Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Washington, D.C. 20549
FORM 10-K
þ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
For the fiscal year ended December 31, 2007 | ||
or | ||
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission FileNumber: 1-14094
Meadowbrook Insurance Group, Inc.
(Exact name of Registrant as specified in its charter)
Michigan | 38-2626206 | |
(State of Incorporation) | (IRS Employer Identification No.) | |
26255 American Drive, Southfield, MI | 48034-6112 | |
(Address of principal executive offices) | (Zip Code) |
Registrant’s telephone number, including area code:(248) 358-1100
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class | Name of Exchange on Which Registered | |
Common Stock, $.01 par value per share | New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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. Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to thisForm 10-K. o
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” inRule 12b-2 of the Exchange Act (Check one):
Large accelerated filer o Accelerated filerþ Non-accelerated filer o Smaller reporting companyo
Indicate by check mark whether the Registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o No þ
The aggregate market value of the voting and non-voting common stock held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of June 30, 2007 was $334,600,690. As of March 3, 2008, there were 37,020,677 shares of the Company’s common stock ($.01 par value) outstanding.
Documents Incorporated by Reference
Certain portions of the Registrant’s Proxy Statement for the 2008 Annual Shareholders’ Meeting scheduled for May 9, 2008 are incorporated by reference into Part III of this report.
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
PART I
Item 1. | Business |
The Company
Meadowbrook Insurance Group, Inc. (“We,” “Our,” or “Us”) (NYSE: MIG) is a holding company organized as a Michigan corporation in 1985. We were formerly known as Star Holding Company and in November 1995, upon acquisition of Meadowbrook, Inc. (“Meadowbrook”), we changed our name. Meadowbrook was founded in 1955 as Meadowbrook Insurance Agency and was subsequently incorporated in Michigan in 1965.
We serve as a holding company for our wholly owned subsidiary Star Insurance Company (“Star”), and Star’s wholly owned subsidiaries, Savers Property and Casualty Insurance Company, Williamsburg National Insurance Company, and Ameritrust Insurance Corporation (which collectively are referred to as the “Insurance Company Subsidiaries”), as well as, American Indemnity Insurance Company, Ltd. and Preferred Insurance Company, Ltd (“PICL”). We also serve as a holding company for Meadowbrook, Crest Financial Corporation, and their subsidiaries. As of December 31, 2007, PICL was deregulated under Bermuda law and merged into Meadowbrook’s subsidiary, Meadowbrook Risk Management, Ltd. On January 31, 2008, PICL was contemporaneously dissolved.
Pursuant to Financial Accounting Standards Board Interpretation Number (“FIN”) 46(R), we do not consolidate our subsidiaries, Meadowbrook Capital Trust I and II (the “Trusts”), as they are not variable interest entities and we are not the primary beneficiary of the Trusts. Our consolidated financial statements, however, include the equity earnings of the Trusts. In addition and in accordance with FIN 46(R), we do not consolidate our subsidiary American Indemnity Insurance Company, Ltd. (“American Indemnity”). While we and our subsidiary Star are the common shareholders, neither are the primary beneficiaries of American Indemnity. Our consolidated financial statements, however, include the equity earnings of American Indemnity.
Significant Acquisitions
• | On April 16, 2007, we acquired the business of U.S. Specialty Underwriters, Inc. (“USSU”). USSU is a specialty program manager that produces fee based income by underwriting excess workers’ compensation coverage for a select group of insurance companies. | |
• | In November 2005, we acquired Insurance & Benefit Consultants (“IBC”) of Sarasota, Florida. IBC is a retail agency specializing in group and individual health insurance products and personal financial planning services. | |
• | In August 1999, we acquired the assets of TPA Associates, Inc., all the outstanding stock of TPA Insurance Agency, Inc., and Preferred Insurance Agency, Inc., and approximately ninety-four percent of the outstanding stock of PICL (collectively, “TPA”). TPA is a program-oriented risk management company that provides risk management services to self-insured clients, manages alternative risk management programs, and performs underwriting, policy issuance and loss control services for an unaffiliated insurance company. In January 2002, we purchased the remaining six percent minority interest of PICL. As previously indicated, PICL was dissolved effective January 31, 2008. | |
• | In July 1998, we acquired Florida Preferred Administrators, Inc. (“Florida Preferred”), a third party administrator and Ameritrust Insurance Corporation (“Ameritrust”). In December 2002, Ameritrust became a wholly owned subsidiary of Star. Florida Preferred provides a broad range of risk management services for Ameritrust and other third parties. | |
• | In July 1997, we acquired Crest Financial Corporation (“Crest”), a California-based holding company, which formerly owned Williamsburg National Insurance Company (“Williamsburg”). Crest provides |
2
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
risk management services primarily to Williamsburg. On December 31, 1999, Williamsburg became a wholly owned subsidiary of Star.
• | In July 1990, we acquired Savers Property and Casualty Insurance Company (“Savers”). |
Proposed Merger with ProCentury Corporation
On February 20, 2008, we executed a definitive merger agreement with ProCentury Corporation (“ProCentury”) for a merger transaction valued at approximately $272.6 million in cash and stock to be paid to ProCentury shareholders. The combined entity will adopt and operate under the Meadowbrook name and will continue to trade on the NYSE under the ticker symbol “MIG”. Our Chief Executive Officer, Robert S. Cubbin, will continue in his current role in the post-merger combined entity and two ProCentury board members are expected to join Meadowbrook’s Board of Directors.
The merger is expected to expand and complement our specialty lines capabilities with ProCentury’s insurance professionals and product expertise in the excess and surplus lines market. We believe there are significant profitable revenue growth opportunities, as well as cost savings opportunities.
We expect to finance the cash portion of the purchase price through a combination of cash and debt. Completion of the transaction is subject to various closing conditions, including the receipt of required regulatory and shareholder approval. We expect to complete the merger in the third quarter of 2008.
Employees
At March 3, 2008, we employed approximately 643 associates to service our clients and provide management services to ourInsurance Operationsas defined below. We believe we have good relationships with our employees.
Overview
We are a full-service risk management organization which focuses on niche or specialty program business and risk management solutions for agents, professional and trade associations, pools, trusts, and small to medium-sized insureds. Our programs are primarily on a regional basis with a single line of business within a program. Within the workers’ compensation line of business we have a regional focus in New England, Florida, and Nevada. Within the commercial auto and commercial multiple peril we have a regional focus in California. Ourfee-for-service business is also on a regional basis with an emphasis in the Midwest and southeastern regions, as well as the self-insured market in Nevada. Our corporate strategy emphasizes a regional focus and diverse sources of revenue between underwritten premiums, service fee revenue, and commissions. This allows us to leverage fixed costs without sacrificing pricing of our insurance premiums. Currently, we manage over $800 million in gross written premiums.
We were founded in 1955 as a retail insurance agency. We earn commission revenue through the operation of our retail property and casualty insurance agencies, located in Michigan, California, and Florida. Our Michigan-based retail insurance agency operations are consistently ranked as a leading business insurance agency in Michigan and the United States.
For over thirty years, we have specialized in providing risk management solutions for our clients. By forming risk-sharing partnerships, we align our financial objectives with our clients. By utilizing our products and services, small to medium-sized client groups gain access to more sophisticated risk management techniques previously available only to larger corporations. This enables our clients to control insurance costs and potentially turn risk management into a profit center. By having their capital at risk, our clients are motivated to reduce exposure and share in the underwriting profits and investment income derived from their risk management plan.
Based upon the particular risk management goals of our clients and our assessment of the opportunity for operating profit, we offer solutions on a managed basis, a risk-sharing basis, or a fully-insured basis, in
3
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
response to a specific market opportunity. In a managed program, we earn service fee revenue by providing management and other services to a client’s risk-bearing entity, but generally do not share in the operating results. In a risk-sharing program, we share the operating results with the client through a reinsurance agreement with a captive orrent-a-captive. The captive andrent-a-captive structures are licensed reinsurance companies and are accounted for under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.” In risk-sharing programs, we derive revenue from net earned premiums,fee-for-service revenue and commissions, and investment income. In addition, we may benefit from the fees our risk management subsidiary earns for services we perform on behalf of our Insurance Company Subsidiaries. These fees are eliminated upon consolidation. However, the fees associated with the captive’s portion of the program are reimbursed through a ceding commission. In a fully-insured program, we provide insurance products without a risk-bearing mechanism and derive revenue from net earned premiums and investment income.
We have developed a broad range of capabilities and services in the design, management, and servicing of our clients’ risk management needs. These capabilities and services include:
• | program and product design; | |
• | underwriting, risk selection, and policy issuance; | |
• | sales, marketing, and public relations to members of groups; | |
• | administration of risk-bearing entities, such as mutual insurance companies, captives,rent-a-captives, public entity pools, and risk retention and risk purchasing groups; | |
• | claims handling and administration; | |
• | loss prevention and control; | |
• | reinsurance placement; | |
• | risk analysis and identification; | |
• | actuarial and loss reserve analysis; | |
• | information technology and processing; | |
• | feasibility studies; | |
• | litigation management; | |
• | accounting and financial statement preparation; | |
• | regulatory compliance; and | |
• | audit support. |
We remain committed to our long-term return on equity goal of 14% to 16%. While the equity offering in 2007 created a temporary dilutive impact on our return on equity, we expect to deploy the remaining capital and reach our targeted return on equity of 15% by the end of 2009 and beginning of 2010. Our targeted return on equity focuses on growing net commissions and fees and growing net investment leverage and income, while maintaining underwriting profitability. During 2008, we expect gross written premium to grow to between $385.0 million and $395.0 million, based upon premium volume growth from new programs implemented in 2007, as well as from the expansion of existing programs.
Company Segments
Agency Operations
We earn commission revenue through the operation of our retail property and casualty insurance agencies, located in Michigan, California, and Florida. Our agency operations produce commercial, personal lines, life,
4
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
and accident and health insurance, with more than fifty unaffiliated insurance carriers. The agency produces an immaterial amount of business for our affiliated Insurance Company Subsidiaries.
In total, our agency operations generated commissions of $11.3 million, $12.3 million, and $11.3 million, for the years ended December 31, 2007, 2006, and 2005, respectively.
Specialty Risk Management Operations
Our specialty risk management operations segment, which includes insurance company specialty programs andfee-for-service specialty programs, focuses on specialty or niche insurance business. Specialty risk management operations provide 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 various types of property and casualty insurance coverage, including workers’ compensation, commercial multiple peril, general liability, commercial auto liability, and inland marine. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of our agent-partners. We recognize revenue related to the services and coverages from our specialty risk management operations within seven categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance placement, investment income, and net realized gains (losses).
Net earned premiums include the following lines of business:
• | Workers’ Compensation | |
• | Commercial Multiple Peril | |
• | General Liability |
— Errors and Omissions
— Automobile
— Owners, Landlord and Tenant
• | Employment Practices Liability | |
• | Professional Liability |
— Medical
— Real Estate Appraisers
— Pharmacists
• | Inland Marine | |
• | Product Liability | |
• | Excess Reinsurance | |
• | Commercial Property |
Description of Specialty Risk Management Programs
Fee-for-Service Specialty Programs:
With a managed program, we earnfee-for-service revenue by providing management and other services to a client’s risk-bearing entity, but generally do not share in the operating results of the program. We believe our managed programs provide a consistent source of revenue, as well as opportunities for revenue growth without a proportionate increase in capital. Revenue growth may occur through the sale of existing products to
5
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
additional members of the group, the expansion of coverages and services provided to existing programs and the creation of programs for new client groups.
Services for which we receive fee revenue from managed programs include:
• | program design and development; | |
• | underwriting; | |
• | reinsurance placement; | |
• | policy administration; | |
• | loss prevention and control; | |
• | claims administration and handling; | |
• | litigation management; | |
• | information technology and processing; | |
• | accounting functions; and | |
• | general management and oversight of the program. |
The fees we receive from our managed programs are generally either a fixed amount or based on a percentage of premium serviced or claim count.
We provide insurance management services to public entity associations and currently manage public entity pools and other insurance entities, which provide insurance coverage for approximately 1,700 participants, including city, county, township, and village governments in three states, as well as other diverse industry groups.
Insurance Company Programs:
We provide three broad types of insurance company programs, including fully insured, captives and client risk-sharing programs. With a client risk-sharing program, our Insurance Company Subsidiaries underwrite individual primary insurance policies for members of a group or association, or a specific industry and then share the operating results with the client or client group through a reinsurance agreement with a captive orrent-a-captive. In some instances, a captive owned by a client or client group reinsures a portion of the risk on a quota-share basis. A captive is an insurance company or reinsurance company, which is formed for the purpose of insuring or reinsuring risks related to the businesses of its shareholders or members. Arent-a-captive allows organizations to obtain the benefits of a captive insurance company, without the initial costs and capital investment required to form their own captive. This is often an interim step utilized by groups and associations prior to forming their own captive. As part of its participation in arent-a-captive, the client group purchases redeemable preferred stock of our unconsolidated subsidiary. These shares entitle the client group to participate in profits and losses of the program through a dividend or additional capital contribution. Dividends or additional capital contributions are determined and accrued on the basis of underwriting profits or losses plus investment income on trust accounts less costs. The captive andrent-a-captive structures are licensed reinsurance companies, which have a self-sustaining integrated set of activities and assets, and are in the reinsurance business for the purpose of providing a return to their investors, who are the shareholders (“primary beneficiaries”) of the captive company. The primary beneficiaries have their own equity at risk, decision making authority, and the ability to absorb losses. Therefore, the transactions associated with the captive andrent-a-captive structures are accounted for under the provisions of SFAS No. 113,“Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.”
In addition to premium revenue and investment income from our net retained portion of the operating results, we may also be compensated through the receipt of fees for policy issuance services and acquisition costs, captive administration, reinsurance placement, loss prevention services, and claims administrative and handling services. In
6
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
addition, we may benefit from the fees our risk management subsidiary earns for services we perform on behalf of our Insurance Company Subsidiaries. These fees are eliminated upon consolidation. However, the fees associated with the captive’s portion of the program are reimbursed through a ceding commission. For financial reporting purposes, ceding commissions are treated as a reduction in underwriting expenses.
Our experience has been that the number of claims and the cost of losses tend to be lower in risk-sharing programs than with traditional forms of insurance. We believe that client risk-sharing motivates participants to focus on loss prevention, risk control measures and adherence to stricter underwriting guidelines.
The following schematic illustrates the basic elements in many of our client risk-sharing programs.
CAPTIVE RISK-SHARING STRUCTURE
(1) | We account for transactions with these risk-sharing clients as reinsurance under the provisions of SFAS No. 113“Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Clients.” |
The captive’s shareholders, which may or may not include the insured, and its board of directors make the decision to form the captive or terminate the captive, based upon either their own analysis or the analysis performed by an independent third party consultant they hire. The shareholders of the captive make the decision whether to invest and how much to invest in the captive. This decision may be based upon advice from third party consultants.
