Summary of AMERICAN PHYSICIANS SERVICE GROUP INC

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto accompanying this report. Except for historical information contained here, the discussions in this Item 7 contain forward-looking information that involves risks and uncertainties. As discussed under "Cautionary Statement Regarding Forward-Looking Statements," our actual financial condition and operating results could differ significantly from these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under Item 1A. Risk Factors.

General

We provide, through our wholly-owned subsidiaries, (1) insurance services, specifically medical professional liability insurance in Texas, Oklahoma and Arkansas and (2) financial services, including brokerage and investment services to institutions and high net worth individuals.

Insurance Services.

Effective April 1, 2007, American Physicians Insurance Exchange, or APIE, converted from a reciprocal insurance exchange to a Texas stock insurance company, pursuant to a plan of conversion, and changed its name to American Physicians Insurance Company, or API. Simultaneously, API merged with a wholly owned subsidiary of ours and became our wholly-owned subsidiary.

API provides medical professional liability insurance primarily in Texas, where it has written business for over 30 years. API is authorized to do business in the States of Texas, Arkansas and Oklahoma and specializes in writing medical professional liability insurance for physicians and other healthcare providers. API became authorized to do business in Oklahoma in August 2007. Historically, we operated as the attorney-in-fact manager for API since 1975. In April 2007, we acquired API, thus combining our insurance management experience with an insurance underwriting entity to allow for the increased possibility for expansion into new markets and for continued growth in existing markets.

Financial Services.

Through our subsidiaries, APS Financial Corporation, or APS Financial, APS Capital Corporation, or APS Capital, and APS Asset Management, Inc., or Asset Management, we provide our brokerage and investment services to institutions and high net worth individuals.

APS Financial.

APS Financial is a licensed broker/dealer that provides brokerage and investment services primarily to institutional and high net worth individual clients. APS Financial also provides portfolio accounting, analysis, and other services to insurance companies and banks. We recognize commission revenue, and the related compensation expense, on a trade date basis.

APS Capital.

APS Capital engages in the trading, clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios. Trade claims are private debt instruments representing a pre-petition claim on a debtor's estate. We recognize commission revenue and the related compensation expense when the transaction is complete and fully funded.

Asset Management.

Asset Management manages fixed income and equity assets for institutional and individual clients on a fee basis. We recognize fee revenue monthly based on the amount of funds under management.

Other Investments.

In 2003, we acquired 385,000 shares of common stock of Financial Industries Corporation ("FIC"). The total purchase price was approximately $5,647,000. Our policy in regards to our investment in FIC had been that we would record pretax charges to earnings should the common stock price on the last day of each interim or annual period fall below the adjusted cost basis of our investment in FIC. From 2004 through 2007, we wrote down the carrying value of the FIC stock by $3,414,000. In 2008 FIC was acquired. The basis in our investment in FIC common stock at the closing of the merger was $5.80 per share and based on the sale price of $7.25 per share, we recognized a $558,000 gain in the third quarter of 2008.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES.

The accompanying financial statements have been prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). The preparation of our consolidated GAAP financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to: reserve for losses and loss adjustment expenses; death, disability and retirement reserves; reinsurance premiums recoverable/payable; premiums ceded; deferred policy acquisition costs, impairment of assets; bad debts; income taxes; and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and estimates affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. We periodically review the carrying value of our assets to determine if events and circumstances exist indicating that assets might be impaired. If facts and circumstances support this possibility of impairment, our management will prepare undiscounted and discounted cash flow projections, which require judgments that are both subjective and complex. Management may also obtain independent valuations.

Revenue Recognition. Historically, our Insurance Services segment recognized revenues in accordance with Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition. Prior to April 1, 2007, our Insurance Services revenues were historically related to management fees based on the earned premiums of API and included a profit sharing component related to API's annual earnings. Management fees equaled 13.5% of API's earned premiums before payment of reinsurance premiums plus profit sharing equal to 50% of API's pre-tax earnings up to a maximum of 3% of earned premiums before payment of reinsurance premiums. Management fees were recorded, based upon the terms of the management agreement, in the period the related premiums are earned by API. API recognizes premiums as earned ratably over the terms of the related policy. The profit sharing component was historically recognized in the fourth quarter when it was certain API would have an annual profit. In 2007, however, since the management contract ended March 31, 2007, we recognized the quarter's profit in March, based on our ability to fully determine the profit sharing base.

