Company received notice of that formal judgment on November 5, 2007. The current exposure to the Company for this judgment approximates $9.0 million, net of anticipated reinsurance and, as required by the Court, the Company secured the judgment amount with a surety bond on January 17, 2008. However, the Company believes that it has a strong appellate case and strategy and intends to vigorously pursue

the appellate process. Upon appeal, the Company believes the matter will be resolved in a manner that will not have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows. As of September 30, 2008, the Company had not established a case reserve for this claim but has and will continue to closely monitor this case with counsel. The Company has consistently established litigation expense reserves to account for the cost associated with the defense of the Company’s position, which it will continue to reserve for throughout the appeal process.

As a direct writer of insurance, the Company receives assessments by state funds to cover losses to policyholders of insolvent or rehabilitated companies and other authorized fees. These mandatory assessments may be partially recovered through a reduction in future premium taxes in some states over several years. At September 30, 2008 and December 31, 2007, the liability for such assessments was $5.2 million and $3.6 million, respectively, and will be paid over several years as assessed by the various state funds.

9. Earnings Per Common Share

The following table sets forth the computation of basic and diluted net income per share:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(In thousands, except per share)								(In thousands, except per share)
Net (loss) income		$	(4,228	)		$	10,145			$	9,713			$	32,470
Weighted average shares outstanding during period			19,293				19,199				19,281				19,189
Additional shares issuable under employee common stock option plans using treasury stock method			—				260				94				212
Weighted average shares outstanding assuming exercise of stock options 1			19,293				19,459				19,375				19,401
Net (loss) income per share:
Basic		$	(0.22	)		$	0.53			$	0.50			$	1.69
Diluted		$	(0.22	)		$	0.52			$	0.50			$	1.67

For the three months ended September 30, 2008 and 2007, there were 607,050 and 51,440, respectively, outstanding options excluded from diluted earnings per share because they were anti-dilutive. For the nine months ended September 30, 2008 and 2007, there were 264,113 and 102,723, respectively, outstanding options excluded from diluted earnings per share because they were anti-dilutive.

10. Segment Information

The Company operates its business as one segment, property and casualty insurance. The Company manages this segment through a product management structure. The following table shows revenues summarized by the broader business component description. These business components were determined based primarily on similar economic characteristics, products and services:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(Dollars in thousands)								(Dollars in thousands)
Revenue:
Premiums earned:
Alternative Risk Transfer		$	35,814			$	27,033			$	99,212			$	77,495
Transportation			19,162				18,596				56,882				55,436
Specialty Personal Lines and Commercial Vehicle			14,046				13,252				40,797				38,564
Hawaii and Alaska			4,467				4,562				13,393				13,075
Other			1,569				2,744				4,237				5,172
Total premiums earned			75,058				66,187				214,521				189,742
Net investment income			5,417				5,690				16,849				16,421
Net realized gains (losses) on investments			(8,376	)			(319	)			(10,824	)			(47	)
Other			605				1,564				2,199				3,384
Total revenues		$	72,704			$	73,122			$	222,745			$	209,500

11. Income Taxes

A reconciliation of the provision for federal income taxes for financial reporting purposes and the provision for federal income taxes calculated at the prevailing federal income tax rate of 35% is as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
						(Dollars in thousands)
Expected federal income tax expense (benefit) at statutory rate		$	(768	)		$	5,351			$	6,374			$	16,729
Tax effect of tax-exempt investment income			(339	)			(241	)			(1,006	)			(665	)
Change of valuation allowance on capital losses			3,191				—				3,191				—
Other items, net			(51	)			35				(60	)			(737	)
		$	2,033			$	5,145			$	8,499			$	15,327

The tax effects of temporary differences that give rise to significant portions of the net deferred tax assets and liabilities in the Consolidated Balance Sheets were as follows:

		September 30, 2008				December 31, 2007
		(Dollars in thousands)
Deferred Tax Assets:
Unearned premiums		$	10,280			$	8,528
Unpaid losses and LAE expenses			8,024				6,599
Assignments and assessments			1,516				992
Unrealized losses on investments			9,702				2,412
Realized losses on investments			3,867				—
Other, net			1,949				1,220
			35,338				19,751
Valuation allowance			(6,976	)			(842	)
			28,362				18,909
Deferred Tax Liabilities:
Deferred policy acquisition costs			(7,723	)			(6,152	)
Other, net			(1,382	)			(764	)
Total deferred tax liabilities			(9,105	)			(6,916	)
Net deferred income tax assets		$	19,257			$	11,993

Management has reviewed the recoverability of the deferred tax asset and believes that with the exception of unrealized losses on investments and capital losses, the amount will be recoverable against future earnings. The gross deferred tax assets have been reduced by a valuation allowance on unrealized losses on equity investments of $3.7 million and a valuation allowance on realized losses on investments of $3.2 million based on limitations set forth in the Internal Revenue Code which restrict the recoverability of taxes.

12. Comprehensive Income

Comprehensive income or loss includes the Company’s net income or loss plus the changes in the unrealized gains or losses (net of income taxes) on the Company’s available-for-sale securities. There was a total comprehensive loss for the third quarter of 2008 of $11.6 million and comprehensive income of $11.2 million for the third quarter of 2007. The total comprehensive loss for the nine months ended September 30, 2008 was $6.7 million and total comprehensive income for the nine months ended September 30, 2007 was $32.3 million.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This document, including information incorporated by reference, contains “forward-looking statements” (within the meaning of the Private Securities Litigation Reform Act of 1995). All statements, trend analyses and other information contained in this Form 10-Q relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as “may,” “target,” “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “project,” and other similar expressions, constitute forward-looking statements. We made these statements based on our plans and current analyses of our business and the insurance industry as a whole. We caution that these statements may and often do vary from actual results and the differences between these statements and actual results can be material. Factors that could contribute to these differences include, among other things:

	•		general economic conditions and other factors, including prevailing interest rate levels and stock and credit market performance, which may affect (among other things) our ability to sell our products, our ability to access capital resources and the costs associated with such access to capital and the market value of our investments;
	•		customer response to new products and marketing initiatives;
	•		tax law changes;
	•		increasing competition in the sale of our insurance products and services and the retention of existing customers;
	•		changes in legal environment;
	•		regulatory changes or actions, including those relating to regulation of the sale, underwriting and pricing of insurance products and services and capital requirements;
	•		levels of natural catastrophes, terrorist events, incidents of war and other major losses;
	•		adequacy of insurance reserves; and
	•		availability of reinsurance and ability of reinsurers to pay their obligations.

The forward-looking statements herein are made only as of the date of this report. We assume no obligation to publicly update any forward-looking statements.

General

We underwrite and sell traditional and alternative risk transfer property and casualty insurance products to the passenger transportation industry and the trucking industry, general commercial insurance to small businesses in Hawaii and Alaska and personal insurance to owners of recreational vehicles, commercial vehicles and watercraft throughout the United States.

As of September 30, 2008, Great American Insurance Company (“Great American”) owned 52.6% of our outstanding common shares. Great American is a wholly-owned subsidiary of American Financial Group, Inc. We have four property and casualty insurance subsidiaries, National Interstate Insurance Company (“NIIC”), Hudson Indemnity, Ltd. (“HIL”), National Interstate Insurance Company of Hawaii, Inc. (“NIIC-HI”) and Triumphe Casualty Company (“TCC”) and six other agency and service subsidiaries. NIIC is licensed in all 50 states and the District of Columbia. HIL is domiciled in the Cayman Islands and conducts insurance business outside the United States. We write our insurance policies on a direct basis through NIIC, NIIC-HI and TCC. We also assume a portion of premiums written by other affiliated companies whose passenger transportation insurance business we manage. Insurance products are marketed through multiple distribution channels, including independent agents and brokers, affiliated agencies and agent internet initiatives. We use our six other agency and service subsidiaries to sell and service our insurance business.