The agent of the business will make the decision to submit the risk to the insurance company for underwriting and the policyholders make the decision to purchase the quoted policy.
The captive administrator provides administrative services to the captive in exchange for a fee. This fee is usually a fixed amount, but can be a variable amount based upon premium volume, and is negotiated on an annual basis with the captive’s board of directors. Such services may include bookkeeping, providing regulatory information, and other administrative services. We also may provide loss prevention, claims handling, underwriting, and other insurance services directly to certain of our captives. However, our risk
7
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
management services subsidiary provides these services to our Insurance Company Subsidiaries for a fee, which is eliminated upon consolidation. The costs associated with these services are included within the premium quoted to the policyholder.
In applying FIN 46(R)’s provisions to the captive risk-sharing structure, our variable interest in the captive is limited to administrative fees based upon a fixed amount or a percentage of premiums and the credit risk associated with any reinsurance recoverables recognized.
The captives are generally capitalized with common stock and may use preferred stock in isolated instances. The captive’s variability is: (1) created based upon the experience of their portion of business directly written through our Insurance Company Subsidiaries and ceded to the captive on a quota share basis; and (2) absorbed by the captive’s shareholders.
In general, the captive’s commonand/or preferred shareholders are either the agents or producers of the business, a sponsoring group or association, a group of policyholders, a policyholder, or a general agent. The captive’s shareholders are not related parties of ours pursuant to either SFAS No. 57,Related Party Disclosures, or paragraph 16 of FIN 46(R).
By design, the capital base of the captive is structured to absorb the projected losses of the program, and the captive’s shareholders bear the risk of loss. Through a trust agreement, we protect ourselves from potential credit risk related to reinsurance recoverables from the captive by a collateral requirement of up to 110% of the estimated reserves for losses and unearned premiums. In addition, we monitor the capital adequacy and financial leverage ratios of the captive to mitigate future credit risk.
In another variation of client risk-sharing, we establish retrospectively rated programs for individual accounts. With this type of program, we work with the client to develop the appropriate self-insured retention and loss fund amount and then help arrange forexcess-of-loss reinsurance. The client reimburses us for all claim payments within the client’s retention. We generally earn a management fee (which includes claims and loss control fees). In most of these programs, we also share in the operating results with the client and receive a ceding commission in theexcess-of-loss reinsurance contract to reimburse us for expenses, including a fee for services.
In another version of client risk-sharing, the agent accepts an up-front commission that is adjusted up or down based on operating results of the program produced.
With a fully-insured program, we provide our insurance products without a risk-sharing mechanism and derive revenue from net earned premiums and investment income. Fully-insured programs are generally developed in response to specific market opportunities and may evolve into a risk-sharing arrangement.
Description of Major Specialty Risk Management Services
Our risk management subsidiary provides the following services to ourfee-for-service clients and to our Insurance Company Subsidiaries for a fee. The fees associated with services provided to our Insurance Company Subsidiaries are eliminated upon consolidation. The costs associated with these services are charged to our insureds in the form of premiums.
Program and Product Design. Before implementing a new program, we generally review: (1) financial projections for the contemplated program, (2) historical loss experience, (3) actuarial studies of the underlying risks, (4) the credit worthiness of the potential agent or client, and (5) the availability of reinsurance. Our senior management team and associates representing each of the risk-management disciplines work together to design, market, and implement new programs. Our due diligence process is structured to provide a risk assessment of the program and how the program fits within our entity wide business plan and risk profile.
Underwriting Risk Selection and Policy Issuance. Through our risk management subsidiary, we perform underwriting services for our Insurance Company Subsidiaries that meet our corporate underwriting guidelines. We retain ultimate underwriting authority and monitor adherence to our corporate underwriting guidelines
8
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
through a periodic audits. Our underwriting personnel help develop the proper criteria for selecting risks, while actuarial and reinsurance personnel evaluate and recommend the appropriate levels of rate and risk retention. The program is then tailored according to the requirements and qualifications of each client. With managed programs, we may also perform underwriting services based upon the profile of the specific program for a fee.
Claims Administration and Handling. Through our risk management subsidiary, we provide substantially all claims management and handling services for workers’ compensation and most other lines, such as property, professional liability, and general liability. Our claims handling standards are set by our corporate claims department and are monitored through self-audits, corporate claim audits, internal controls, and other executive oversight reports. We handle substantially all claims functions for the majority of the programs we manage. Our involvement in claims administration and handling provides feedback to program managers in assessing the client’s risk environment and the overall structure of the program.
Loss Prevention and Control. Through our risk management subsidiary, we provide loss control services, which are designed to help clients prevent or limit the impact of certain loss events. Through an evaluation of the client’s workplace environment, our loss control specialists assist the client in planning and implementing a loss prevention program and, in certain cases, provide educational and training programs. With our managed programs, we provide these same services for a fee based upon the profile of the specific program.
Administration of Risk-Bearing Entities. We generate fee revenue by assisting in the formation and administration of risk-bearing entities for clients and agents. We currently provide administrative services for approximately eleven captivesand/orrent-a-captives and hold an insignificant minority interest in two of these captives. These services are provided by our subsidiaries in Bermuda and Barbados.
Reinsurance Placement. Through our reinsurance intermediary subsidiary, Meadowbrook Intermediaries, Inc., we earn commissions from placingexcess-of-loss reinsurance and insurance coverage with high deductibles for insurance companies, captives, and managed self-insured programs. Reinsurance is also placed for clients who do not have other business relationships with us.
Sales, Marketing, and Public Relations. We market our programs and services to associations, professional and trade groups, local, regional and national insurance agents, and insurance consultants. Sales and marketing efforts include personal contact through independent agents, direct mail, telemarketing, association publications/newsletters, advertising, internet-based marketing including our corporate website (www.meadowbrook.com), and subsidiary branch/division websites. We access or manage a range of distribution systems and regional agency networks on a program-specific basis.
We also participate in seminars, trade and industry conventions such as Target Markets Program Administrators Association, American Association of Managing General Agents, American Society of Association Executives, Self Insurance Institute of America, National Association of Professional Surplus Lines Offices, Public Risk Management Association, and various individual state independent agent associations.
In 2000, we launched our Advantage System (“Advantage”). Advantage is an internet-based business processing system for quoting and binding workers’ compensation insurance policies. In addition to reducing our internal administrative processing costs, Advantage enhances underwriting practices by automating risk selection criteria.
Insurance Company Subsidiaries
Our Insurance Company Subsidiaries issue insurance policies. Through our Insurance Company Subsidiaries, we engage in specialty risk management programs where we assume underwriting risks in exchange for premium. Our Insurance Company Subsidiaries primarily focus on specialty programs designed specifically for trade groups and associations, whose members are homogeneous in nature. Members are typicallysmall-to-medium sized businesses. Our programs focus on select classes of property and casualty business which, through our due diligence process, we believe have demonstrated a fundamentally sound prospect for generating underwriting profits. We occasionally do offer our programs on a multi-state basis; but more
9
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
generally, our programs operate on a regional or state-specific basis. We maintain underwriting authority through our regional offices based upon underwriting guidelines set forth by our corporate underwriting department, which we monitor through underwriting audits and a series of executive underwriting and rate monitor reports. We seek to avoid geographic concentration of risks that might lead to aggregation of exposure to losses from natural or intentionally caused catastrophic events. We also handle the majority of our claims through our regional offices based upon standards set forth by our corporate claims office and monitored through a series of self-audits and corporate claims audit, internal control audits, and executive claims monitoring reports. American Indemnity, which offers our clients a captive orrent-a-captive option, complements our Insurance Company Subsidiaries.
Star, Williamsburg and Ameritrust are domiciled in Michigan. Savers is domiciled in Missouri and American Indemnity is a Bermuda-based insurance company.
We may at times place risks directly with third party insurance carriers and participate in the risk as a reinsurance partner. Such arrangements typically generate management fee revenue and provide a means to manage premium leverage ratios.
Our insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. Our targets for gross and net written premium to statutory surplus are 2.8 to 1.0 and 2.25 to 1.0, respectively. As of December 31, 2007, on a statutory consolidated basis, gross and net premium leverage ratios were 1.8 to 1.0 and 1.5 to 1.0, respectively.
Our Insurance Company Subsidiaries are authorized to write business, on either an admitted or surplus lines basis, in all fifty states. Star is admitted in all fifty states. Williamsburg is admitted in thirty-seven states, and is authorized to write business on a surplus lines basis in one state. Savers is admitted in five states and is authorized to write business on a surplus lines basis in forty-six states. Ameritrust is admitted in seven states. Our Insurance Company Subsidiaries primarily offer workers’ compensation, commercial multiple peril, general liability, inland marine, and other liability coverages. For the year ended December 31, 2007, the workers’ compensation line of business accounted for 33.7%, 38.1%, and 37.5% of gross written premiums, net earned premiums, and net written premiums, respectively.
In 2001, 2000, and 1999, we eliminated a limited group of unprofitable programs that were not aligned with our historic and present business strategy. The uncertainty of future reserve development on these discontinued programs has been reduced as a result of aggressive claims handling and reserve strengthening. However, while we believe we have adequate reserves, there can be no assurances that there will not be additional losses in the future relating to these programs. Outstanding reserves related to these discontinued programs as of December 31, 2007 and 2006 were $3.3 million and $5.6 million, respectively.
In April 2007, we received an upgrade of our financial strength rating by A.M. Best Company to “A−” (Excellent), from “B++” (Very Good) for our Insurance Company Subsidiaries.
The following table summarizes gross written premiums, net earned premiums, and net written premiums for the years ended December 31, 2007, 2006, 2005, 2004, and 2003 (in thousands):
Gross Written Premium | 2007 | % | 2006 | % | 2005 | % | 2004 | % | 2003 | % | ||||||||||||||||||||||||||||||
Workers’ Compensation | $ | 116,717 | 33.69 | % | $ | 118,794 | 35.90 | % | $ | 133,732 | 40.26 | % | $ | 146,982 | 46.89 | % | $ | 141,456 | 55.85 | % | ||||||||||||||||||||
Commercial Multi-Peril | 100,364 | 28.97 | % | 94,355 | 28.52 | % | 85,978 | 25.88 | % | 71,715 | 22.88 | % | 48,091 | 18.99 | % | |||||||||||||||||||||||||
Inland Marine | 11,629 | 3.36 | % | 12,837 | 3.88 | % | 12,467 | 3.75 | % | 10,925 | 3.48 | % | 9,758 | 3.85 | % | |||||||||||||||||||||||||
Other Liability | 28,550 | 8.24 | % | 20,001 | 6.04 | % | 16,167 | 4.87 | % | 15,248 | 4.86 | % | 10,473 | 4.13 | % | |||||||||||||||||||||||||
Other Commercial Auto Liability | 61,119 | 17.64 | % | 59,308 | 17.92 | % | 59,144 | 17.80 | % | 48,070 | 15.33 | % | 26,902 | 10.62 | % | |||||||||||||||||||||||||
All Other Lines | 28,072 | 8.10 | % | 25,577 | 7.73 | % | 24,721 | 7.44 | % | 20,553 | 6.56 | % | 16,600 | 6.55 | % | |||||||||||||||||||||||||
Total | $ | 346,451 | 100.00 | % | $ | 330,872 | 100.00 | % | $ | 332,209 | 100.00 | % | $ | 313,493 | 100.00 | % | $ | 253,280 | 100.00 | % | ||||||||||||||||||||
10
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Net Earned Premium | 2007 | % | 2006 | % | 2005 | % | 2004 | % | 2003 | % | ||||||||||||||||||||||||||||||
Workers’ Compensation | $ | 102,256 | 38.13 | % | $ | 108,085 | 42.40 | % | $ | 119,423 | 47.78 | % | $ | 117,914 | 54.97 | % | $ | 93,324 | 61.72 | % | ||||||||||||||||||||
Commercial Multi-Peril | 71,049 | 26.49 | % | 63,138 | 24.77 | % | 54,829 | 21.94 | % | 43,701 | 20.37 | % | 26,075 | 17.24 | % | |||||||||||||||||||||||||
Inland Marine | 1,165 | 0.43 | % | 1,528 | 0.60 | % | 1,727 | 0.69 | % | 1,628 | 0.76 | % | 1,556 | 1.03 | % | |||||||||||||||||||||||||
Other Liability | 15,571 | 5.81 | % | 10,433 | 4.09 | % | 8,072 | 3.23 | % | 6,416 | 2.99 | % | 4,849 | 3.21 | % | |||||||||||||||||||||||||
Other Commercial Auto Liability | 53,469 | 19.94 | % | 49,341 | 19.36 | % | 45,374 | 18.15 | % | 29,274 | 13.65 | % | 12,940 | 8.56 | % | |||||||||||||||||||||||||
All Other Lines | 24,687 | 9.20 | % | 22,395 | 8.79 | % | 20,534 | 8.21 | % | 15,560 | 7.25 | % | 12,461 | 8.24 | % | |||||||||||||||||||||||||
Total | $ | 268,197 | 100.00 | % | $ | 254,920 | 100.00 | % | $ | 249,959 | 100.00 | % | $ | 214,493 | 100.00 | % | $ | 151,205 | 100.00 | % | ||||||||||||||||||||
Net Written Premium | 2007 | % | 2006 | % | 2005 | % | 2004 | % | 2003 | % | ||||||||||||||||||||||||||||||
Workers’ Compensation | $ | 105,003 | 37.47 | % | $ | 104,846 | 39.92 | % | $ | 117,287 | 45.44 | % | $ | 122,896 | 52.53 | % | $ | 111,572 | 58.78 | % | ||||||||||||||||||||
Commercial Multi-Peril | 76,280 | 27.22 | % | 67,504 | 25.70 | % | 59,870 | 23.19 | % | 46,351 | 19.81 | % | 36,628 | 19.30 | % | |||||||||||||||||||||||||
Inland Marine | 1,212 | 0.43 | % | 1,271 | 0.48 | % | 1,690 | 0.65 | % | 1,630 | 0.70 | % | 1,500 | 0.79 | % | |||||||||||||||||||||||||
Other Liability | 18,915 | 6.75 | % | 12,384 | 4.71 | % | 8,004 | 3.10 | % | 7,568 | 3.23 | % | 6,278 | 3.31 | % | |||||||||||||||||||||||||
Other Commercial Auto Liability | 52,798 | 18.84 | % | 52,950 | 20.16 | % | 49,122 | 19.03 | % | 37,762 | 16.14 | % | 19,599 | 10.32 | % | |||||||||||||||||||||||||
All Other Lines | 26,003 | 9.28 | % | 23,713 | 9.03 | % | 22,161 | 8.59 | % | 17,754 | 7.59 | % | 14,250 | 7.51 | % | |||||||||||||||||||||||||
Total | $ | 280,211 | 100.00 | % | $ | 262,668 | 100.00 | % | $ | 258,134 | 100.00 | % | $ | 233,961 | 100.00 | % | $ | 189,827 | 100.00 | % | ||||||||||||||||||||
Since 2004, there has been a shift in our mix of business, which was intended to diversify our product line and produce more predictable, stable results. The mix of business has impacted our expense ratio, as the percentage of workers’ compensation premium in relation to our other lines of business has declined from a high of approximately 56% in 2003 to approximately 34% in 2007. The decline in workers’ compensation premium from 2004 is primarily due to our decision to exit a limited number of small programs that were no longer meeting our pricing standards, an overall reduction in audit-related premiums, and a decline in the amount of residual market assignments we receive relative to workers’ compensation premiums. The residual market assignments are in essence a form of a “tax” whereby any workers’ compensation risk that cannot be written in the voluntary market is assigned to carriers underwriting workers’ compensation business in that state.
