For purposes of this Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"), "APS," "we," "our," "us" and the "Company" refer to American Physicians Service Group, Inc., together with its subsidiaries, unless the context requires otherwise. The following MD&A should be read in conjunction with the accompanying unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2009, included in Part I, Item 1, as well as the audited, consolidated financial statements and notes in our Annual Report on Form 10-K for the year ended December 31, 2008, which was filed with the United States Securities and Exchange Commission (the "SEC") on March 4, 2009.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements involve risks and uncertainties, as well as assumptions that, if they do not materialize or prove correct, could cause our results to differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including statements: of our plans, strategies and objectives for future operations; concerning new products, services or developments; regarding future economic conditions, performance or outlook; as to the outcome of contingencies; of beliefs or expectations; and of assumptions underlying any of the foregoing.

Forward-looking statements may be identified by their use of forward-looking terminology, such as "believes," "expects," "may," "should," "would," "intends," "plans," "estimates," "anticipates," "projects" and similar words or expressions. You should not place undue reliance on these forward-looking statements, which reflect our management's beliefs and assumptions only as of the date of the filing of this Quarterly Report on Form 10-Q. We undertake no obligation, other than that imposed by law, to update forward-looking statements to reflect further developments or information obtained after the date of filing of this Quarterly Report on Form 10-Q or, in the case of any document incorporated by reference, the date of that document.

The following important factors, in addition to those referenced under "Risk Factors" in Part II, Item 1A and Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2008, as filed with the Securities and Exchange Commission on March 4, 2009, could affect the future results of our operations and could cause those results to differ materially from those expressed in or implied by such forward-looking statements:

•

general economic conditions, either nationally or in our market area, that are worse than expected;

•

changes in the healthcare industry;

•

regulatory and legislative actions or decisions that adversely affect our business plans or operations;

•

inflation and changes in the interest rate environment, and/or changes in the securities markets including the performance of financial markets affecting the fair value of our investments or making it difficult to determine the value of our investments;

•

uncertainties inherent in the estimate of loss and loss adjustment expense reserves and reinsurance;

•

significantly increased competition among insurance providers;

•

changes in the availability or cost of reinsurance including our ability to renew our existing reinsurance treaty or obtain new reinsurance;

•

failure or inability of our reinsurers to pay claims or amounts due us in a timely manner;

•

loss of key executives, personnel, accounts or customers; and

•

potential losses and litigation risk associated with our Financial Services businesses.

The foregoing factors should not be construed as exhaustive and we caution you not to place undue reliance on forward-looking statements, which speak only as of the date of this report. In addition to any risks and uncertainties specifically identified in the text surrounding forward-looking statements, you should consult our other filings under the Securities Act of 1933 and the Securities Exchange Act of 1934 for factors that could cause our actual results to differ materially from those presented.

Business Overview

We provide (1) insurance services, specifically medical professional liability insurance in Texas, Arkansas and Oklahoma and (2) financial services, including brokerage and investment services to individuals and institutions.

Insurance Services. We provide medical professional liability insurance primarily in Texas, where our insurance subsidiary has written business for over 30 years. Our insurance subsidiary 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, including physician extenders and clinical staff. Our insurance subsidiary currently insures approximately 6,400 physicians, dentists, and other healthcare providers, including physician extenders and clinical staff, the majority of which are in Texas. Approximately 93% of our premiums are written in Texas.

Financial Services. We provide investment and investment advisory services to institutions and individuals throughout the United States through the following subsidiaries:

o

APS Financial. APS Financial Corporation ("APS Financial") is a fully 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, banks and public funds. We recognize commission revenue, and the related compensation expense, on a trade date basis.

o

APS Capital. APS Capital is dedicated to the clearing and settlement of trades involving non-securities including syndicated bank loans, trade claims and distressed private loan portfolios. We seek to develop business with clients who trade in distressed markets. We recognize commission revenue, and the related compensation expense, when the transaction is complete and fully funded.

o

APS Asset Management. APS Asset Management, Inc. ("APS Asset Management"), a registered investment adviser under the Investment Advisers Act of 1940, manages fixed income and equity assets for institutional and individual clients on a fee basis. We recognize fee revenues monthly based on the amount of funds under management.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires us to make estimates and assumptions that affect amounts reported in the accompanying unaudited Condensed Consolidated Financial Statements and Notes thereto. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, or that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in our results of operations in the period in which those estimates changed.