As a result of the acquisition, our Insurance Services segment recognizes revenue in accordance with SFAS No. 60, Accounting and Reporting of Insurance Enterprises. We issue policies written on a claims-made basis. A claims-made policy provides coverage for claims reported during the policy year. We charge both a base premium and a premium maintenance fee. Policies are written for a one-year term and premiums and maintenance fees are earned on a pro rata basis over the term of the policy. Premium maintenance fees are charged to offset the costs incurred by API to issue and maintain policies. Unearned premiums and maintenance fees are determined on a monthly pro rata basis. Upon termination of coverage, policyholders may purchase an extended reporting period, or tail, endorsement for additional periods of time. These extended reporting period coverage endorsement premiums are earned when written.

Our Financial Services revenues are composed primarily of commissions on securities trades and clearing of trade claims and asset management fees. Revenues related to securities transactions are recognized on a trade date basis. Revenues from the clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios are recognized when the transaction is complete and fully funded. Asset management fees are recognized as a percentage of assets under management during the period based upon the terms of agreements with the applicable customers.

Fair Value Measurements. In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS 157, Fair Value Measurements. SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. Under the standard, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts its business.
SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability.
In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy.

Effective January 1, 2008, we adopted SFAS 157, Fair Value Measurements, for our financial assets and financial liabilities, but have not yet adopted SFAS 157 as it relates to nonfinancial assets and liabilities based on the February 2008 issuance of FASB Staff Position 157-2, Effective Date of FASB Statement No. 157, which permits a one-year deferral of the application of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008.
The adoption of SFAS 157 as it pertains to financial assets and liabilities did not have a material impact on our results of operations, financial position or liquidity. We will adopt SFAS 157 for non-financial assets and non-financial liabilities on January 1, 2009 and do not expect the provisions to have a material effect on our results of operations, financial position or liquidity.

SFAS 157 describes three levels of inputs that may be used to measure fair value:

Level 1

Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2

Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3

Valuations are developed from unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

When determining the fair value measurements for assets and liabilities required or permitted to be recorded at and/or marked to fair value, we consider the principal or most advantageous market in which it would trade and consider assumptions that market participants would use when pricing the asset or liability. When possible, we look to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, we look to market observable data for similar assets and liabilities, independent industry-standard models such as matrix pricing and independent, third-party dealer quotes whose inputs may be less observable than Level 1 pricing. When market observable data is not as readily available, the valuation of financial instruments becomes more subjective and could involve substantial judgment. Certain assets and liabilities are not actively traded in observable markets and the Company must use alternative valuation techniques to derive a fair value measurement. For additional disclosures, see Note 23, Fair Value Disclosures, to the unaudited financial statements included herein.

In September 2008, the SEC and FASB issued joint guidance providing clarification of issues surrounding the determination of fair value measurements under the provisions of SFAS 157 in the current market environment. In October 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which amended SFAS 157 to provide an illustrative example of how to determine the fair value of a financial asset when the market for that asset is not active.

Fair value is used on a recurring basis for our equity and fixed maturity, available for sale securities in which fair value is the primary basis of accounting. Fair value for these securities is the market value based on quoted market prices, when available (Level 1) or quoted prices for similar assets or liabilities in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Certain assets and liabilities are not actively traded in observable markets with listed prices or quotes and we must use alternative valuation techniques based on independent dealer quotes on the security and our own assumptions and professional judgment to derive a fair value measurement (Level 3). In these instances when significant valuation assumptions are not readily observable in the market, instruments are valued based on the best available data to approximate fair value. This data would consider a risk premium that a market participant would require. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. Typically, during periods of market dislocation, the observability of prices and inputs may be reduced for the instruments we hold. This condition could cause an instrument to be reclassified to a lower level during any given period.