In addition, workers’ compensation has declined due to reduction of premium writings in the state of Florida as pricing competition has intensified and due to mandatory rate deceases in Florida, Massachusetts and Nevada. We do believe the benefit changes and other actions we have taken in those states have allowed us to maintain underwriting profitability even in these more competitive environments. The increase in premium volume in lines other than workers’ compensation has been driven by new programs we have implemented with both existing and new programs partners, all of which have a history of profitability and for which we believe we are receiving adequate pricing to produce our targeted return on equity. Overall, both net written premium and net earned premium have increased over the same time frame, largely as a result of the increase in the amount of premium we retain versus premium ceded to excess of loss reinsurers.
Reserves
The following table shows the development of reserves for unpaid losses and loss adjustment expenses (“LAE”) from 1998 through 2007 for our Insurance Company Subsidiaries including PICL, and the deconsolidation impact of American Indemnity.
In accordance with SFAS 113, the bottom portion of the table shows the impact of reinsurance for the years 1998 through 2007, reconciling the net reserves shown in the upper portion of the table to gross reserves.
Additional information relating to our reserves is included within theLosses and Loss Adjustment Expenses and Reinsurance Recoverablessection of Note 1 —Summary of Significant Accounting Policiesand Note 3 —Liability for Losses and Loss Adjustment Expensesof the Notes to the Consolidated Financial
11
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Statements, as well as to theCritical Accounting Policiessection and theReservessection of Item 7,Management’s Discussion and Analysis.
Analysis of Loss and Loss Adjustment Expense Development(1)
Years Ended December 31, | ||||||||||||||||||||||||||||||||||||||||
1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | |||||||||||||||||||||||||||||||
(In thousands) | ||||||||||||||||||||||||||||||||||||||||
Reserves for losses and LAE at end of period | $ | 84,254 | $ | 127,500 | $ | 172,862 | $ | 198,653 | $ | 193,116 | $ | 192,019 | $ | 226,996 | $ | 271,423 | $ | 302,655 | $ | 341,541 | ||||||||||||||||||||
Deconsolidation of subsidiary(1) | (147 | ) | (1,425 | ) | (3,744 | ) | (5,572 | ) | (2,973 | ) | (2,989 | ) | ||||||||||||||||||||||||||||
Adjusted reserves for losses and LAE at end of period | $ | 84,107 | $ | 126,075 | $ | 169,118 | $ | 193,081 | $ | 190,143 | $ | 189,030 | $ | 226,996 | $ | 271,423 | $ | 302,655 | $ | 341,541 | ||||||||||||||||||||
Cumulative paid as of | ||||||||||||||||||||||||||||||||||||||||
1 year later | 39,195 | 54,928 | 70,952 | 77,038 | 78,023 | 71,427 | 79,056 | 83,271 | 81,779 | |||||||||||||||||||||||||||||||
2 years later | 56,763 | 90,416 | 115,669 | 130,816 | 122,180 | 118,729 | 124,685 | 133,809 | ||||||||||||||||||||||||||||||||
3 years later | 76,776 | 116,001 | 146,548 | 157,663 | 151,720 | 145,279 | 153,780 | |||||||||||||||||||||||||||||||||
4 years later | 85,447 | 132,995 | 160,673 | 176,172 | 167,288 | 159,220 | ||||||||||||||||||||||||||||||||||
5 years later | 93,009 | 139,939 | 171,992 | 186,847 | 174,778 | |||||||||||||||||||||||||||||||||||
6 years later | 96,739 | 146,997 | 179,010 | 191,936 | ||||||||||||||||||||||||||||||||||||
7 years later | 101,433 | 150,514 | 182,954 | |||||||||||||||||||||||||||||||||||||
8 years later | 104,225 | 152,544 | ||||||||||||||||||||||||||||||||||||||
9 years later | 105,569 | |||||||||||||||||||||||||||||||||||||||
Reserves re-estimated as of end of year: | ||||||||||||||||||||||||||||||||||||||||
1 year later | 98,587 | 146,213 | 182,976 | 199,171 | 193,532 | 193,559 | 231,880 | 268,704 | 295,563 | |||||||||||||||||||||||||||||||
2 years later | 106,487 | 144,453 | 186,191 | 205,017 | 196,448 | 203,394 | 227,462 | 263,069 | ||||||||||||||||||||||||||||||||
3 years later | 102,075 | 152,630 | 189,632 | 207,379 | 202,126 | 205,650 | 226,437 | |||||||||||||||||||||||||||||||||
4 years later | 104,017 | 156,997 | 190,305 | 211,394 | 203,738 | 202,748 | ||||||||||||||||||||||||||||||||||
5 years later | 106,668 | 158,287 | 196,158 | 213,802 | 202,028 | |||||||||||||||||||||||||||||||||||
6 years later | 109,038 | 159,449 | 199,520 | 212,274 | ||||||||||||||||||||||||||||||||||||
7 years later | 110,541 | 161,376 | 198,500 | |||||||||||||||||||||||||||||||||||||
8 years later | 112,340 | 161,023 | ||||||||||||||||||||||||||||||||||||||
9 years later | 111,935 | |||||||||||||||||||||||||||||||||||||||
Net cumulative deficiency: | ||||||||||||||||||||||||||||||||||||||||
Dollars | $ | (27,828 | ) | $ | (34,948 | ) | $ | (29,382 | ) | $ | (19,193 | ) | $ | (11,885 | ) | $ | (13,718 | ) | $ | 559 | $ | 8,354 | $ | 7,092 | ||||||||||||||||
Percentage | —33.1 | % | —27.7 | % | —17.4 | % | —9.9 | % | —6.3 | % | —7.3 | % | 0.2 | % | 3.1 | % | 2.3 | % | ||||||||||||||||||||||
Net reserves | 84,107 | 126,075 | 169,118 | 193,081 | 190,143 | 189,030 | 226,996 | 271,423 | 302,655 | 341,541 | ||||||||||||||||||||||||||||||
Ceded reserves | 64,590 | 101,744 | 168,962 | 195,943 | 181,817 | 147,446 | 151,161 | 187,254 | 198,422 | 198,461 | ||||||||||||||||||||||||||||||
Gross reserves | 148,697 | 227,819 | 338,080 | 389,024 | 371,960 | 336,476 | 378,157 | 458,677 | 501,077 | 540,002 | ||||||||||||||||||||||||||||||
Net re-estimated | 111,935 | 161,023 | 198,500 | 212,274 | 202,028 | 202,748 | 226,437 | 263,069 | 295,563 | |||||||||||||||||||||||||||||||
Ceded re-estimated | 107,654 | 178,143 | 260,841 | 286,528 | 255,523 | 244,468 | 205,638 | 205,037 | 196,575 | |||||||||||||||||||||||||||||||
Gross re-estimated | 219,589 | 339,166 | 459,341 | 498,802 | 457,551 | 447,216 | 432,075 | 468,106 | 492,138 | |||||||||||||||||||||||||||||||
Gross cumulative (deficiency) redundancy | $ | (70,892 | ) | $ | (111,347 | ) | $ | (121,261 | ) | $ | (109,778 | ) | $ | (85,591 | ) | $ | (110,740 | ) | $ | (53,918 | ) | $ | (9,429 | ) | $ | 8,939 | ||||||||||||||
(1) | In accordance with FIN 46(R), we performed an evaluation of our business relationships and determined our wholly owned subsidiary, American Indemnity, did not meet the tests for consolidation, as neither us, nor our subsidiary Star, are the primary beneficiaries of American Indemnity. Therefore, effective January 1, 2004, we deconsolidated American Indemnity on a prospective basis in accordance with the provisions of FIN 46(R). Accordingly, we have adjusted the reserves and development within the above table. The adoption of FIN 46(R) and the deconsolidation of American Indemnity did not have a material impact on our consolidated balance sheet or consolidated statement of income. |
12
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
The following table sets forth the difference between generally accepted accounting principles (“GAAP”) reserves for loss and loss adjustment expenses and statutory reserves for loss and loss adjustment expenses at December 31, (in thousands):
2007 | 2006 | |||||||
GAAP reserves for losses and LAE | $ | 540,002 | $ | 501,077 | ||||
Reinsurance recoverables for unpaid losses | (198,461 | ) | (198,422 | ) | ||||
Allowances against reinsurance recoverables* | (833 | ) | (1,041 | ) | ||||
Non-regulated foreign insurance subsidiary; PICL** | — | (1,273 | ) | |||||
Statutory reserves for losses and LAE | $ | 340,708 | $ | 300,341 | ||||
* | The GAAP allowance for reinsurance recoverables is reported as a Schedule F penalty or a non-admitted asset for statutory accounting. | |
** | PICL offered clients captive orrent-a-captive options. It was a foreign insurance company and, therefore, was not included in the combined statutory financial statements filed with the National Association of Insurance Commissioners and state regulators. Effective September 30, 2007, Star entered into a novation agreement with PICL in which Star assumed a portion of PICL’s assets and liabilities. PICL was dissolved effective January 31, 2008. |
For the year ended December 31, 2007, we reported a decrease of $8.9 million in gross ultimate loss estimates for accident years 2006 and prior, or 1.8% of $501.1 million of gross losses and LAE reserves at January 1, 2007. We reported a $7.1 million decrease in net ultimate losses and LAE estimates for accident years 2006 and prior, or 2.3% of $302.7 million.
As a result of favorable development on prior accident years’ reserves, the provision for losses and loss adjustment expenses decreased by $7.1 million for calendar year 2007 and $2.7 million for calendar year 2006. As a result of adverse development on prior accident years’ reserves, the provision for losses and loss adjustment expenses increased by $4.9 million for calendar year 2005.
Investments
Information relating to our investment portfolio is included within Note 2 —Investmentsof the Notes to the Consolidated Financial Statements and theInvestmentssection of Item 7, Management’s Discussion and Analysis, as well as Item 7A Quantitative and Qualitative Discloures about Market Risk.
Competition and Pricing
We compete with other providers of risk management programs and services, as well as, with traditional providers of commercial insurance. Both the risk management and the traditional property and casualty insurance markets are highly competitive. Our risk management programs and services compete with products and services offered by insurance companies, other providers of risk management services (including domestic and foreign insurers and reinsurers and insurance agents), as well as with self-insurance plans, captives managed by others, and a variety of other risk-financing vehicles and mechanisms. These competitive products are offered by other companies that may have greater financial resources than we do. Our agency operations compete with other local, regional, and national insurance agencies for individual client insurance needs.
The market for risk management products and services is significantly influenced by market conditions affecting the traditional property and casualty insurance industry. Insurance market conditions historically have been subject to significant variability due to premium rate competition, natural disasters and other catastrophic events, judicial trends, changes in the investment and interest rate environment, regulation, and general economic conditions. Pricing is a primary means of competition in the commercial insurance market. Competition is also based on the availability and quality of products, quality and speed of service (including claims service), financial strength, ratings, distribution systems and technical expertise. The primary basis for competition among risk management providers varies with the financial and insurance needs and resources of each potential insured. Principle factors that are considered by insureds include an analysis of the net present-
13
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
value (after-tax) of the cost of financing the insured’s expected level of losses; the amount of excess coverage provided in the event losses exceed expected levels; cash flow and tax planning considerations; and the expected quality and consistency of the services to be provided. We believe that we are able to compete based on our experience, the quality of our products and services, and our program-oriented approach. However, our ability to successfully compete is dependent upon a number of factors, including market and competitive conditions, many of which are outside of our control.
Regulation
Insurance Company Regulation
Our Insurance Company Subsidiaries are subject to regulation by government agencies in the states in which they do business. The nature and extent of such regulation varies from jurisdiction to jurisdiction but typically involves:
• | prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company; | |
• | regulation of certain transactions entered into by an insurance company with any of its affiliates; | |
• | approval of premium rates, forms and policies used for many lines of insurance; | |
• | standards of solvency and minimum amounts of capital and surplus which must be maintained; | |
• | establishment of reserves required to be maintained for unearned premium, loss and loss adjustment expense, or for other purposes; | |
• | limitations on types and amounts of investments; | |
• | underwriting and claims settlement practices; | |
• | restrictions on the size of risks that may be insured by a single company; | |
• | licensing of insurers and agents; | |
• | deposits of securities for the benefit of policyholders; and | |
• | the filing of periodic reports with respect to financial condition and other matters. |
In addition, state regulatory examiners perform periodic examinations of insurance companies. Such regulation is generally intended for the protection of policyholders, rather than security holders.
Holding Company Regulatory Acts
In addition to the regulatory oversight of our Insurance Company Subsidiaries, we are subject to regulation under the Michigan, Missouri, California, and Florida Insurance Holding Company System Regulatory Acts (the “Holding Company Acts”). The Holding Company Acts contain certain reporting requirements including those that require us to file information relating to our capital structure, ownership, and financial condition and general business operations of our Insurance Company Subsidiaries. The Holding Company Acts contain certain reporting and prior approval requirements with respect to transactions among affiliates.
Various State and Federal Regulation
Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinition of risk exposure in areas such as product liability, environmental damage, and workers’ compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such
14
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through repricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business.
Reinsurance Intermediary
Our reinsurance intermediary is also subject to regulation. Under applicable regulations, the intermediary is responsible, as a fiduciary, for funds received on account of the parties to the reinsurance transaction and is required to hold such funds in appropriate bank accounts subject to restrictions on withdrawals and prohibitions on commingling.
Licensing and Agency Contracts
We, or certain of our designated employees, must be licensed to act as agents by state regulatory authorities in the states in which we conduct business. Regulations and licensing laws vary in individual states and are often complex.
The applicable licensing laws and regulations in all states are subject to amendment or reinterpretation by state regulatory authorities, and such authorities are vested in most cases with relatively broad discretion as to the granting, revocation, suspension and renewal of licenses. The possibility exists that we, or our employees, could be excluded, or temporarily suspended, from continuing with some or all of our activities in, or otherwise subjected to penalties by, a particular state.