Results of Operations

Overview

Through the operations of our subsidiaries, we are engaged in property and casualty insurance operations. We generate underwriting profits by providing specialized insurance products, services and programs not generally available in the marketplace. We focus on niche insurance markets where we offer insurance products designed to meet the unique needs of targeted insurance buyers that we believe are underserved by the insurance industry.

We derive our revenues primarily from premiums generated by our insurance policies and income from our investment portfolio. Our expenses consist primarily of losses and loss adjustment expenses (“LAE”), commissions and other underwriting expenses, and other operating and general expenses.

For the third quarter of 2008, we had a net loss of $4.2 million ($0.22 per share, diluted) compared to net earnings for the third quarter 2007 of $10.1 million ($0.52 per share, diluted). For the nine months ended September 30, 2008 and 2007, we reported net income of $9.7 million ($0.50 per share, diluted) compared to $32.5 million ($1.67 per share, diluted), respectively. Our income in the third quarter and year-to-date were adversely impacted by the turbulent market environment, as evidenced by our net realized losses on investments of $8.4 million for the third quarter of 2008 and $10.8 million for year-to-date 2008.

Exclusive of our net realized investment losses, we had pre-tax operating income of $6.2 million for the three months ended September 30, 2008 compared to $15.6 million in the comparable period in 2007. For the nine months ended September 30, 2008 and 2007, we had pre-tax operating income of $29.0 million and $47.8 million, respectively. Although, we have experienced strong revenue growth for the third quarter of 2008 and through the first nine months of 2008, our revenue growth has been offset by an increase in large loss severity, primarily due to our charter passenger transportation business. While the losses have occurred with both large and small charter companies, we have focused our attention on the small fleet operators, which represent a relatively small portion of our public transportation premium and have historically performed well. We are in the process of reviewing most of our large fleet charter transportation book and our entire in-force small fleet book of charter transportation business to ensure that our high underwriting standards are in place. Other initiatives centered on risk selection and pricing adequacy have been implemented relative to the entire charter transportation product. In addition to an increase in loss severity, we have also experienced a higher net commission expense compared to prior year due to a change in our business mix.

Gross Premiums Written

We operate our business as one segment, property and casualty insurance. We manage this segment through a product management structure. The following table sets forth an analysis of gross premiums written by business component during the periods indicated:

		Three Months Ended September 30,
		2008								2007
		Amount				Percent				Amount				Percent
						(Dollars in thousands)
Alternative Risk Transfer		$	33,808				43.7	%		$	22,435				31.1	%
Transportation			20,972				27.1	%			25,717				35.7	%
Specialty Personal Lines and Commercial Vehicle			14,120				18.2	%			12,773				17.7	%
Hawaii and Alaska			6,996				9.0	%			7,747				10.8	%
Other			1,555				2.0	%			3,385				4.7	%
Gross premiums written		$	77,451				100.0	%		$	72,057				100.0	%

		Nine Months Ended September 30,
		2008								2007
		Amount				Percent				Amount				Percent
						(Dollars in thousands)
Alternative Risk Transfer		$	172,024				55.1	%		$	132,866				48.4	%
Transportation			71,735				23.0	%			72,830				26.5	%
Specialty Personal Lines and Commercial Vehicle			46,800				15.0	%			43,746				15.9	%
Hawaii and Alaska			17,727				5.7	%			19,834				7.2	%
Other			3,961				1.2	%			5,594				2.0	%
Gross premiums written		$	312,247				100.0	%		$	274,870				100.0	%