Our "critical" accounting policies are those policies that we believe to be most sensitive to estimates and judgments. These policies are more fully described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the year ended December 31, 2008 and Note 2 to our audited consolidated financial statements contained in that report. There have been no material changes to these policies since the most recent year end.

Although we have not changed our accounting policies, we believe it is beneficial, given the recent market turmoil and the adoption beginning with the three months ended June 30, 2009 of FASB ASC 820-10, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly and FASB ASC 320-10, Recognition and Presentation of Other-Than-Temporary Impairments, to explain our accounting policies regarding the determination of the fair value and OTTI of our investment securities.

In April 2009, FASB ASC 820-10, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, was issued. It provides additional guidance to highlight and expand on the factors that should be considered in estimating fair value when there has been a significant decrease in market activity for a financial asset and identifying circumstances that indicate a transaction is not orderly. This FSP also requires new disclosures relating to fair value measurement inputs and valuation techniques (including changes in inputs and valuation techniques). FASB ASC 820-10 does not change the objective of fair value measurement. That is, even though there has been a significant decrease in market activity for a security, the fair value objective remains the same. Fair value is the price that would be received to sell a security in an orderly transaction (i.e. not a forced liquidation or distressed sale), between market participants at the measurement date under current market conditions (i.e., an exit price notion). We adopted FASB ASC 820-10 for the three months ended June 30, 2009.

The fair value of our investment securities are determined by following the guidance and hierarchy in FASB ASC 820-10, Fair Value Measurements. FASB ASC 820-10 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.

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, our own assumptions including internal pricing models 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. For additional discussion regarding fair value measurement, see Note 6 to the unaudited financial statements included herein.

In April 2009, the FASB also issued FASB ASC 320-10, Recognition and Presentation of Other-Than-Temporary Impairments ("FSP 115-2"), which replaces the requirement in FASB ASC 320-10, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" for management to assert that it has the intent and ability to hold an impaired debt security until recovery with the requirement that management assert if it either has the intent to sell the debt security or if it is more likely than not the entity will be required to sell the debt security before recovery of its amortized cost basis.

When assessing our intent to sell a debt security or if it is more likely that we will be required to sell a debt security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio, sale of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing. In order to determine the amount of the credit loss for a debt security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying debt security. The effective interest rate is the original yield or the coupon if the debt security was previously impaired. If an OTTI exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our Condensed Consolidated Statements of Operations. If we do not intend to sell a debt security or it is not more likely than not we will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Condensed Consolidated Statements of Operations, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to OCI, as an unrealized OTTI loss on our Condensed Consolidated Balance Sheets, as this is considered a noncredit (i.e., recoverable) impairment.

To determine the recovery period of a debt security, we consider the facts and circumstances surrounding the underlying issuer including, but not limited to, the following:

·

Historic and implied volatility of the security;

·

Length of time and extent to which the fair value has been less than amortized cost;

·

Adverse conditions specifically related to the security or to specific conditions in an industry or geographic area;

·

Failure, if any, of the issuer of the security to make scheduled payments; and

·

Recoveries or additional declines in fair value subsequent to the balance sheet date.