Insurance Regulation Concerning Change or Acquisition of Control
Star, Williamsburg and Ameritrust are domestic property and casualty insurance companies organized under the insurance laws (the “Insurance Codes”) of Michigan, while Savers is organized under the Insurance Codes of Missouri. The Insurance Codes provide that acquisition or change of control of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the relevant insurance regulatory authority. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company must generally file with the relevant insurance regulatory authority an application for change of control (commonly known as a “Form A”) containing information required by statute and published regulations and provide a copy of such Form A to the domestic insurer. In Michigan and Missouri, control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing ten percent or more of the voting securities of the company.
In addition, many state insurance regulatory laws contain provisions that require pre-notification to state agencies of a change in control of a non-domestic admitted insurance company in that state. While such pre-notification statutes do not authorize the state agency to disapprove the change of control, such statutes do authorize issuance of a cease and desist order with respect to the non-domestic admitted insurer if certain conditions exist, such as undue market concentration.
Any future transactions that would constitute a change in control would also generally require prior approval by the Insurance Departments of Michigan and Missouri and would require pre-acquisition notification in those states that have adopted pre-acquisition notification provisions and in which the insurers are admitted. Such requirements may deter, delay or prevent certain transactions that could be advantageous to our shareholders.
Membership in Insolvency Funds and Associations and Mandatory Pools
Most states require admitted property and casualty insurers to become members of insolvency funds or associations, which generally protect policyholders against the insolvency of such insurers. Members of the fund or association must contribute to the payment of certain claims made against insolvent insurers. Maximum contributions required by law in any one year vary between 1% and 2% of annual premium written
15
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
by a member in that state. Assessments from insolvency funds were $156,000, $306,000, and $664,000, respectively, for 2007, 2006, and 2005. Most of these payments are recoverable through future policy surcharges and premium tax reductions.
Our Insurance Company Subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. Among the pools participated in are those established in certain states to provide windstorm and other similar types of property coverage. These pools typically require all companies writing applicable lines of insurance in the state for which the pool has been established to fund deficiencies experienced by the pool based upon each company’s relative premium writings in that state, with any excess funding typically distributed to the participating companies on the same basis. To the extent that reinsurance treaties do not cover these assessments, they may adversely affect us. Total assessments paid to all such facilities were $2.6 million, $3.1 million, and $3.0 million, respectively, for 2007, 2006, and 2005.
Restrictions on Dividends and Risk-Based Capital
For information on Restrictions on Dividends and Risk-based Capital which affect us please refer to Note 8 —Regulatory Matters and Rating Issuesof the Notes to the Consolidated Financial Statements and theRegulatory and Rating Issuessection within Item 7, Management’s Discussion and Analysis.
NAIC-IRIS Ratios
The National Association of Insurance Commissioners’ (“NAIC”) Insurance Regulatory Information System (“IRIS”) was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more ratios generally leads to inquiries or possible further review from individual state insurance commissioners. Refer to theRegulatory and Rating Issuessection of Item 7, Management’s Discussion and Analysis.
Effect of Federal Legislation
The Terrorism Risk Insurance Act of 2002 (“TRIA”) established a program under which the United States federal government will provide governmental support for businesses that suffer damages from certain acts of international terrorism. In December 2005 under the Terrorism Risk Insurance Extension Act of 2005, TRIA was modified and extended through December 31, 2007. On December 26, 2007, Congress extended and expanded TRIA beyond 2007. The terms of the legislation enacted now also include domestic terrorist acts. TRIA serves as an additional high layer of reinsurance against losses that may arise from a terrorist incident. The impact to us resulting from TRIA is minimal as we generally do not underwrite risks that are considered targets for terrorism; avoid concentration of exposures in both property and workers’ compensation; and have terrorism coverage included in our reinsurance treaties to cover the most likely exposure.
Recently, as a result of comments made related to claims handling practices by insurers in the wake of the 2005 hurricanes that struck the gulf coast states, Congress has examined a possible repeal of the McCarran-Ferguson Act, which allows insurers to compile and share loss data, develop standard policy forms and manuals and predict future loss costs with greater reliability, among other things. The ability of the industry, under the exemption permitted in the McCarran-Ferguson Act, to collect loss cost data and build a credible database as a means of predicting future loss costs is an important part of cost-based pricing. If the ability to collect this data were removed, the predictability of future loss costs and the reliability of pricing could be undermined. We are unable to predict whether the McCarran-Ferguson Act will be repealed, or that any such repeal, if enacted, would not have a material adverse effect on our business and results of operations.
16
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Available Information
Our Internet address iswww.meadowbrook.com. There we make available, free of charge, our annual report onForm 10-K, quarterly reports onForm 10-Q, current reports onForm 8-K, statements of beneficial ownership (Forms 3, 4, and 5), and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish to, the United States Securities and Exchange Commission (“SEC”). You may read and copy materials we file with the SEC at the SEC’s Public Reference Room at 101 F Street, NW, Washington D.C., 20549. You may obtain information about the operation of the Public Reference Room by calling the SEC at1-800-SEC-0330. In addition, the SEC maintains an internet site that contains reports, proxy statements, and other information that we file atwww.sec.gov. Our SEC reports can also be accessed through the investor relations section of our website. The information found on our website is not part of this or any other report we file with, or furnished to the SEC. The Charters of the Nominating and Governance Committee, the Compensation Committee, the Audit Committee, the Finance Committee, and the Investment Committee of our Board of Directors, are also available on our website, or available in print to any shareholder who requests this information. In addition, our Corporate Governance Guidelines, Code of Conduct, and our Business Conduct Policy are available on our website, or in print to any shareholder who requests this information.
Corporate Governance Listing Standards
On June 5, 2007, we submitted to the New York Stock Exchange a certificate signed by our Chief Executive Officer certifying that he was not aware of any violation by us of New York Stock Exchange’s corporate governance listing standards.
Item 1A. | Risk Factors |
We face risks related to our proposed merger with ProCentury Corporation
There are significant risks and uncertainties associated with our proposed merger with ProCentury Corporation. For example, the merger may not be consummated, or may not be consummated in the third quarter of 2008 as anticipated, as a result of a number of factors, including, but not limited to, the inability to obtain required regulatory and shareholder approvals. In addition, the integration of the combined businesses into the combined entity may not be integrated successfully or such integration may be more difficult, time-consuming or costly than expected; expected revenue synergies and cost savings from the merger may not be fully realized or realized within the expected time frame; revenues following the merger may be lower than expected; and customer and employee relationships and business operations may be disrupted by the merger.
If our estimates of reserves for losses and loss adjustment expenses are not adequate, we will have to increase our reserves, which would result in reductions in net income, retained earnings, statutory surplus, liquidity, and may limit our ability to pay future dividends.
We establish reserves for losses and expenses related to the adjustment of losses for the insurance policies we write. We determine the amount of these reserves based on our best estimate and judgment of the losses and costs we will incur on existing insurance policies. While we believe our reserves are adequate, we base these reserves on assumptions about past and future events. The following factors could have a substantial impact on our future loss experience:
• | the amounts of claims settlements and awards | |
• | legislative activity | |
• | changes in inflation and economic conditions | |
• | accuracy and timely reporting of claim information |
17
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Actual losses and the costs we incur related to the adjustment of losses under insurance policies could exceed, perhaps substantially, the amount of reserves we establish. When we increase reserves, our pre-tax income for the period will decrease by a corresponding amount. An increase in reserves may also require us to write off a portion of our deferred acquisition costs asset, which would cause a further reduction of pre-tax income in that period.
If our financial strength ratings are reduced, we may be adversely impacted.
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors they believe are important to policyholders. Ratings are not recommendations to buy, hold, or sell our securities.
Our ability to write business is most influenced by our rating from A.M. Best. A.M. Best ratings are designed to assess an insurer’s financial strength and ability to meet continuing obligations to policyholders. Currently, our financial strength rating from A.M. Best is “A−” (Excellent) for our Insurance Company Subsidiaries. There can be no assurance that A.M. Best will not change its rating in the future. A rating downgrade from A.M. Best could materially adversely affect the business we write and our results of operations.
If market conditions cause our reinsurance to be more costly or unavailable, we may be required to bear increased risks or reduce the level of our underwriting commitments.
As part of our overall risk and capacity management strategy, we purchase reinsurance for significant amounts of risk underwritten by our Insurance Company Subsidiaries, especially for theexcess-of-loss and severity risks. Market conditions beyond our control determine the availability and cost of the reinsurance we purchase, which may affect the level of our business and profitability. Our reinsurance facilities are generally subject to annual renewal. We may be unable to maintain our current reinsurance facilities or to obtain other reinsurance in adequate amounts and at favorable rates. Increases in the cost of reinsurance would adversely affect our profitability. In addition, if we are unable to renew our expiring facilities or to obtain new reinsurance on favorable terms, either our net exposure to risk would increase or, if we are unwilling to bear an increase in net risk exposures, we would have to reduce the amount of risk we underwrite.
We are subject to credit risk with respect to the obligations of our reinsurers and risk-sharing partners. The inability of our reinsurers or risk-sharing partners to meet their obligations could adversely affect our profitability.
Star, as the lead insurance company under the Inter-Company Reinsurance Agreement, cedes insurance to other insurers under pro rata andexcess-of-loss contracts. These reinsurance arrangements diversify our business and reduce our exposure to large losses or from hazards of an unusual nature. We transfer some of the risk we have assumed to reinsurance companies in exchange for a portion of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, the ceding of insurance does not discharge us of our primary liability to our policyholder. If all or any of the reinsuring companies fail to pay or pay on a timely basis, we would be liable for such defaulted amounts. Therefore, we are subject to credit risk with respect to the obligations of our reinsurers. If our reinsurers fail to pay us or fail to pay on a timely basis, our financial results and financial condition could be adversely affected. In order to minimize our exposure to significant losses from reinsurer insolvencies, we evaluate the financial condition of our reinsurers and monitor the economic characteristics of the reinsurers on an ongoing basis and, if appropriate, we may require trust agreements to collateralize the reinsurers financial obligation to us. As of December 31, 2007, our reinsurance recoverables on paid and unpaid losses was $199.5 million.
In addition, with our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive,rent-a-captive, large deductible programs and indemnification agreements, as
18
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
well as on the portion of risk either ceded to captives or retained by our clients. The capitalization and creditworthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. Generally, we collateralize balances due from our risk-sharing partners through funds withheld trusts or stand-by letters of credit issued by highly rated banks. No assurance can be given regarding the future ability of any of our risk-sharing partners to meet their obligations. The inability of our risk-sharing partners to meet their obligations could adversely affect our profitability.
We face competitive pressures in our business that could cause our revenues to decline and adversely affect our profitability.
We compete with a large number of other companies in our selected lines of business. We and our agents compete, and will continue to compete, with major United States, foreign and other regional insurers, as well as mutual companies, specialty insurance companies, underwriting agencies and diversified financial services companies. Many of our competitors have greater financial and marketing resources than we do. Our profitability could be adversely affected if we lose business or any of our agents to competitors offering similar or better products at or below our prices.
A number of new, proposed or potential legislative or industry developments could further increase competition in our industry. These developments include:
• | the formation of new insurers and an influx of new capital in the marketplace as existing companies attempt to expand their business as a result of better pricingand/or terms | |
• | programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative market types of coverage | |
• | changing practices created by the internet, which has increased competition within the insurance business |
These developments could make the property and casualty insurance marketplace more competitive by increasing the supply of insurance capacity. In that event, the current softer market (a market of declining or stable pricing and generally lower profit or underwriting margins) could continue or be accelerated it may negatively influence our ability to maintain or increase rates. Accordingly, these developments could have an adverse effect on our business, financial condition and results of operations.
Our results may fluctuate as a result of many factors, including cyclical changes in the insurance industry.
The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our industry’s profitability can be affected by:
• | rising levels of actual costs that are not known by companies at the time they price their products | |
• | volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks | |
• | changes in loss reserves resulting from the general claims and legal environments as different types of claims arise and judicial interpretations relating to the scope of insurer’s liability develop | |
• | fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses | |
• | increases in medical costs beyond historic or expected annual inflationary levels |
The demand for property and casualty insurance can also vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases. The property and casualty insurance industry historically is cyclical in nature, with periods of reduced underwriting capacity and favorable premium rates alternating with periods of excess underwriting capacity and flat or falling premium rates. These fluctuations
19
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
in demand and supply could produce underwriting results that would have a negative impact on our financial condition and results of operations.
Negative developments within the workers’ compensation insurance industry may adversely affect our financial condition and results of operations.
Although we engage in other businesses, approximately 34% of our premium was attributable to workers’ compensation insurance for the year ended December 31, 2007. As a result, negative developments within the economic, competitive or regulatory conditions affecting the workers’ compensation insurance industry may have an adverse effect on our financial condition and results of operations. For example, if legislators in one of our larger markets, such as Florida, Nevada, or Massachusetts, were to enact legislation to increase the scope or amount of benefits for employees under workers’ compensation insurance policies without related premium increases or loss control measures, this could negatively affect the workers’ compensation insurance industry. In some states, workers’ compensation insurance premium rates are determined by regulation, and changes in mandated rates could reduce our profitability. Negative developments within the workers’ compensation insurance industry could have a greater effect on us than on more diversified insurance companies with more diversified lines of insurance.
The failure of any of the loss limitation methods we employ could have a material adverse effect on our results of operations and financial condition.
We seek to limit our loss exposure by writing a number of our insurance and reinsurance contracts on anexcess-of-loss basis.Excess-of-loss insurance and reinsurance indemnifies the insured against losses in excess of a specified amount. In addition, we limit program size for each client and purchase third-party reinsurance for our own account. In the case of our assumed proportional reinsurance treaties, we seek per occurrence limitations or loss and loss expense ratio caps to limit the impact of losses ceded by the client. In proportional reinsurance, the reinsurer shares a proportional part of the premiums and losses of the reinsured. We also seek to limit our loss exposure by geographic diversification. Various provisions of our policies, such as limitations or exclusions from coverage or choice of forum negotiated to limit our risks, may not be enforceable in the manner we intend. As a result, one or more catastrophic or other events could result in claims that substantially exceed our expectations, which could have an adverse effect on our results of operations or financial condition.
Because our investment portfolio consists primarily of fixed income securities, our investment income could suffer as a result of fluctuations in interest rates and market conditions.
We currently maintain and intend to continue to maintain an investment portfolio consisting primarily of fixed income securities. The fair value of these securities fluctuates depending on changes in interest rates. Generally, the fair market value of these investments increases or decreases in an inverse relationship with changes in interest rates. Changes in interest rates may result in fluctuations in the income derived from, and the valuation of, our fixed income investments, which could have an adverse effect on our financial condition and results of operations.