The following table presents the estimated fair value of our financial instruments on a recurring basis as of December 31, 2008:

(in thousands)                                                     Fair Value Measurements at December 31, 2008
                                                                                      Using:


                                                                Quoted prices
                                                                  in active       Significant
                                                                   markets         other ob-        Significant
                                                                for identical      servable         other unob-
                                                December 31,       assets           inputs        servable inputs
Description                                         2008           Level 1          Level 2           Level 3
Financial Assets:
 Fixed income securities, available for sale   $     198,011    $     30,993     $    164,359     $         2,659
 Equity securities, available for sale                10,099          10,044               55                   -
   Total                                       $     208,110    $     41,037     $    164,414     $         2,659

Percentage of Assets by Fair Value Hierarchy             100%           19.7%            79.0%                1.3%

A reconciliation of the beginning and ending balances of our financial instruments for fair value measurements made using significant unobservable inputs (Level 3) follows (in thousands):

                                                                      Fixed Maturity
                                                                       Securities,
                                                                        Available
                                                                         for Sale
Balance, January 1, 2008                                              $      11,867

Total gains or losses realized/unrealized:
Included in earnings (or changes in net assets)                              (4,511)
Included in other comprehensive income                                        1,260
Purchases, issuances, and settlements                                        (2,297)
Transfers in and/or out of Level 3                                           (3,660)

Balance, December 31, 2008                                            $       2,659

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
December 31, 2008                                                     $      (4,511)


Gains and losses (realized and unrealized) included in earnings for
the period are
reported in net realized investment gains (losses) as follows:

Total gains or losses included in earnings for the period (above)     $      (4,519)

Change in unrealized gains or losses related to assets held at
December 31, 2008                                                     $     (1,009)

Level 1 consists of instruments whose values are based on quoted market prices in active markets. We receive quoted market prices from a third party, independent, nationally recognized pricing service (pricing service). The Company utilizes the pricing service, either for market values obtained based on quoted, actively traded market prices (Level 1) or quoted prices for similar assets in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Of our investment portfolio of $208,110,000 as of December 31, 2008 approximately 99% of our fixed-income securities are priced either as Level 1 or Level 2. The fair value estimate for our equity portfolio of $10,044,000 and our U.S. Treasury fixed income securities of $30,993,000 are based on Level 1 pricing provided by this pricing service since there is an active, readily tradable market value based on quoted prices, as of December 31, 2008, or the measurement date. Active markets are those in which transactions occur in significant frequency and volume to provide pricing information on an on-going basis. Valuation of Level 1 securities does not entail a significant degree of judgment since an active market exists and quoted prices are readily and regularly available.

With the exception of U.S. Treasury securities, very few of our fixed-income securities are actively traded. Most of our fixed-income securities, such as government or agency mortgage backed securities, tax-exempt municipal securities and corporate securities are valued using a pricing service and fall within Level 2. Level 2 pricing in our fair value hierarchy comprises $164,414,000 or 79.0% of our investment portfolio which as of December 31, 2008 includes our U.S. Government agency bonds/notes of $24,415,000; U.S Government agency mortgage backed bonds of $30,428,000; U.S. Government agency collateralized mortgage obligations ("CMO's") of $50,531,000; Government tax-exempt bonds of $25,446,000; corporate bonds of $7,808,000 and non-agency CMO's of $25,730,000.
Five Alt-A securities with a fair value estimate of $2,659,000 or 1.3% of our investment portfolio are classified as Level 3 since the securities are priced based on non-binding indications provided by dealers and the professional judgment of our investment professionals in our asset management subsidiary, APS Asset Management (Asset Manager) upon review of the specifics of the security, including class, maturity, credit rating, durations, collateral and comparable markets for similar securities. Alt-A securities are CMO's generally considered to have underlying mortgages with underwriting characteristics that are stronger than "Subprime" mortgages but less stringent than "Prime" mortgages.

In regards to Level 2 pricing, fair values are used and are based on the market prices from the pricing service where valuations are based on quoted market prices for identical or similar assets and/or valuations using industry-standard models such as matrix pricing. The pricing service evaluates each asset based on relevant market information, credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation include, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets benchmark securities, bids and offers, quoted forward prices, time value, volatility factors, current market and contractual prices for the underlying instrument, and industry news and economic events. For mortgage related products, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. The pricing service we utilize has indicated that they will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation.