For all debt securities evaluated for OTTI, we consider the timing and amount of the cash flows. When evaluating whether our non-agency CMOs, including our position in Alt-A's, are other-than-temporarily impaired, we also examine the characteristics of the underlying collateral, such as delinquency, loss severities and default rates, the quality of the underlying borrower, the type of collateral in the pool, the vintage year of the collateral, subordination levels within the structure of the collateral pool, the quality of any credit guarantors, the susceptibility to variability of prepayments, our intent to sell the security and whether it is more likely than not we will be required to sell the security before the recovery of its amortized cost basis. In assessing corporate debt securities for OTTI, we evaluate the ability of the issuer to meet its debt obligations and the value of the company or specific collateral securing the debt position including the fundamentals of the issuer to determine what we would recover if they were to file bankruptcy versus the price at which the market is trading; fundamentals of the industry in which the issuer operates; expectations regarding defaults and recovery rates; and changes to the rating of the security by a rating agency.

For an equity security, if we do not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, we conclude that an OTTI has occurred, and the cost of the equity security is written down to the current fair value, with a corresponding change to realized gain (loss) in our Condensed Consolidated Statements of Operations. We base our review on a number of factors including, but not limited to, the severity and duration of the decline in fair value of the equity security as well as the cause of the decline, the length of time we have held the equity security, any third party research reports or analysis, and the financial condition and near-term prospects of the security's issuer, taking into consideration the economic prospects of the issuer's industry and geographical location. For additional discussion regarding OTTI and the impact of the adoption of FASB ASC 320-10, see Note 5 herein to our unaudited consolidated financial statements.

Results of Operations

Despite continued pricing pressure in our Insurance Services segment in the first nine months of 2009, improvements in the terms of our reinsurance contracts coupled with favorable prior year reserve development allowed us to deliver solid results from this operating segment for the three and nine months ended September 30, 2009. As a result of continued favorable development in both claim counts and claim severity post-tort reform and increased competition, we lowered our rates on renewing business approximately 4% on average during the nine months ended September 30, 2009 as compared to approximately 6% for the nine months ended September 30, 2008. The 2009 reductions were the result of negotiated discounts to retain certain group practices with favorable loss histories. As a result, policyholder retention was strong for the first nine months of 2009 at approximately 91% as compared to 92% during the first nine months of 2008. We have seen continued competition by existing professional liability carriers. Many of these carriers have been aggressive in seeking new business and are willing to compete on price. As a result of this increased competition, we continue to be faced with price pressure on both existing renewals and new business. We will continue to monitor frequency of claims and severity of loss and legal expenses to determine if further rate adjustments are warranted. As a result of these market forces, we expect to continue to face extensive competition throughout 2010, but will continue to price insurance products at rates we believe are adequate for the risks assumed.

Furthermore, even though reported claims and claim pay-out trends remain favorable, we increased loss and loss adjustment expenses by $4,837,000 to $33,699,000 for the nine months ended September 30, 2009 accident year as compared to $28,862,000 for the 2008 accident year for the nine months ended September 30, 2008. This increase reflects the change in our 2009 reinsurance contract to $1,000,000 in net retention as well as increases in policyholder count from 5,218 as of September 30, 2008 to 6,401 as of September 30, 2009. The 2009 treaty will reduce our ceded premiums as a percentage of direct premiums written, thus resulting in a relative increase in net premiums written and earned, the overall impact on earnings is uncertain as the frequency and severity of losses in future periods is not yet known.

Our Financial Services segment, which returned to profitability during the second quarter of 2009, turned in an even stronger third quarter as a result of a combination of increased broker/dealer commission revenue and substantially lower costs. Financial Services revenues increased 49% in the current quarter compared to the same period in 2008 based on increased trading activity. The decrease in operating costs is the consequence of a concerted effort begun during the second quarter of 2008 to streamline costs in the face of a weakening economy and difficult market conditions. Though performance in this segment during the current quarter is encouraging, we cannot predict that the factors leading to our increased trading activity, namely a tightening of spreads in the high-yield markets and a slowly growing level of investor confidence, will continue. As a result, we cannot yet be confident positive earnings will become a trend.

The following table sets forth selected historical financial and operating data for the Company. The selected income statement data below for the three and nine months ended September 30, 2009 and 2008 is derived from our condensed consolidated unaudited financial statements included herein which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods and have been prepared in accordance with GAAP. Actual financial results through September 30, 2009 may not be indicative of future financial performance.