Our investment portfolio includes mortgage-backed securities. As of December 31, 2007, mortgage and asset-backed securities constituted approximately 24.2% of our invested assets. As with other fixed income investments, the fair market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to prepayment risks on these investments. When interest rates fall, mortgage-backed securities are prepaid more quickly than expected and the holder must reinvest the proceeds at lower interest rates. Our mortgage-backed securities currently consist of securities with features that reduce the risk of prepayment, but there is no guarantee that we will not invest in other mortgage-backed securities that lack this protection. In periods of increasing interest rates, mortgage-backed securities are prepaid more slowly, which may require us to receive interest payments that are below the prevailing interest rates for longer than expected.
20
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
We could be forced to sell investments to meet our liquidity requirements.
We believe we maintain adequate amounts of cash and short-term investments to pay claims, and do not expect to have to sell securities prematurely for such purposes. We may, however, decide to sell securities as a result of changes in interest rates, credit quality, the rate or repayment or other similar factors. A significant increase in market interest rates could result in a situation in which we are required to sell securities at depressed prices to fund payments to our insureds. Since we carry debt securities at fair value, we expect these securities would be sold with no material impact on our net equity, although it could result in net realized losses. If these securities are sold, future net investment income may be reduced if we are unable to reinvest in securities with similar yields.
Because we are heavily regulated by the states in which we operate, we may be limited in the way we operate.
We are subject to extensive supervision and regulation in the states in which we operate. The supervision and regulation relate to numerous aspects of our business and financial condition. The primary purpose of the supervision and regulation is to maintain compliance with insurance regulations and to protect policyholders and not our shareholders. The extent of regulation varies, but generally is governed by state statutes. These statutes delegate regulatory, supervisory and administrative authority to state insurance departments. This system of regulation covers, among other things:
• | standards of solvency, including risk-based capital measurements | |
• | restrictions on the nature, quality and concentration of investments | |
• | restrictions on the types of terms that we can include in the insurance policies we offer | |
• | required methods of accounting | |
• | required reserves for unearned premiums, losses and other purposes | |
• | permissible underwriting and claims settlement practices | |
• | potential assessments for the provision of funds necessary for the settlement of covered claims under certain insurance policies provided by impaired, insolvent or failed insurance companies |
The regulations of the state insurance departments may affect the cost or demand for our products and may impede us from obtaining rate increases or taking other actions we might wish to take to increase our profitability. Furthermore, we may be unable to maintain all required licenses and approvals and our business may not fully comply with the wide variety of applicable laws and regulations or the relevant authority’s interpretation of the laws and regulations. Also, regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could stop or temporarily suspend us from conducting some or all of our activities or monetarily penalize us.
Also, the insurance industry has recently become the focus of increased scrutiny by regulatory authorities relating to the placement of insurance, as well as claims handling by insurers in the wake of recent hurricane losses. Some states have adopted new disclosure requirements relating to the placement of insurance business, while other states are considering what additional regulatory oversight might be required with regard to claims handling activities of insurers. It is difficult to predict the outcome of these regulatory activities, whether they will expand into other areas of the business not yet contemplated, whether activities and practices currently thought of to be lawful will be characterized as unlawful and what form of additional or new regulations may be finally adopted and what impact, if any, such increase regulatory actions may have on our business. We have received general industry-wide requests for information from a few state insurance departments regarding compensation with insurance agents. We responded to these inquires. Subsequent to our responses, we have not received any further inquiries or comments from the state insurance departments.
21
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Our reliance on producers subjects us to their credit risk.
With respect to our agency billed premiums generated by our Insurance Company Subsidiaries, producers collect premiums from the policyholders and forward them to us. In certain jurisdictions, when the insured pays premium for these policies to producers for payment, the premium might be considered to have been paid under applicable insurance laws and the insured will no longer be liable to us for those amounts, whether or not we have actually received the premium from the producer. Consequently, we assume a degree of credit risk associated with producers. Although producers’ failures to remit premiums to us have not caused a material adverse impact on us to date, there may be instances where producers collect premium but do not remit it to us and we may be required under applicable law to provide the coverage set forth in the policy despite the actual collection of the premium by us. Because the possibility of these events is dependent in large part upon the financial condition and internal operations of our producers, we may not be able to quantify any potential exposure presented by the risk. If we are unable to collect premium from our producers in the future, our financial condition and results of operations could be materially and adversely affected.
Provisions of the Michigan Business Corporation Act, our articles of incorporation and other corporate governing documents and the insurance laws of Michigan and Missouri may discourage takeover attempts.
The Michigan Business Corporation Act contains “anti-takeover” provisions. Chapters 7A (the “Fair Price Act”) and 7B (the “Control Share Act”) of the Business Corporation Act apply to us and may have an anti-takeover effect and may delay, defer or prevent a tender offer or takeover attempt that a shareholder might consider in their best interest, including those attempts that might result in shareholders receiving a premium over market price for their shares.
The Fair Price Act provides that a supermajority vote of ninety percent of the shareholders and no less than two-thirds of the votes of non interested shareholders must approve a “business combination.” The Fair Price Act defines a “business combination” to encompass any merger, consolidation, share exchange, sale of assets, stock issue, liquidation, or reclassification of securities involving an “interested shareholder” or certain “affiliates.” An “interested shareholder” is generally any person who owns ten percent or more of the outstanding voting shares of the company. An “affiliate” is a person who directly or indirectly controls, is controlled by, or is under common control with, a specified person. The supermajority vote required by the Fair Price Act does not apply to business combinations that satisfy certain conditions. These conditions include, among others: (i) the purchase price to be paid for the shares of the company in the business combination must be at least equal to the highest of either (a) the market value of the shares or (b) the highest per share price paid by the interested shareholder within the preceding two-year period or in the transaction in which the shareholder became an interested shareholder, whichever is higher; and (ii) once becoming an interested shareholder, the person may not become the beneficial owner of any additional shares of the company except as part of the transaction which resulted in the interested shareholder becoming an interested shareholder or by virtue of proportionate stock splits or stock dividends.
The Control Share Act establishes procedures governing “control share acquisitions” of large public Michigan corporations. A control share acquisition is defined as an acquisition of shares by an acquiror which, when combined with other shares held by that person or entity, would give the acquiror voting power, alone or as part of a group, at or above any of the following thresholds: 20%, 331/3% or 50%. Under the Control Share Act, an acquiror may not vote “control shares” unless the company’s disinterested shareholders (defined to exclude the acquiring person, officers of the target company, and directors of the target company who are also employees of the company) vote to confer voting rights on the control shares. The Control Share Act does not affect the voting rights of shares owned by an acquiring person prior to the control share acquisition. The Control Share Act entitles corporations to redeem control shares from the acquiring person under certain circumstances. In other cases, the Control Share Act confers dissenters’ right upon all of the corporation’s shareholders except the acquiring person.
22
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Our articles of incorporation allow our Board of Directors to issue one or more classes or series of preferred stock with voting rights, preferences and other privileges as the Board of Directors may determine. Also, we have adopted a shareholder rights plan, which if triggered would significantly dilute the stock ownership percentage of anyone who acquires more than fifteen percent of our shares without the approval of our Board of Directors. The existence of our shareholder rights plan and the possible issuance of preferred shares could adversely affect the holders of our common stock and could prevent, delay or defer a change of control.
We are also subject to the laws of various states, such as Michigan and Missouri, governing insurance holding companies. Under these laws, a person generally must obtain the applicable Insurance Department’s approval to acquire, directly or indirectly, five to ten percent or more of the outstanding voting securities of our Insurance Company Subsidiaries. An Insurance Department’s determination of whether to approve an acquisition would be based on a variety of factors, including an evaluation of the acquirer’s financial stability, the competence of its management, and whether competition in that state would be reduced. These laws may prevent, delay or defer a change of control of us or our Insurance Company Subsidiaries.
Most states assess our Insurance Company Subsidiaries to provide funds for failing insurance companies and those assessments could be material.
Our Insurance Company Subsidiaries are subject to assessments in most states where we are licensed for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies. Maximum contributions required by law in any one year vary by state, and have historically been less than one percent of annual premiums written. We cannot predict with certainty the amount of future assessments. Significant assessments could have a material adverse effect on our financial condition and results of operations.
We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.
Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. To the extent that our present capital is insufficient to meet future operating requirementsand/or cover losses, we may need to raise additional funds through financings. If we had to raise additional capital, equity or debt financing may not be available or, may be on terms that are not favorable to us. In the case of equity financings, dilution to our shareholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares offered hereby. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition could be adversely affected.
Our performance is dependent on the continued services and performance of our senior management and other key personnel.
The success of our business is dependent on our ability to retain and motivate our senior management and key management personnel. The loss of the services of any of our executive officers or other key employees could have a material adverse effect on our business, financial condition, and results of operations. We have existing employment or severance agreements with Merton J. Segal, Robert S. Cubbin, Karen M. Spaun, Michael G. Costello, Stephen Belden, Joseph E. Mattingly, James M. Mahoney, Robert C. Spring, Archie S. McIntyre, and Kenn R. Allen. We maintain a “key person” life insurance policy on Robert S. Cubbin, our President and CEO.
Our future success also will depend on our ability to attract, train, motivate and retain other highly skilled technical, managerial, marketing, and customer service personnel. Competition for these employees is intense and we may not be able to successfully attract, integrate or retain sufficiently qualified personnel. In addition, our future success depends on our ability to attract, retain and motivate our agents and other producers. Our
23
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
failure to attract and retain the necessary personnel and producers could have a material adverse effect on our business, financial condition, and results of operations.
We rely on our information technology and telecommunications systems to conduct our business.
Our business is dependent upon the uninterrupted functioning of our information technology and telecommunication systems. We rely upon our systems, as well as the systems of our vendors, to underwrite and process our business, make claim payments, provide customer service, provide policy administration services, such as endorsements, cancellations and premium collections, comply with insurance regulatory requirements and perform actuarial and other analytical functions necessary for pricing and product development. Our operations are dependent upon our ability to timely and efficiently process our business and protect our information and telecommunications systems from physical loss, telecommunications failure or other similar catastrophic events, as well as from security breaches. While we have implemented business contingency plans and other reasonable and appropriate internal controls to protect our systems from interruption, loss or security breaches, a sustained business interruption or system failure could adversely impact our ability to process our business, provide customer service, pay claims in a timely manner or perform other necessary business functions. Likewise, a security breach of our computer systems could also interrupt or damage our operations or harm our reputation in the event confidential customer information is disclosed to third parties. Either of these circumstances could have a material adverse effect upon our financial condition, operations or reputation.
Managing technology initiatives and obtaining the efficiencies anticipated with technology implementation may present significant challenges.
While technological enhancements and initiatives can streamline several business processes and ultimately reduce the costs of operations, these initiatives can present short-term costs and implementation risks. Projections of associated costs, implementation timelines, and the benefits of those results may be inaccurate and such inaccuracies could increase over time. In addition, there are risks associated with not achieving the anticipated efficiencies from technology implementation that could impact our results of operations.
Item 1B. | Unresolved Staff Comments |
None.
Item 2. | Properties |
In 1998, we purchased land in Southfield, Michigan for a cost of $3.2 million. In 2004, the construction of our corporate headquarters was completed on half of this land. In December 2004, we relocated to the new office building. This new building is approximately 72,000 square feet. The total construction cost of the building approximated $12.0 million, which was paid in full at the closing on January 19, 2005. Previously, we leased our corporate offices from an unaffiliated third party.
In 2003, we entered into a Purchase and Sale Agreement, whereby we agreed to sell the remaining portion of the land to an unaffiliated third party for the purpose of constructing an office building adjacent to our corporate headquarters. Under the Purchase and Sale Agreement, the third party agreed to pay $2.1 million for the land, $1.2 million for their share of the costs related to the common areas of the building, and other related costs of approximately $226,000. In May 2005, we closed on the transaction.
The unaffiliated third party had until July 2007 to pay the principal balance. We have negotiated an extension through May 1, 2009. The unaffiliated third party continues to pay interest during the extension period and has the option to pay the principal balance, or $750,000 less in exchange for granting us an ownership interest in the building.
Through our subsidiaries, we are also a party to various leases for locations in which we have offices. We do not consider any of these leases to be material.
24
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Item 3. | Legal Proceedings |
We are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, we vigorously defend such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, we have established provisions against these items, which are believed to be adequate in light of current information and legal advice. In accordance with SFAS No. 5,“Accounting for Contingencies,”if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is estimable, an accrual is provided for the costs to resolve these claims in our consolidated financial statements. Period expenses related to the defense of such claims are included in other operating expenses in the accompanying consolidated statements of income. With the assistance of outside counsel, we adjust such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, we do not expect the outcome of the claims, lawsuits and proceedings to which we are subject to, either individually, or in the aggregate, will have a material adverse effect on our financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters.
Item 4. | Submission of Matters to a Vote of Security Holders |
None.
25
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
PART II
Item 5. | Market for Registrant’s Common Equity and Related Stockholder Matters |
Shareholder Information Corporate Headquarters 26255 American Drive Southfield, MI48034-6112 Phone:(248) 358-1100 Independent Registered Public Accounting Firm Ernst & Young LLP Detroit, MI Corporate Counsel Howard & Howard Attorneys, P.C. Bloomfield Hills, MI | Transfer Agent & Registrar LaSalle Bank National Association Corporate Trust Shareholder Services P.O. Box 3319 South Hackensack, NJ 07606-1919 Stock Listing New York Stock Exchange Symbol: MIG | Annual Meeting The Annual Meeting of Meadowbrook Shareholders will be held at: 2:00 p.m. May 9, 2008 Corporate Headquarters 26255 American Drive Southfield, MI |
Shareholder Relations andForm 10-K
A copy of our 2007 Annual Report andForm 10-K, as filed with the Securities and Exchange Commission, may be obtained upon written request to our Investor Relations Department at our corporate headquarters, or contact:
Karen M. Spaun, Senior Vice President and Chief Financial Officer
(248) 204-8178 karen.spaun@meadowbrook.com
Holly A. Moltane, Director of External Financial Reporting
(248) 204-8590 holly.moltane@meadowbrook.com
Direct Investment Plan
Our Shareholder Investment Plan (“Plan”) offers a simple and systematic way to purchase our common stock without paying brokerage fees or commissions. With the Plan’s many flexible features, an account may be customized to reflect individual financial and investment objectives. If you would like additional information including a prospectus and an application, please contact:
LaSalle Bank National Association1-800-442-8134
Share Price and Dividend Information
Our common stock is traded on the New York Stock Exchange under the symbol “MIG.” The following table sets forth the high and low closing sale prices of our common shares as reported by the NYSE and our quarterly dividends declared for each period shown:
December 31, 2007 | High | Low | Dividends | |||||||
First Quarter | $ | 11.68 | $ | 9.10 | — | |||||
Second Quarter | 12.45 | 9.94 | — | |||||||
Third Quarter | 11.57 | 8.02 | — | |||||||
Fourth Quarter | 10.00 | 8.40 | — |
26
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
December 31, 2006 | High | Low | Dividends | |||||||
First Quarter | $ | 7.00 | $ | 5.63 | — | |||||
Second Quarter | 8.91 | 6.68 | — | |||||||
Third Quarter | 11.83 | 8.32 | — | |||||||
Fourth Quarter | 12.48 | 8.78 | — |
For additional information regarding dividend restrictions, refer to theLiquidity and Capital Resourcessection of Management’s Discussion and Analysis.