Through our Asset Manager, we review the estimates and assumptions of fair value of each security provided by the pricing service for Level 1 and Level 2 pricing and compare these estimates to our custodial bank statement, which also provides a fair market value for the securities we hold to determine if the estimates are representative of the prices in the market. Comparing our fair value pricing obtained from our custodial bank statement serves as a cross-check to the validity of the information provided from the pricing service. Valuations are reviewed for reasonableness based upon the specifics of the security, including class, maturity, credit rating, durations, collateral and comparable markets for similar securities. We may adjust the valuation of securities from the independent pricing service when we believe its pricing does not fairly represent the market value of the investment. For example, when market observable data is not as readily available or if the security trades in an inactive market, the valuation of financial instruments becomes more subjective and could involve substantial judgment resulting in Level 3 pricing. We generally consider a market to be inactive if the following conditions exist:
(1) there are very few transactions for the financial instrument; (2) the prices in the market are not current; (3) the price quotes we receive vary significantly over time or among independent pricing services or dealers; and
(4) there is a limited availability of public market information.

In the third quarter of 2007, the market for non-agency collateralized debt obligations, specifically the market for Alt-A's, became increasingly inactive based on the limited number of transactions, varying market prices provided by dealers and the limited availability of market data for these securities. The inactivity was evidenced by a significant widening of the bid and ask spread in the dealer markets in which these securities trade and a significant decrease in the volume of trades relative to historical levels. As of December 31, 2008, our portfolio contained seven CMO securities classified as Alt-A of which five of these securities, or $2,659,000 representing 1.3% of our investment portfolio, are classified as Level 3 pricing. The remaining non-agency CMO's in our investment portfolio have underlying mortgages categorized as "Prime" quality loans with no adjustable features, and none of our CMO's have underlying mortgages classified as "Subprime." All of our CMO's, including our Alt-A securities have underlying mortgages with fixed interest rates and all but one Alt-A security is investment grade, currently rated either AA or A. During the quarter ended December 31, 2008, one of the Alt-A securities with a fair market value of $27,000 at December 31, 2008 was downgraded to a "C" rating.

The deepening national housing crisis and its potential impact on the underlying collateral of our Alt-A securities has resulted in a significant and rapid decline of their fair market value, especially in relation to the market prices provided by the outside pricing service. Consistent with our approach to pricing our entire portfolio, we initially received market pricing on these securities from the pricing service. We then reviewed the pricing of our Alt-A securities based on the market environment and the specific characteristics including the overall structure of the instrument; default rates; demographic and geographic characteristics of the underlying mortgages; support levels; and loan to value ratios. As a result of this review, as of December 31, 2008, we have adjusted five of the seven Alt-A securities to lower fair market value from those indicated by the pricing service, (a market-corroborated observable input) based on non-binding indications received from dealers and the judgment of our Asset Manager (unobservable inputs). We obtain two to three indications from dealers who actively trade in these or similar securities, but are not binding offers.
Because the approach to valuing these securities involves significant professional judgment and the expertise of our Asset Manager including the use of unobservable inputs from non-binding dealer indications, we classify securities valued in this manner as Level 3.

As noted in the table above (reconciliation of beginning and ending balances of our financial instruments for fair value measurements made using significant unobservable inputs (Level 3)), $3,660,000 was transferred out of Level 3 to Level 2 during the twelve months ended December 31, 2008 as the pricing from dealer indications we received was comparable to the independent pricing service. We attempt to apply consistent methods and techniques utilized in previous evaluation periods to determine the appropriate level within the fair value hierarchy. Changes in pricing based on Level 3 pricing assumptions of our lowest rated Alt-A securities can have a material effect on our results of operations and financial position as evidenced by the recognition of realized losses of $1,220,100 and $5,818,600, respectively for the three and the twelve months ended December 31, 2008 on these Alt-A securities. If we would have selected pricing based on Level 2 assumptions provided by the pricing service, we would have recognized realized losses of only $693,900 and $3,194,400, respectively, or a $526,100 and $2,624,200 difference for the three and the twelve months ended December 31, 2008. Additionally, our financial position would have been higher since our fixed maturities, available for sale and accumulated, other comprehensive income would have been increased by $1,387,500 as of December 31, 2008 based on different pricing assumptions.

Investments. Our policy is to account for investments as available-for-sale securities which requires that we assess fluctuations in fair value and determine whether these fluctuations are temporary or "other than temporary" as defined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," ("SFAS 115").

In accordance with SFAS No. 115, we evaluate our investment securities on at least a quarterly basis for declines in market value below cost for the purpose of determining whether these declines represent other than temporary declines. A decline in the fair value of a security below cost judged to be other than temporary is recognized as a loss in the current period and its fair value . . .