Gross premiums written include both direct premium and assumed premium. Gross premiums written increased $5.4 million for the third quarter of 2008 compared to 2007. During the third quarter of 2008, as a percent of total gross premiums written, the alternative risk transfer component of the business had the largest dollar increase of $11.4 million, or 50.7%, compared to the same period in 2007. The growth in this business component is primarily due to the addition of a new captive program in the third quarter of 2008 and continued growth in our existing captive programs. Our specialty personal lines and commercial vehicle (“CV”) component grew $1.3 million during the third quarter 2008 compared to 2007, due to additional policies in force for both our CV and watercraft products. The increases in the alternative risk transfer and specialty personal lines and CV components were offset by decreases in the transportation, Hawaii and Alaska and Other components of $4.7 million, $0.8 million and $1.8 million, respectively. The transportation and Hawaii

and Alaska components decreased due to the increased competition in the market and our focus on maintaining our underwriting discipline by achieving an underwriting profit even if we forgo volume as a result. Our Other component is comprised of assigned risk policies over which we have no control.

For the first nine months of 2008, both the alternative risk transfer component and the specialty personal lines component experienced growth in gross premiums written. Our alternative risk transfer component increased $39.2 million, or 29.5%, over the comparable period in 2007. The growth in this component is primarily due to three new captive programs added during 2008, which contributed to $16.1 million of the total year-to-date increase. Additional increases in this component are related to expanded lines of coverage in one of our existing captive programs and the addition of new members to existing captive programs.

The group captive programs, which focus on specialty or niche businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to associations or companies with similar risk profiles and to specified classes of business of our agent partners.

As part of our captive programs, we have analyzed, on a quarterly basis, captive members’ loss performance on a policy year basis to determine if there would be a premium assessment to participants, or if there would be a return of premium to members as a result of less than expected losses. We record assessment premium and return of premium as adjustments to written premium (assessments increase written premium; returns of premium reduce written premium). For the third quarter of 2008 and 2007, we recorded a return of premium of $2.8 million and $0.3 million, respectively. For the first nine months of 2008 and 2007, we recorded a return of premium of $5.3 million and $1.6 million, respectively.

In addition to the alternative risk transfer component, our specialty personal lines and CV component had a $3.1 million, or 7.0%, increase in gross premiums written for the nine months ended September 30, 2008 over the same period in 2007. The growth in this component is primarily due to additional policies in force in our CV and watercraft products from expanded marketing initiatives and product enhancements. Our Transportation and Hawaii and Alaska components decreased $1.1 million and $2.1 million, respectively, over the comparable period in 2007 due to increased competition in a soft market. The Other component, which is comprised of assigned risk policies that we receive from involuntary state insurance plans normally based on our written premium in that state and over which we have no control, decreased $1.6 million, or 29.2%, compared to the same period in 2007.

Premiums Earned

Three months ended September 30, 2008 compared to September 30, 2007. The following table shows premiums earned summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:

		Three Months Ended September 30,								Change
		2008				2007				Amount				Percent
						(Dollars in thousands)
Premiums earned:
Alternative Risk Transfer		$	35,814			$	27,033			$	8,781				32.5	%
Transportation			19,162				18,596				566				3.0	%
Specialty Personal Lines and CV			14,046				13,252				794				6.0	%
Hawaii and Alaska			4,467				4,562				(95	)			(2.1	%)
Other			1,569				2,744				(1,175	)			(42.8	%)
Total premiums earned		$	75,058			$	66,187			$	8,871				13.4	%

Our net premiums earned increased $8.9 million, or 13.4%, to $75.1 million during the three months ended September 30, 2008 compared to $66.2 million for the same period in 2007. This increase is primarily attributable to the $8.8 million increase in the alternative risk transfer component due to expanded insurance offerings in one of our larger programs, and continued growth in our existing captive programs. The specialty personal lines and CV component increased $0.8 million, or 6.0%, during the third quarter of 2008 compared to 2007, due to an increase in the number of policies in force in our CV product. Our transportation component grew $0.6 million, or 3.0%, from growth experienced in our community and medical transportation product and truck products during the fourth quarter of 2007 and first half of 2008. Our Other component decreased $1.2 million, or 42.8%, due to a decrease in our assigned risk policies over which we have no control.