                         Selected Condensed Consolidated Financial and
                   Operating Data of American Physicians Service Group, Inc.

(in thousands, except per share and ratio data)        Three Months             Nine Months
                                                           Ended                   Ended
                                                       September 30,           September 30,
                                                     2009         2008       2009        2008
Income Statement Data:
Gross premiums and maintenance fees written -      $ 21,446    $ 21,246    $ 53,668    $ 51,106
direct and assumed
Premiums ceded                                          676         711       1,339       1,087
Net premiums and maintenance fees written            22,122      21,957      55,007      52,193
Net premiums and maintenance fees earned             17,595      15,709      50,877      47,657
Investment income, net of investment expenses         2,460       2,996       7,677       9,011
Net realized capital gains (losses) and OTTI            (78)       (474)     (2,602)     (4,312)
Financial services                                    2,320       1,558       5,595       4,835
Other revenue                                            71          97         173         150
Total revenues                                       22,368      19,886      61,720      57,341
Losses and loss adjustment expenses                   6,421       2,259      19,339      11,347
Other underwriting expenses                           3,053       3,220       8,784       8,322
Change in deferred acquisition costs                   (331)       (403)       (248)       (206)
Financial services expenses                           2,207       2,127       5,582       8,013
General and administrative expenses                   1,335       1,502       3,723       4,221
Total expenses                                       12,685       8,705      37,180      31,697
Income from Operations                                9,683      11,181      24,540      25,644
Income tax expense                                    3,241       3,998       8,447       8,935
Net income                                         $  6,442    $  7,183    $ 16,093    $ 16,709

Diluted weighted average shares outstanding           6,989       7,244       7,073       7,286
Diluted earnings per common share                  $   0.92    $   0.99    $   2.28    $   2.29

Underwriting Ratios:
Loss ratio (1)
Current accident year                                    63%         63%         66%         61%
Prior accident years                                    -27%        -49%        -28%        -37%
Calendar year                                            36%         14%         38%         24%
Expense ratio (2)                                        15%         18%         17%         17%
Combined ratio (3)                                       51%         32%         55%         41%

Loss ratio is defined as the ratio of losses and loss adjustment expenses to net premiums and maintenance fees earned.

Expense ratio is defined as the ratio of other underwriting expenses and net change in deferred acquisition costs to net premiums and maintenance fees earned.

Combined ratio is the sum of the loss ratio and the expense ratio.

  (in thousands)                                   September 30,     December 31,
                                                       2009              2008
  Balance Sheet Data:
  Cash and cash equivalents and investments       $      253,814    $     231,769
  Premiums and maintenance fees receivable                19,435           17,186
  Reinsurance recoverables                                10,016           15,293
  All other assets                                        17,635           19,306
  Total Assets                                    $      300,900    $     283,554

  Reserve for losses and loss adjustment expenses         91,393           92,141
  Unearned premiums and maintenance fees                  40,916           36,785
  Manditorily redeemable preferred stock                   6,617            7,568
  All other liabilities                                    8,957           10,595
  Total Liabilities                                      147,883          147,089
  Total stockholders'  equity                            153,017          136,465
  Total Liabilities & Stockholders' Equity        $      300,900    $     283,554

The discussion that follows should be read in connection with the unaudited Condensed Consolidated Financial Statements and Notes thereto included elsewhere in this report.

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

Condensed income statement data for the three months ended September 30, 2009 and 2008 are included in the following table:

      (in thousands except per share          Three Months ended September 30,
      data and percentages)
                                          2009        2008       Change     % Change
      Revenues                          $ 22,368    $ 19,886    $  2,482         12%
      Income from Operations               9,683      11,181      (1,498)       -13%
      Net Income                           6,442       7,183        (741)       -10%
      Diluted Net Income Per Share      $   0.92    $   0.99    $  (0.07)        -7%

. . .