When evaluating the declaration of a dividend, our Board of Directors considers a variety of factors, including but not limited to, our cash flow, liquidity needs, results of operations strategic plans, industry conditions, and our overall financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from our subsidiaries. We did not receive any dividends from our Insurance Company Subsidiaries in 2007 or 2006.
Shareholders of Record
As of March 3, 2008, there were approximately 249 shareholders of record of our common stock. For purposes of this determination, Cede & Co., the nominee for the Depositary Trust Company is treated as one holder.
Recent Sales of Unregistered Securities and Use of Proceeds from Registered Securities
On July 19, 2007, we sold 6,437,500 shares of common stock in a secondary public offering at a price of $9.65 per share pursuant to a Registration Statement onForm S-3 (RegistrationNo. 333-143244), which was declared effective by the Securities and Exchange Commission on July 6, 2007. The net proceeds we received from the offering were approximately $58.6 million, reflecting gross proceeds of $62.1 million, net of underwriting fees of approximately $3.0 million and other offering costs of approximately $500,000. During the period from the offering through December 31, 2007, we used a portion of the proceeds to reduce our outstanding line of credit balance from $22.0 million to zero and for other general corporate purposes.
Purchase of Equity Securities by the Issuer
During the year ended December 31, 2007, we did not purchase any of our securities.
27
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Performance Graph
The following graph sets forth, for the five year period ended December 31, 2007, the cumulative total stockholder return for the Company’s common stock, the Russell 2000 Index, and a Peer Group index. The graph assumes the investment of $100 on December 31, 2002 in Common Stock of the Company, the Russell 2000 Index, and a Peer Group index. The stock price performance represented on the following graph is not necessarily indicative of future stock price performance.
The performance graph shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be deemed to be incorporated by reference into any future filing of the Company under the Securities Exchange Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent the Company specifically incorporates it by reference into such filing.
Comparison of Five Year Cumulative Total Return
Period Ending | ||||||||||||||||||||||||||||||
Index | 12/31/2002 | 12/31/2003 | 12/31/2004 | 12/31/2005 | 12/31/2006 | 12/31/2007 | ||||||||||||||||||||||||
Meadowbrook Insurance Group, Inc. | 100.00 | 170.56 | 201.21 | 235.48 | 398.79 | 379.44 | ||||||||||||||||||||||||
Russell 2000 | 100.00 | 147.25 | 174.24 | 182.18 | 215.64 | 212.26 | ||||||||||||||||||||||||
SNL Insurance $500M-$1B Index | 100.00 | 138.64 | 168.56 | 152.61 | 167.02 | 159.80 | ||||||||||||||||||||||||
28
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Item 6. | Selected Financial Data |
MEADOWBROOK INSURANCE GROUP, INC.
SELECTED CONSOLIDATED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
For the Years Ended December 31, | ||||||||||||||||||||
2007 | 2006 | 2005 | 2004 | 2003 | ||||||||||||||||
(In thousands, except per share and ratio data) | ||||||||||||||||||||
Income Statement Data: | ||||||||||||||||||||
Gross written premiums | $ | 346,451 | $ | 330,872 | $ | 332,209 | $ | 313,493 | $ | 253,280 | ||||||||||
Net written premiums | 280,211 | 262,668 | 258,134 | 233,961 | 189,827 | |||||||||||||||
Net earned premiums | 268,197 | 254,920 | 249,959 | 214,493 | 151,205 | |||||||||||||||
Net commissions and fees | 45,988 | 41,172 | 35,916 | 40,535 | 45,291 | |||||||||||||||
Net investment income | 26,400 | 22,075 | 17,975 | 14,911 | 13,484 | |||||||||||||||
Net realized gains | 150 | 69 | 167 | 339 | 823 | |||||||||||||||
Total revenue | 340,735 | 318,236 | 304,017 | 270,278 | 210,803 | |||||||||||||||
Net losses and LAE | 150,969 | 146,293 | 151,542 | 135,938 | 98,472 | |||||||||||||||
Policy acquisition and other underwriting expenses | 53,717 | 50,479 | 44,439 | 33,424 | 23,606 | |||||||||||||||
Other administrative expenses | 32,269 | 28,824 | 26,810 | 25,588 | 22,879 | |||||||||||||||
Salaries and employee benefits | 56,433 | 54,569 | 51,331 | 52,297 | 48,238 | |||||||||||||||
Amortization expense | 1,930 | 590 | 373 | 376 | 353 | |||||||||||||||
Interest expense | 6,030 | 5,976 | 3,856 | 2,281 | 977 | |||||||||||||||
Income before income taxes and equity earnings of affiliates | 39,387 | 31,505 | 25,666 | 20,374 | 16,278 | |||||||||||||||
Equity earnings of affiliates | 331 | 128 | 1 | 39 | 3 | |||||||||||||||
Net income | 27,992 | 22,034 | 17,910 | 14,061 | 10,099 | |||||||||||||||
Earnings per share — Diluted | $ | 0.85 | $ | 0.75 | $ | 0.60 | $ | 0.48 | $ | 0.35 | ||||||||||
Balance Sheet Data: | ||||||||||||||||||||
Total investments and cash and cash equivalents | $ | 651,601 | $ | 527,600 | $ | 460,233 | $ | 402,156 | $ | 324,235 | ||||||||||
Total assets | 1,113,966 | 969,000 | 901,344 | 801,696 | 692,266 | |||||||||||||||
Loss and LAE reserves | 540,002 | 501,077 | 458,677 | 378,157 | 339,465 | |||||||||||||||
Debt | — | 7,000 | 7,000 | 12,144 | 17,506 | |||||||||||||||
Debentures | 55,930 | 55,930 | 55,930 | 35,310 | 10,310 | |||||||||||||||
Shareholders’ equity | 301,894 | 201,693 | 177,365 | 167,510 | 155,113 | |||||||||||||||
Book value per share | $ | 8.16 | $ | 6.93 | $ | 6.19 | $ | 5.76 | $ | 5.34 | ||||||||||
Other Data: | ||||||||||||||||||||
GAAP ratios (insurance companies only): | ||||||||||||||||||||
Net loss and LAE ratio(1) | 61.2 | % | 62.3 | % | 65.2 | % | 67.9 | % | 70.1 | % | ||||||||||
Expense ratio(1) | 34.2 | % | 34.5 | % | 33.5 | % | 33.5 | % | 34.3 | % | ||||||||||
Combined ratio | 95.4 | % | 96.8 | % | 98.7 | % | 101.4 | % | 104.4 | % |
(1) | Both the GAAP loss and loss adjustment expense ratio and the GAAP expense ratio are calculated based upon unconsolidated insurance company operations. The following table sets forth the intercompany fees, which are eliminated upon onsolidation. |
29
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Unconsolidated GAAP data — Ratio Calculation Table:
For the Years Ended December 31, | ||||||||||||||||||||
2007 | 2006 | 2005 | 2004 | 2003 | ||||||||||||||||
Net earned premiums | $ | 268,197 | $ | 254,920 | $ | 249,959 | $ | 214,493 | $ | 151,205 | ||||||||||
Consolidated net losses and LAE | $ | 150,969 | $ | 146,293 | $ | 151,542 | $ | 135,938 | $ | 98,472 | ||||||||||
Intercompany claim fees | 13,058 | 12,553 | 11,523 | 9,691 | 7,514 | |||||||||||||||
Unconsolidated net losses and LAE | $ | 164,027 | $ | 158,846 | $ | 163,065 | $ | 145,629 | $ | 105,986 | ||||||||||
GAAP net loss and LAE ratio | 61.2 | % | 62.3 | % | 65.2 | % | 67.9 | % | 70.1 | % | ||||||||||
Consolidated policy acquisition and other underwriting expenses | $ | 53,717 | $ | 50,479 | $ | 44,439 | $ | 33,424 | $ | 23,606 | ||||||||||
Intercompany administrative and other underwriting fees | 37,890 | 37,442 | 39,231 | 38,359 | 28,296 | |||||||||||||||
Unconsolidated policy acquisition and other underwriting expenses | $ | 91,607 | $ | 87,921 | $ | 83,670 | $ | 71,783 | $ | 51,902 | ||||||||||
GAAP expense ratio | 34.2 | % | 34.5 | % | 33.5 | % | 33.5 | % | 34.3 | % | ||||||||||
GAAP combined ratio | 95.4 | % | 96.8 | % | 98.7 | % | 101.4 | % | 104.4 | % |
Management uses the GAAP combined ratio and its components to assess and benchmark underwriting performance.
The GAAP combined ratio is the sum of the GAAP loss and loss adjustment expense ratio and the GAAP expense ratio. The GAAP loss and loss adjustment expense ratio is the unconsolidated net loss and loss adjustment expense in relation to net earned premiums. The GAAP expense ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premiums.
30
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
Forward-Looking Statements
ThisForm 10-K may provide information including certain statements which constitute 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. These include statements regarding the intent, belief, or current expectations of management, including, but not limited to, those statements that use the words “believes,” “expects,” “anticipates,” “estimates,” or similar expressions. You are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks and uncertainties, and results could differ materially from those indicated by such forward-looking statements. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are: the frequency and severity of claims; uncertainties inherent in reserve estimates; catastrophic events; a change in the demand for, pricing of, availability or collectibility of reinsurance; increased rate pressure on premiums; ability to obtain rate increases in current market conditions; investment rate of return; changes in and adherence to insurance regulation; actions taken by regulators, rating agencies or lenders; attainment of certain processing efficiencies; changing rates of inflation; general economic conditions and other risks identified in our reports and registration statements filed with the Securities and Exchange Commission. We are not under any obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements whether as a result of new information, future events or otherwise.
Description of Business
We are a publicly traded specialty risk management organization offering a full range of insurance products and services, focused on niche and specialty program business, which we believe is under served by the standard insurance market. Program business refers to an aggregation of individually underwritten risks that have some unique characteristic and are distributed through a select group of focused general agencies, retail agencies and program administrators. We perform the majority of underwriting and claims services associated with these programs. We also provide property and casualty insurance coverage and services through programs and specialty risk management solutions for agents, professional and trade associations, public entities and small to medium-sized insureds. In addition, we also operate as an insurance agency representing unaffiliated insurance companies in placing insurance coverages for policyholders. We define our business segments as specialty risk management operations and agency operations.
In July 2007, we completed an offering of 6,437,500 additional shares of newly issued common stock at $9.65 per share. The gross proceeds of the offering were $62.1 million. The net proceeds were $58.6 million. The net proceeds from the offering are being utilized to support organic growth within our underwriting operations, to fund select acquisitions and other general corporate purposes. Upon receipt of the net proceeds, we also reduced our outstanding line of credit balance from $22.0 million to zero.
In June 2002, we sold 21,275,000 shares of newly issued common stock at $3.10 per share in a public offering. After deducting underwriting discounts, commissions, and expenses, we received net proceeds from the offering of $60.5 million. We utilized $57.5 million of the $60.5 million raised in the public offering to pay down our line of credit by $20.0 million and contributed $37.5 million to the surplus of our Insurance Company Subsidiaries. The remaining proceeds were used for general corporate purposes.
Since 2003, we have issued $30.9 million and $25.0 million in junior subordinated debentures and senior debentures, respectively. We received a total of $53.3 million in net proceeds from the issuances of these debentures, of which $26.2 million was contributed to the surplus of our Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes. These debentures are callable after five years
31
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
from the date of issuance. Since the junior subordinated debentures issued in 2003 are callable in 2008, we will be reviewing the capital strategy associated with refinancing at lower costs through debentures or equity.
Specialty Risk Management Operations
Our specialty risk management operations segment, which includes insurance company specialty programs andfee-for-service specialty programs, focuses on specialty or niche insurance business. Specialty risk management operations provide 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 various types of property and casualty insurance coverage, including workers’ compensation, commercial multiple peril, general liability, commercial auto liability, and inland marine. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of our agent-partners. We recognize revenue related to the services and coverages the specialty risk management operations provides within seven categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance placement, investment income, and net realized gains (losses).
With afee-for-service program, or managed program, we earnfee-for-service revenue by providing management and other services to a client’s risk-bearing entity, but generally do not share in the operating results of the program. The fees we receive from these programs are generally either a fixed amount or based on a percentage of premium serviced or claim count.
We provide three broad types of insurance company programs, including fully insured, captives and client risk-sharing programs. With a client risk-sharing program, our Insurance Company Subsidiaries underwrite individual primary insurance policies for members of a group or association, or a specific industry and then share the operating results with the client or client group through a reinsurance agreement with a captive orrent-a-captive. In some instances, a captive owned by a client or client group reinsures a portion of the risk on a quota-share basis. A captive is an insurance company or reinsurance company, which is formed for the purpose of insuring or reinsuring risks related to the businesses of its shareholders or members. Arent-a-captive allows organizations to obtain the benefits of a captive insurance company, without the initial costs and capital investment required to form their own captive. This is often an interim step utilized by groups and associations prior to forming their own captive. As part of its participation in arent-a-captive, the client group purchases redeemable preferred stock of our unconsolidated subsidiary. These shares entitle the client group to participate in profits and losses of the program through a dividend or additional capital contribution. Dividends or additional capital contributions are determined and accrued on the basis of underwriting profits or losses plus investment income on trust accounts less costs. The captive andrent-a-captive structures are licensed reinsurance companies, which have a self-sustaining integrated set of activities and assets, and are in the reinsurance business for the purpose of providing a return to their investors, who are the shareholders (“primary beneficiaries”) of the captive company. The primary beneficiaries have their own equity at risk, decision making authority, and the ability to absorb losses. Therefore, the transactions associated with the captive andrent-a-captive structures are accounted for under the provisions of SFAS No. 113,“Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.”
In addition to premium revenue and investment income from our net retained portion of the operating results, we may also be compensated through the receipt of fees for policy issuance services and acquisition costs, captive administration, reinsurance placement, loss prevention services, and claims administrative and handling services. In addition, we may benefit from the fees our risk management subsidiary earns for services we perform on behalf of our Insurance Company Subsidiaries. These fees are eliminated upon consolidation. However, the fees associated with the captive’s portion of the program are reimbursed through a ceding commission. For financial reporting purposes, ceding commissions are treated as a reduction in underwriting expenses.
32
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
With fully insured programs, we provide our insurance products without a risk-bearing mechanism and derive revenue from net earned premiums and investment income. Fully insured programs are generally developed in response to specific market opportunities and may evolve into a risk-sharing arrangement.