Nine months ended September 30, 2008 compared to September 30, 2007. The following table shows premiums earned summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:

		Nine Months Ended September 30,								Change
		2008				2007				Amount				Percent
		(Dollars in thousands)
Premiums earned:
Alternative Risk Transfer		$	99,212			$	77,495			$	21,717				28.0	%
Transportation			56,882				55,436				1,446				2.6	%
Specialty Personal Lines and CV			40,797				38,564				2,233				5.8	%
Hawaii and Alaska			13,393				13,075				318				2.4	%
Other			4,237				5,172				(935	)			(18.1	%)
Total premiums earned		$	214,521			$	189,742			$	24,779				13.1	%

Our net premiums earned increased $24.8 million, or 13.1%, to $214.5 million during the nine months ended September 30, 2008 compared to $189.7 million for the same period in 2007. This increase is primarily attributable to the alternative risk transfer component, which accounts for approximately 88% of the overall total premiums earned growth. The $21.7 million increase in this component is mainly due to expanded insurance offerings in two of our products during 2007 and the first half of 2008, as well as new participants in our captive programs. The specialty personal lines and CV component increased $2.2 million, or 5.8%, in the first nine months of 2008 compared to the same period in 2007, due primarily to an increase in policies in force in the CV product during the last half of 2007 and first half of 2008. The transportation component increased $1.4 million, or 2.6%, the first nine months of 2008 compared to the same period in 2007 primarily due to an increase in the number of policies in force mainly from our community and medical transportation product and truck products. In the transportation component, we are still experiencing a modest decline in year over year renewal rates due to the current softening market.

Underwriting and Loss Ratio Analysis

Underwriting profitability, as opposed to overall profitability or net earnings, is measured by the combined ratio. The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio. A combined ratio under 100% is indicative of an underwriting profit. Our underwriting approach is to price our products to achieve an underwriting profit even if we forgo volume as a result. For the three and nine months ended September 30, 2008, we experienced single digit decreases to our rate levels on our renewal business.

The table below presents our net premiums earned and combined ratios for the periods indicated:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(Dollars in thousands)								(Dollars in thousands)
Gross premiums written		$	77,451			$	72,057			$	312,247			$	274,870
Ceded reinsurance			(15,036	)			(12,786	)			(72,674	)			(61,837	)
Net premiums written			62,415				59,271				239,573				213,033
Change in unearned premiums, net of ceded			12,643				6,916				(25,052	)			(23,291	)
Net premiums earned		$	75,058			$	66,187			$	214,521			$	189,742
Combined Ratios:
Loss and LAE ratio (1)			69.3	%			60.2	%			67.2	%			59.3	%
Underwriting expense ratio (2)			28.2	%			22.7	%			25.3	%			22.1	%
Combined ratio			97.5	%			82.9	%			92.5	%			81.4	%

Three months ended September 30, 2008 compared to September 30, 2007. Losses and LAE are a function of the amount and type of insurance contracts we write and of the loss experience of the underlying risks. We seek to establish case reserves at the maximum probable exposure based on our historical claims experience. Our ability to estimate losses and LAE at the time of pricing our contracts is a critical factor in determining our profitability. The amount reported under losses and LAE in any period includes payments in the period net of the change in reserves for unpaid losses and LAE between the beginning and the end of the period. The loss and LAE ratio for the third quarter of 2008 increased 9.1 percentage points to 69.3% compared to 60.2% in the same period in 2007. The loss and LAE ratio for the third quarter of 2008 reflects an increase in claims severity primarily in our charter passenger transportation products and includes a $0.3 million, or 0.4 percentage points, reduction for favorable development of losses from prior years compared to favorable development of $0.4 million, or 0.5 percentage points, in the third quarter of 2007 . During the third quarter of 2008 these large losses from the charter passenger transportation products contributed approximately 4 percentage points to the loss ratio. The increase in the loss and LAE ratio during the third quarter of 2008 from 2007 also reflects the impact of modestly lower renewal rates that we have been experiencing from the softening market and frequency associated with the seasonality of our RV product.

Our underwriting expense ratio includes commissions and other underwriting expenses and other operating and general expenses, offset by other income. Commissions and other underwriting expenses consist principally of brokerage and agent commissions reduced by ceding commissions received from assuming reinsurers, and vary depending upon the amount and types of contracts written and, to a lesser extent, premium taxes. The underwriting expense ratio for the third quarter of 2008 increased 5.5 percentage points to 28.2% compared to 22.7% for the same period in 2007. A one-time state guarantee fund charge contributed 1.7 percentage points increase to the expense ratio for the third quarter 2008. During the third quarter of 2007, we received a $0.8 million lease buyout from a tenant that leased space at our corporate campus. This buyout increased rental income by approximately $0.8 million and reduced the 2007 third quarter expense ratio by 1.2 percentage points. The remainder of the change in the expense ratio in the third quarter of 2008 is attributable to increased commission expenses due to a change in our overall mix of business.

Nine months ended September 30, 2008 compared to September 30, 2007. The loss and LAE ratio for the nine months ended September 30, 2008 increased 7.9 percentage points to 67.2% compared to 59.3% in the same period in 2007. The loss and LAE ratio for the nine months ended September 30, 2008 includes a $0.8 million, or 0.4 percentage points, increase for unfavorable development of losses from prior years compared to a reduction to the loss and LAE ratio for favorable development of $5.0 million, or 2.6 percentage points, in the first nine months of 2007. Additionally in the first nine months of 2008, we experienced increased claims severity primarily in our charter passenger transportation products, which accounted for approximately a 5 percentage point increase to the loss ratio. We are currently focusing our attention on our small fleet passenger transportation product to ensure that our high underwriting standards are still in place. Initiatives centered on risk selection and pricing adequacy have been implemented to address the unusually high losses that we have encountered.

The underwriting expense ratio for the nine months ended September 30, 2008 increased 3.2 percentage points to 25.3% compared to 22.1% for the same period in 2007. The increase in our year-to-date 2008 expense ratio is primarily due to a change in our overall mix of business, including high premium growth in products that tend to have higher commission rates.

Net Investment Income

2008 compared to 2007. Net investment income remained relatively constant at $5.4 million for the three months ended September 30, 2008 compared to $5.7 million in the same period in 2007 as a result of higher average cash and invested assets offset by lower yields. For the nine months ended September 30, 2008 compared to the same period in 2007, net investment income increased $0.4 million, or 2.6%, to $16.8 million. We have experienced lower interest rates on cash and short-term investments and flat rates on our fixed income investments.

Net Realized Gains (Losses) on Investments

2008 compared to 2007. Net realized losses were $8.4 million and $0.3 million for the third quarter of 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, net realized losses were $10.8 million and $0.1 million, respectively. Continuing turmoil in investment markets has caused market declines in our investment portfolio, particularly in the financial and real estate related holdings. This has had an adverse impact on our investment portfolio in 2008, as we recognized other-than-temporary impairment charges on investments of $8.0 million and $10.5 million for the third quarter and first nine months of 2008, respectively. Of the $8.0 million, $5.8 million related to securities issued by Fannie Mae, Freddie Mac and Lehman Brothers Holdings Inc. and $1.6 million related to securities in the financial and real estate sector. The others are in insurance and asset backed. For both the quarter and nine months ended September 30, 2007, we recognized a $0.2 million other-than-temporary impairment charge.

Realized gains are taken when opportunities arise. When evaluating fixed maturity sales opportunities, we consider multiple factors, such as reinvestment alternatives and specific circumstances of the investment currently held. Credit quality, portfolio allocation and other-than-temporary impairment are additional factors that may encourage us to sell a fixed maturity security, at a gain or loss, prior to maturity. Historically, we have not had the need to sell our investments to generate liquidity.