Agency Operations
We earn commission revenue through the operation of our retail property and casualty insurance agencies, located in Michigan, California, and Florida. The agency operations produce commercial, personal lines, life, and accident and health insurance, for more than fifty unaffiliated insurance carriers. The agency produces an immaterial amount of business for our affiliated Insurance Company Subsidiaries.
In recent years, we have derived our revenue from the following sources (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Revenues | ||||||||||||
Net earned premiums | $ | 268,197 | $ | 254,920 | $ | 249,959 | ||||||
Management fees | 23,963 | 18,714 | 16,741 | |||||||||
Claims fees | 9,025 | 8,776 | 7,113 | |||||||||
Loss control fees | 2,151 | 2,216 | 2,260 | |||||||||
Reinsurance placement | 929 | 735 | 660 | |||||||||
Investment income | 25,487 | 21,115 | 17,692 | |||||||||
Net realized gains | 150 | 69 | 85 | |||||||||
Specialty risk management | 329,902 | 306,545 | 294,510 | |||||||||
Agency operations | 11,316 | 12,285 | 11,304 | |||||||||
Holding Company interest income earned | 913 | 960 | 365 | |||||||||
Intersegment revenue | (1,396 | ) | (1,554 | ) | (2,162 | ) | ||||||
Consolidated revenue | $ | 340,735 | $ | 318,236 | $ | 304,017 | ||||||
Critical Accounting Policies
General
In certain circumstances, we are required to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on a variety of factors. There can be no assurance, however, the actual results will not be materially different than our estimates and assumptions, and that reported results of operation will not be affected by accounting adjustments needed to reflect changes in these estimates and assumptions. We believe the following policies are the most sensitive to estimates and judgments.
Losses and Loss Adjustment Expenses
Significant periods of time can elapse between the occurrence of a loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for unpaid losses and loss adjustment expenses (“LAE”), insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and LAE.
We establish a liability for losses and LAE, which represent case based estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported losses (“IBNR”) and LAE. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the
33
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
ultimate liability may be greater or less than the estimate. As of December 31, 2007 and 2006, we have accrued $540.0 million and $501.1 million of gross loss and LAE reserves, respectively.
Components of Losses and Loss Adjustment Expense
The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, at December 31, 2007 (in thousands):
Case | IBNR | Total | ||||||||||
Direct | $ | 168,979 | $ | 252,186 | $ | 421,165 | ||||||
Assumed-Directly Managed(1) | 25,313 | 61,123 | 86,436 | |||||||||
Assumed-Residual Markets(2) | 9,697 | 15,730 | 25,427 | |||||||||
Assumed-Retroceded | 1,372 | 356 | 1,728 | |||||||||
Assumed-Other | 3,272 | 1,974 | 5,246 | |||||||||
Gross | 208,633 | 331,369 | 540,002 | |||||||||
Less Ceded | 79,412 | 119,049 | 198,461 | |||||||||
Net | $ | 129,221 | $ | 212,320 | $ | 341,541 | ||||||
(1) | Directly managed represents business managed and processed by our underwriting, claims, and loss control departments, utilizing our internal systems and related controls. | |
(2) | Residual markets represent mandatory pooled workers’ compensation business allocated to individual insurance company writers based on the insurer’s market share in a given state. |
The reserves referenced in the above table related to our direct and assumed business, which we directly manage and are established through transactions processed through our internal systems and related controls. Accordingly, the case reserves are established on a current basis, therefore there is no delay or lag in reporting of losses from a ceding company, and IBNR is determined utilizing various actuarial methods based upon historical data. Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag between the date of the evaluation and the receipt of the estimate from the National Council on Compensation Insurance (“NCCI”), and include an estimated reserve based upon actuarial methods for this lag. Assumed business, which is subsequently 100% retroceded to participating reinsurers, relates to business previously discontinued and now is in run-off. Relative to assumed business from other sources, we receive case and paid loss data within a forty-five day reporting period and develop our estimates for IBNR based on both current and historical data.
The completeness and accuracy of data received from cedants on assumed business that we do not manage directly is verified through monthly reconciliations to detailed statements, inception to date rollforwards of claim data, actuarial estimates of historical trends, field audits, and a series of management oversight reports on a program basis.
34
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
The following table sets forth our net case and IBNR reserves for losses and LAE by line of business at December 31, 2007 (in thousands):
Net Case | Net IBNR | Total | ||||||||||
Workers’ Compensation | $ | 58,665 | $ | 82,694 | $ | 141,359 | ||||||
Residual Markets | 9,697 | 15,731 | 25,428 | |||||||||
Commercial Multiple Peril/General Liability | 25,972 | 61,840 | 87,812 | |||||||||
Commercial Automobile | 30,081 | 39,345 | 69,426 | |||||||||
Other | 4,806 | 12,710 | 17,516 | |||||||||
Total | $ | 129,221 | $ | 212,320 | $ | 341,541 | ||||||
Claim Reserving Process and Methodology
When a claim is reported to one of our Insurance Company Subsidiaries, for the majority of claims, our claims personnel within our risk management subsidiary will establish a case reserve for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon acase-by-case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, which focus on the ultimate probable cost of each reported claim, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments, new information or periodic reviews of the claims.
In addition to case reserves and in accordance with industry practice, we maintain estimates of reserves for losses and LAE incurred but not yet reported. We project an estimate of ultimate losses and LAE at each reporting date. The difference between the projected ultimate loss and LAE reserves and the case loss reserves and LAE reserves, is carried as IBNR reserves. By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, we estimate the ultimate liability for losses and LAE, net of reinsurance recoverables.
In developing claim and claim adjustment expense (loss(es)) reserve estimates, we perform a complete and detailed reserve analyses each quarter. To perform this analysis the data is organized at a “reserve category” level. A reserve category can be a line of business such as commercial automobile liability, or it may be a particular geographical area within a line of business such as Nevada workers’ compensation. The reserves within a reserve category level are characterized as either short tail or long tail. About ninety-eight percent of our reserves can be characterized as coming from long tail lines of business. For long tail business, several years may lapse between the time the business is written and the time when all claims are settled. Our long-tail exposures include workers’ compensation, commercial automobile liability, general liability, professional liability, products liability, excess, and umbrella. Short-tail exposures include property, commercial automobile physical damage, and inland marine. The analyses generally review losses both gross and net of reinsurance.
The standard actuarial methods that we use to project ultimate losses for both long-tail and short-tail exposures include, but are not limited to, the following:
Paid Development Method,
Incurred Development Method,
Paid Bornhuetter-Ferguson Method,
Reported Bornhuetter-Ferguson Method,
Initial Expected Loss Method,
35
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Paid Roll-forward Method, and
Incurred Roll-forward Method
All of these methods are consistently applied to every reserve category where they are applicable and they create indications for each accident year. We use judgment selecting the best estimate from within these estimates or adjusted estimates. As such, no one method or group of methods is strictly used for any line of business or reserve category within a line of business. The individual selections by year are our best judgments based on the strengths and weaknesses of the method, indications, the inherent variability in the data and the specific modifications to selections for data characteristics.
A brief description of the methods and some discussion of their inherent strengths, weaknesses and uses are as follows:
Paid Development Method. This method uses historical, cumulative paid losses by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment environment, and to the extent necessary supplemented by analyses of the development of broader industry data.
Selection of the paid loss pattern requires analysis of several factors including the impact of inflation on claims costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, the impact of large claim payments and other factors. Claim cost inflation itself requires evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors. Because this method assumes that losses are paid at a consistent rate, changes in any of these factors can impact the results. Since the method does not rely on case reserves, it is not directly influenced by changes in the adequacy of case reserves.
Incurred Development Method. This method uses historical, cumulative reported loss dollars by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment and case reserving environment, and to the extent necessary supplemented by analyses of the development of broader industry data.
Since the method uses more data (case reserves in addition to paid losses) than the paid development method, the incurred development patterns may be less variable than paid patterns. However, selection of the incurred loss pattern requires analysis of all of the factors listed in the description of the paid development method. In addition, the inclusion of case reserves can lead to distortions if changes in case reserving practices have taken place and the use of case incurred losses may not eliminate the issues associated with estimating the incurred loss pattern subsequent to the most mature point available.
Paid Bornhuetter-Ferguson Method. This is a method that assigns partial weight to initial expected losses for each accident year and partial weight to observed paid losses. The weights assigned to the initial expected losses decrease as the accident year matures.
The method assumes that only future losses will develop at the expected loss ratio level. The percent of paid loss to ultimate loss implied from the paid development method is used to determine what percentage of ultimate loss is yet to be paid. The use of the pattern from the paid development method requires consideration of all factors listed in the description of the paid development method. The estimate of losses yet to be paid is added to current paid losses to estimate the ultimate loss for each year. This method will react very slowly if actual ultimate loss ratios are different from expectations due to changes not accounted for by the expected loss ratio calculation.
36
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Reported Bornhuetter-Ferguson Method. This is a method that assigns partial weight to the initial expected losses and partial weight to observed reported loss dollars (paid losses plus case reserves). The weights assigned to the initial expected losses decrease as the accident year matures.
The use of case incurred losses instead of paid losses can result in development patterns that are less variable than paid patterns. However, the inclusion of case reserves can lead to distortions if changes in case reserving have taken place, and the method requires analysis of all the factors that need to be reviewed for the expected loss ratio and incurred development methods.
Initial Expected Loss Method. This method is used directly, and as an input to the Bornhuetter-Ferguson methods. Initial expected losses for an accident year are based on adjusting prior accident year projections to the current accident year levels using underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments specific to the line of business.
This method may be useful if loss development patterns are inconsistent, losses emerge very slowly, or there is relatively little loss history from which to estimate future losses. The selection of the expected loss ratio requires analysis of loss ratios from earlier accident years or pricing studies and analysis of inflationary trends, frequency trends, rate changes, underwriting changes, and other applicable factors.
Paid Roll-forward Method. This method adjusts prior estimates of ultimate losses based on the actual paid loss emergence in the quarter compared to the expected emergence. It is useful in determining reserves that avoid overreacting to ordinary fluctuations in the development patterns.
Incurred Roll-forward Method. This method adjusts prior estimates of ultimate losses based on the actual case incurred loss emergence in the quarter compared to the expected emergence. It may also be useful in determining reserves that avoid overreacting to ordinary fluctuations in the development patterns and generally reacts faster than the paid roll-forward method.
Claims for short-tail lines of business settle more quickly than long-tail lines of business, and in general, loss development factors for short-tail lines are smaller than long-tail lines. For long-tail lines, we tend to rely on initial expected loss methods throughout the current accident year then move to development factor based methods for older accident years. Development methods on short-tail lines are generally reliable in the third and fourth quarter of the initial accident year and recorded loss ratios reflect a blend of the development and forecast methods. Short-tail lines represent two percent of our total reserves at December 31, 2007.
The reserve categories where the above methods are not applicable are few. The largest of these is our workers’ compensation residual market reserve category, where we utilize detailed reserve analyses performed by the industry statistical agency NCCI in making our estimates. We adjust these estimates for timing differences in the reporting of the data. The other reserve categories that deviate from the above methods are smaller; as a group constituting less than three percent of the total reserves.
Each of the methods listed above requires the selection and application of parameters and assumptions. For all but the initial expected loss method, the key assumptions are the patterns with which our aggregate claims data will be paid or will emerge over time (“development patterns”). These patterns incorporate inherent assumptions of claims cost inflation rates and trends in the frequency of claims, both overall and by severity of claim. These are affected by underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments which are explicit key assumptions underlying the initial expected loss method. Each of these key assumptions is discussed in the following paragraphs.
To analyze the development patterns, we compile, to the extent available, long-term and short-term historical data for our insurance subsidiaries, organized in a manner which provides an indication of the historical development patterns. To the extent that the historical data may provide insufficient information about future patterns — whether due to environmental changes such as legislation or due to the small volume or short history of data for some segments of our business — benchmarks based on industry data, and forecasts
37
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
made by industry rating bureaus regarding the effect of legislative benefit changes on such patterns, may be used to supplement, adjust, or replace patterns based on our insurance companies’ historical data.
Actuarial judgment is required in selecting the patterns to apply to each segment of data being analyzed, and our views regarding current and future claim patterns are among the factors that enter into our establishment of the losses and LAE reserves at each balance sheet date. When short-term averages or external rate bureau analyses indicate the claims patterns are changing from historical company or industry patterns, the new or forecasted information typically is factored into the methodologies. When new claims emergence or payment patterns have appeared in the actual data repeatedly over multiple evaluations, those new patterns are given greater weight in the selection process.
Because some claims are paid over many years, the selection of claim emergence and payment patterns involves judgmentally estimating the manner in which recently occurring claims will develop for many years and at times, decades in the future. When it is likely the actual development will occur in the distant future, the potential for actual development to differ substantially from historical patterns or current projections is increased.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. In particular, the development factor based methods all have as a key assumption that the development of losses in the future will follow a pattern similar to those measured by past experience and as adjusted either explicitly or by actuarial judgment. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple and varied factors. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the years ended December 31, 2007 and 2006.
Variability of Claim Reserve Estimates
By its nature, the estimate of ultimate loss and LAE is subject to variability due to differences between our assumptions and actual events in the future. Although many factors influence the actual cost of claims and our corresponding reserve estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors known to impact the cost of claims cannot be measured directly, such as the impact on claim costs due to economic inflation, coverage interpretations and jury determinations. In most instances, we rely on our historical experience or industry information to estimate the values for the variables that are explicitly used in our reserve analyses. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of the future effects of these factors. Where we have reason to expect a change in the effect of one of these factors, we perform analyses to perform the necessary adjustments.
One implicit assumption underlying development patterns is that the claims inflation trends will continue into the future similar to their past patterns. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, the actuarial department derived expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2007 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. General inflation trends have been fairly stable over the past several years but there have been fluctuations of one to two percent over the past ten years and therefore we used a one percent annual inflation variance factor. The effect differed by line of business but overall was a three percent change in reserve adequacy or approximately $6.8 million effect on after tax net income. A variance of this type would
38
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.
An explicit assumption used in the analysis is the set of initial expected loss ratios (“IELRs”) used in the current accident year reserve projections and in some of the prior accident year ultimate loss indications. To estimate the sensitivity of the estimated ultimate loss to a change in IELRs, the actuarial department recasted the loss reserve indications using a set of IELRs all one percent higher than the final IELRs. The effect differed by line of business but overall was less than a one percent change in reserve adequacy or a $2.2 million effect on after tax net income. Often the loss ratios by line of business will vary from the IELR in different directions causing them to partially offset each other. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.
The other factors having influence upon the loss and LAE reserve levels are too numerous and interdependent to efficiently model and test for sensitivity. Likewise, the development factors by reserve category and age are too numerous to model and test for sensitivity. Instead, ranges are estimated by reserve category considering past history, fluctuations in the development patterns, emerging issues, trends and other factors. The ranges are compiled and the total range is estimated considering the sensitivity to all of the underlying factors together. The resulting range is our best estimate of the expected ongoing variability in the loss reserves.