Commissions and Other Underwriting Expenses

2008 compared to 2007. During the third quarter of 2008, commissions and other underwriting expenses increased $4.7 million, or 34.2%, to $18.5 million from $13.8 million in the comparable period in 2007. For the first nine months of 2008 and 2007, commissions and other underwriting expenses were $46.7 and $36.3 million, respectively, increasing $10.3 million, or 28.4%. Both the quarter and year-to-date increases relate to an increase in net commission expense due to growth and a change in our business mix. Our various products have different commission rates, therefore the quarterly and year-to-date commission expense can vary based on the product mix written during the period. During both the third quarter of 2008 and year-to-date 2008 results, our premium growth has typically been in products that have higher commission rates. In addition to a change in our overall mix of business, we recorded an approximate $1.3 million charge for a one-time state guarantee fund in the third quarter of 2008, which was also a contributing factor to the increase in our commissions and other underwriting expenses.

Other Operating and General Expenses

2008 compared to 2007. For the three and nine months ended September 30, 2008, other operating and general expenses were $3.2 million and $9.8 million, respectively, as compared to $2.8 million and $9.0 million in the comparable periods in 2007. Other operating and general expenses for both the quarter and year-to-date results increased mainly as a result of an increase in employee headcount over prior year.

Expense on Amounts Withheld

2008 compared to 2007. For the three and nine months ended September 30, 2008, the expense on amounts withheld were $1.0 million and $3.3 million, respectively, as compared to $1.0 million and $2.6 million in the comparable periods in 2007. The increases in the expense on amounts withheld during the first nine months of 2008 are a direct result of continued growth in our alternative risk transfer component. The expense on amounts withheld remained relatively constant for the third quarter 2008 compared to third quarter 2007 primarily due to the current market turmoil.

Income Taxes

2008 compared to 2007. The effective tax rate was (92.6%) and 33.6% for the three-month period ended September 30, 2008 and 2007, respectively. The 2008 year-to-date effective tax rate increased 14.6 percentage points to 46.7% compared to 32.1% rate for the same period in 2007. The change in the effective tax rate is due to a valuation allowance of $3.2 million that was taken on our realized investment losses, which increased both the 2008 third quarter and year-to-date income tax provision and increased the year-to-date 2008 effective tax rate 17.5 percentage points.

Financial Condition

Investments and Securities Lending Collateral

At September 30, 2008, our investment portfolio contained $432.9 million in fixed maturity securities, $46.4 million in equity securities and $78.0 million in securities lending collateral, all carried at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity on an after-tax basis. At September 30, 2008, we had pretax net unrealized loss of $9.3 million on fixed maturities, $7.8 million on securities lending collateral and $10.7 million on equity securities. Our investment portfolio allocation is driven by our investment policy, which is weighted towards high quality fixed maturity investments. Although our current holdings and investment policy are focused on maintaining a high quality portfolio, we remain exposed to future market fluctuations, especially given the current global financial crisis.

At September 30, 2008, 99.6% of our fixed maturities were rated “investment grade” (credit rating of AAA to BBB-) by Standard & Poor’s Corporation. At September 30, 2008, 91.6% of the securities lending collateral was rated “investment grade” by Standard & Poor’s Corporation or invested in overnight repurchase agreements. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade.

Summarized information for the unrealized gains and losses recorded in the Company’s investment portfolio on the Balance Sheet at September 30, 2008, is shown in the following table. Approximately $1.8 million of available for sale “Fixed maturities” and $13.5 million of “Equity securities” had no unrealized gains or losses at September 30, 2008.

		Securities with				Securities with
		Unrealized				Unrealized
		Gains				Losses
		(Dollars in thousands)
Fixed Maturities:
Fair value of securities		$	187,839			$	243,278
Amortized cost of securities		$	186,010			$	254,374
Gross unrealized gain or (loss)		$	1,829			$	(11,096	)
Fair value as a % of amortized cost			101.0	%			95.6	%
Number of security positions held			171				201
Number individually exceeding $50,000 gain or loss			4				46
Concentration of gains or (losses) by type or industry:
US Government and government agencies		$	1,060			$	(928	)
State, municipalities and political subdivisions			235				(3,544	)
Mortgage-backed securities			391				(427	)
Banks, insurance and brokers			121				(5,679	)
Industrial and other			22				(518	)
Percentage rated investment grade (1)			99.6	%			99.6	%
Equity Securities:
Fair value of securities		$	3,244			$	29,679
Cost of securities		$	3,054			$	40,572
Gross unrealized gain or (loss)		$	190			$	(10,893	)
Fair value as a % of cost			106.2	%			73.2	%
Number individually exceeding $50,000 gain or (loss)			1				40

Summarized information for the unrealized gains and losses recorded in the Company’s security lending collateral on the Balance Sheet at September 30, 2008, is shown in the following table. Approximately $27.4 million of fixed maturity investments had no unrealized gains or losses at September 30, 2008.

		Unrealized
		Losses
Fixed Maturities:
Fair value of securities		$	50,580
Amortized cost of securities		$	58,331
Gross unrealized gain or (loss)		$	(7,751	)
Fair value as a % of amortized cost			86.7	%
Number of security positions held			16
Number individually exceeding $50,000 gain or loss			11
Concentration of gains or (losses) by type:
Repurchase agreements — overnight			—
Mortgage-backed securities			(6,854	)
Banks, insurance and brokers			(897	)
Percentage rated investment grade (1)			96.0	%

The table below sets forth the scheduled maturities of available for sale fixed maturity securities at September 30, 2008, based on their fair values. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.

		Securities with				Securities with
		Unrealized				Unrealized
		Gains				Losses
Maturity:
One year or less			3.9	%			4.9	%
After one year through five years			69.9	%			31.8	%
After five years through ten years			6.8	%			45.0	%
After ten years			1.1	%			5.2	%
			81.7	%			86.9	%
Mortgage-backed securities			18.3	%			13.1	%
			100.0	%			100.0	%

The table below sets forth the scheduled maturities for securities lending collateral at September 30, 2008, based on their fair values:

		Securities with
		Unrealized
		Losses
Maturity:
One year or less			48.7	%
After one year through five years			6.9	%
			55.6	%
Mortgage-backed securities			44.4	%
			100.0	%

The table below summarizes the unrealized gains and losses on our investment portfolio fixed maturities and equity securities by dollar amount:

		September 30, 2008
						Aggregate				Fair Value as
		Aggregate Fair				Unrealized				% of Cost
		Value				Gain (Loss)				Basis
		(Dollars in thousands)
Fixed Maturities:
Securities with unrealized gains:
Exceeding $50,000 and for:
Less than one year (4 issues)		$	7,037			$	281				104.2	%
More than one year (0 issues)			—				—				—
Less than $50,000 (167 issues)			180,802				1,548				100.9	%
		$	187,839			$	1,829
Securities with unrealized losses:
Exceeding $50,000 and for:
Less than one year (39 issues)		$	55,478			$	(4,409	)			92.6	%
More than one year (7 issues)			8,834				(4,157	)			68.0	%
Less than $50,000 (155 issues)			178,966				(2,530	)			98.6	%
		$	243,278			$	(11,096	)
Equity Securities:
Securities with unrealized gains:
Exceeding $50,000 and for:
Less than one year (0 issue)		$	—			$	—				—
More than one year (1 issues)			2,150				150				107.5	%
Less than $50,000 (2 issues)			1,094				40				103.8	%
		$	3,244			$	190
Securities with unrealized losses:
Exceeding $50,000 and for:
Less than one year (36 issues)		$	23,138			$	(8,465	)			73.2	%
More than one year (4 issues)			3,517				(1,942	)			64.4	%
Less than $50,000 (19 issues)			3,024				(486	)			86.2	%
		$	29,679			$	(10,893	)