Historic development as shown within the“Analysis of Loss and Loss Adjustment Expense Development”table has been three percent or less in the last two years but was ten to thirty-three percent in the years prior to the underwriting and reserving shift in 2002. At that time, we concentrated our efforts on eliminating underwriting relationships where we had substantial liabilities above an aggregate exposure retained by risk sharing associations and captives. For a large share of our business, we also accelerated the pace at which we brought the claim administration to our employees and away from outside third party administrators. This enabled us to rapidly recognize trends and underlying loss patterns, while being able to quickly set more accurate reserves.
Our range of estimates table shows that presently we evaluate it as going from favorable development of 7.8% to unfavorable of 6.1%. The range was evaluated based on the ultimate loss estimates from the actuarial methods described above.
Pre-tax Impact on Earnings from a Variance in Future Loss Payments and Case Reserves as of December 31, 2007 | ||||||||||||||||
(in thousands) | ||||||||||||||||
Line of Business | Minimum Reserve Range | Maximum Reserve Range | ||||||||||||||
Workers’ Compensation (including Residual Markets) | $ | (10,959 | ) | (6.6 | )% | $ | 5,672 | 3.4 | % | |||||||
Commercial Multiple Peril/General Liability | (8,894 | ) | (10.1 | )% | 9,694 | 11.0 | % | |||||||||
Commercial Automobile | (4,892 | ) | (7.0 | )% | 3,116 | 4.5 | % | |||||||||
Other | (2,057 | ) | (11.7 | )% | 2,368 | 13.5 | % | |||||||||
Total | $ | (26,802 | ) | (7.8 | )% | $ | 20,850 | 6.1 | % | |||||||
The sensitivity around our workers’ compensation reserves primarily reflects the size and the maturity of the underlying book of business. Our workers’ compensation reserves represent 49% percent of our total reserves at December 31, 2007. Workers’ compensation was our first line of business and is still our largest.
The sensitivity around our commercial multiple peril/general liability reserves primarily reflects the longer duration of reserves relating to our liability excess program which started in 2003 and currently represents 49% of the $87.8 million reserves in this line of business, as of December 31, 2007.
39
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
The sensitivity around our commercial automobile reserves primarily reflects the speed of reporting of the underlying losses, as well as the maturity of the case law surrounding automobile liability.
The sensitivity around the other lines of business primarily reflects the size of the underlying book of business. Our other reserves represent 5% of total reserves at December 31, 2007. The majority of these reserves represent professional liability programs which tend to be claims-made and reinsured at lower limits, therefore reducing the volatility that is inherent in a smaller book of business.
All of our reserves are sensitive to changes in the underlying claim payment and case reserving practices, as well as the other sources of variations mentioned above.
Reinsurance Recoverables
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR losses and LAE. Such recoverables, by necessity, are based upon estimates. Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded. Instead of being netted against the appropriate liabilities, ceded unearned premiums and reinsurance recoverables on paid and unpaid losses and LAE are reported separately as assets in our consolidated balance sheets. Reinsurance recoverable balances are also subject to credit risk associated with the particular reinsurer. In our selection of reinsurers, we continually evaluate their financial stability. While we believe our reinsurance recoverables are collectible, the ultimate recoverable may be greater or less than the amount accrued. At December 31, 2007 and 2006, reinsurance recoverables on paid and unpaid losses were $199.5 million and $202.7 million, respectively.
In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive,rent-a-captive, large deductible programs, indemnification agreements, or on the portion of risk either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. We collateralize balances due from our risk-sharing partners through funds withheld trusts or stand-by letters of credit issued by highly rated banks. We have historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which may be in dispute. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. At December 31, 2007, we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of any of our risk-sharing partners to meet their obligations.
Investments and Other Than Temporary Impairments of Securities and Unrealized Losses on Investments
Our investment securities are classified as available for sale. Investments classified as available for sale are available to be sold in the future in response to our liquidity needs, changes in market interest rates, tax strategies and asset-liability management strategies, among other reasons. Available for sale securities are reported at fair value, with unrealized gains and losses reported in the accumulated other comprehensive income component of shareholders’ equity, net of deferred taxes and, accordingly, have no effect on net income. However, if there is a decline in the fair value of an investment below its cost and the decline is considered other than temporary, the amount of decline below cost is charged to earnings.
Our investment portfolio is primarily invested in debt securities classified as available for sale, with a concentration in fixed income securities of a high quality. Our investment philosophy is to maximize after-tax earnings and maintain significant investments in tax-exempt bonds. Our policy for the valuation of temporarily
40
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
impaired securities is to determine impairment based on analysis of, but not limited to, the following factors: (1) rating downgrade or other credit event (e.g., failure to pay interest when due); (2) financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology or discontinuance of a business segment; (3) prospects for the issuer’s industry segment; and (4) intent and ability to retain the investment for a period of time sufficient to allow for anticipated recovery in market value. We evaluate our investments in securities to determine other than temporary impairment, no less than quarterly. Investments that are deemed other than temporarily impaired are written down to their estimated net fair value and the related losses recognized in income. There were no impaired investments written down in 2007, 2006, and 2005. There can be no assurance, however, that significant changes in the above factors in relation to our investment portfolio, will not result in future impairment charges.
Our investment portfolio includes investments in mortgage-backed and agency-backed securities, however we do not have any direct exposure to anysub-prime risks. Our asset-backed securities sector comprises only 4.2%, or $26.6 million of our investment portfolio. Within this sector, $2.8 million relates to home equity loans, of which $1.2 million is insured. The remaining $23.8 million primarily relates to credit cards, auto loans, and utility and equipment loans. These asset-backed securities are adequately collateralized, AAA- rated investment quality that we currently expect will continue to perform. Our mortgage-backed securities have no exposure to anysub-prime risks.
At December 31, 2007 and 2006, we had 160 and 293 securities that were in an unrealized loss position, respectively. These investments all had unrealized losses of less than ten percent. At December 31, 2007, 128 of those investments, with an aggregate $122.2 million and $1.3 million fair value and unrealized loss, respectively, have been in an unrealized loss position for more than eighteen months. At December 31, 2006, 128 of those investments, with an aggregate $127.3 million and $3.1 million fair value and unrealized loss, respectively, have been in an unrealized loss position for more than eighteen months. As of December 31, 2007 and 2006, gross unrealized losses on available for sale securities were $1.9 million and $5.1 million, respectively.
Revenue Recognition
We recognize premiums written as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written that are applicable to the unexpired terms of an in force policy. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received and actuarial estimates.
For the year ending December 31, 2007, total assumed written premiums were $39.2 million, of which $31.0 million, relates to assumed business we manage directly, and therefore, no estimation is involved. The remaining $8.2 million of assumed written premiums includes $6.9 million related to residual markets.
Assumed premium estimates are specifically related to the mandatory assumed pool business from the NCCI, or residual market business. The pools cede workers’ compensation business to participating companies based upon the individual company’s market share by state. The activity is reported from the NCCI to participating companies on a two quarter lag. To accommodate this lag, we estimate premium and loss activity based on historical and market based results. Historically, we have not experienced any material difficulties or disputes in collecting balances from NCCI; and therefore, no provision for doubtful accounts is recorded related to the assumed premium estimate.
In addition, certain premiums are subject to retrospective premium adjustments. Premium is recognized over the term of the insurance contract.
Fee income, which includes risk management consulting, loss control, and claims administration services, is recognized in the period the services are provided. Claims processing fees are recognized as revenue over
41
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
the estimated life of the claims, or the estimated life of the contract. For those contracts that provide services beyond the contractually defined termination date of the related contracts, fees are deferred in an amount equal to an estimate of our obligation to continue to provide services.
Commission income, which includes reinsurance placement, is recorded on the later of the effective date or the billing date of the policies on which they were earned. Commission income is reported net of anysub-producer commission expense. Any commission adjustments that occur subsequent to the earnings process are recognized upon notification from the insurance companies. Profit sharing commissions from insurance companies are recognized when determinable, which is when such commissions are received.
We review, on an ongoing basis, the collectibility of our receivables and establish an allowance for estimated uncollectible accounts. As of December 31, 2007 and 2006, the allowance for uncollectibles on receivables was $2.7 million and $2.9 million, respectively.
Legal Contingencies
We are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, we vigorously defend such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, we have established provisions against these items, which are believed to be adequate in light of current information and legal advice. In accordance with SFAS No. 5,“Accounting for Contingencies,”if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is estimable, an accrual is provided for the costs to resolve these claims in our consolidated financial statements. Period expenses related to the defense of such claims are included in other operating expenses in the accompanying consolidated statements of income. We, with the assistance of outside counsel, adjust such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, we do not expect the outcome of the claims, lawsuits and proceedings to which we are subject to, either individually, or in the aggregate, will have a material adverse effect on our financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters.
Goodwill
Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. As required by SFAS No. 142“Goodwill and Other Intangible Assets,”we no longer amortize goodwill and, at least annually, we test all existing goodwill for impairment using a fair value approach, on a reporting unit basis. Our annual assessment date for goodwill impairment testing is October 1st. We test for impairment more frequently if events or changes in circumstances indicate that there may be an impairment to goodwill. We carry goodwill on two reporting units within the agency operations segment in the amount of $6.5 million and three reporting units within the specialty risk management operations segment in the amount of $37.0 million. Based on our most recent evaluation of goodwill impairment, we determined that no impairment to goodwill exists.
42
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Results of Operations
Executive Overview
Our overall results in 2007 continued to reflect growth of net income in comparison to prior year. These improvements reflect our commitment to selective growth, as well as our adherence to strict corporate underwriting guidelines and price adequacy. We continue to maintain strong underwriting discipline and growth within our profitable programs. Our generally accepted accounting principles (“GAAP”) combined ratio improved 1.4 percentage points to 95.4% in 2007 from 96.8% in 2006. We also continue to experience solid growth in our fee-based operations. Net operating income, excluding amortization, increased 32.1% to $29.8 million, or $0.90 per diluted share, compared to $22.6 million, or $0.76 per diluted share in 2006.
Gross written premium increased $15.6 million, or 4.7%, to $346.5 million in 2007, compared to $330.9 million in 2006. Our existing underwritten business, which excludes residual market premium, was up $18.8 million, or 5.9% in comparison to 2006. This growth included business from new programs implemented in 2006. The growth in existing business was slightly offset by a reduction in residual market premiums that are assigned to us as a result of a decrease in the estimate of the overall size of the residual market.
We continue to follow pricing guidelines mandated by our corporate underwriting guidelines. Overall, ouryear-to-date rate change was down 1.7%, compared to industry average price decreases of approximately 15%. We anticipate that rates will continue to remain slightly down into 2008. We continue to be selective on new program implementation by focusing only on those programs that meet our underwriting guidelines and have a proven history of profitability. Our statutory surplus increased by $23.3 million in 2007 to $188.4 million, from $165.1 million in 2006. Currently, our earned surplus is $33.7 million, which represents our ability to dividend from the Insurance Company Subsidiaries to our holding company for capital strategies, such as acquisitions, dividends, debt repayments, and share repurchases.
In April 2007, we received an upgrade of our financial strength rating by A.M. Best Company to “A−” (Excellent), from “B++” (Very Good) for our Insurance Company Subsidiaries. This rating upgrade validates our commitment to create value through excellent underwriting and consistent operating performance. We are continuing to implement new insurance programs as a result of this upgrade from A.M. Best and other business development strategies. We have a comprehensive due diligence process that incorporates an entity wide risk analysis, as well as an operational review. While this process can be lengthy, we believe the initial work leads to long term relationships with solid longer term favorable underwriting performance. We believe we are in a good position to achieve our top-line and bottom-line growth objectives in 2008. In addition, subsequent to the A.M. Best upgrade, we have renewed policies formerly written on a fronted basis by a non-affiliated insurance company and assumed by our Insurance Company Subsidiaries in exchange for a 5.5% fronting fee. As this renewal process continues and we earn the premium previously fronted, we expect to see this reduction in cost reflected within our expense ratio.
In April 2007, we purchased certain business assets of U.S. Specialty Underwriters, Inc. (“USSU”) for a purchase price of $23.0 million. This purchase price was comprised of $13.0 million in cash and $10.0 million in our common stock. USSU is based in Cleveland, Ohio, and is a specialty program manager that produces fee based income by underwriting excess workers’ compensation coverage for a select group of insurance companies. The total shares issued for the $10.0 million portion of the purchase price was 907,935 shares. Under the terms of the Agreement, we acquired the excess workers’ compensation business and other related assets. In addition, we entered into a Management Agreement with the shareholders of USSU. Under the terms and conditions of the Management Agreement, the shareholders were responsible for certain aspects of the administration and management of the acquired business. The shareholders’ consideration for the performance of their duties was in the form of a Management Fee payable by us based on a share of net income before interest, taxes, depreciation, and amortization. In addition, we retained the option to terminate the Management Agreement, at our discretion, based on a multiple of the Management Fee calculated for the trailing twelve
43
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
months. On January 31, 2008, we exercised our option to purchase the remainder of the economics related to the acquisition of the USSU business, by eliminating the Management Agreement for a payment of $21.5 million, which now completes the transaction.
In July 2007, we completed an offering of 6,437,500 additional shares of newly issued common stock at $9.65 per share. The gross proceeds of the offering were $62.1 million. The net proceeds were $58.6 million. The net proceeds from the offering are being utilized to support organic growth within our underwriting operations, to fund select acquisitions and for other general corporate purposes. Upon receipt of the net proceeds, we reduced our outstanding line of credit balance from $22.0 million to zero.
On February 8, 2008, our Board of Directors declared a quarterly dividend of $0.02 per common share. This is the first quarterly dividend since the third quarter of 2001. Our Board of Directors determined that reinstating the dividend best serves shareholder interests by creating long-term value and is part of our capital management strategy.
On February 20, 2008, we executed a definitive merger agreement with ProCentury Corporation (“ProCentury”) for a merger transaction valued at approximately $272.6 million in cash and stock to be paid to ProCentury shareholders. The combined entity will adopt and operate under the Meadowbrook name and will continue to trade on the NYSE under the ticker symbol “MIG”. Our Chief Executive Officer, Robert S. Cubbin, will continue in his current role in the post-merger combined entity and two ProCentury board members are expected to join Meadowbrook’s Board of Directors.
The merger is expected to expand and complement our specialty lines capabilities with ProCentury’s insurance professionals and product expertise in the excess and surplus lines market. We believe there are significant profitable revenue growth opportunities, as well as cost savings opportunities.
We expect to finance the cash portion of the purchase price through a combination of cash and debt. Completion of the transaction is subject to various closing conditions, including the receipt of required regulatory and shareholder approval. We expect to complete the merger in the third quarter of 2008.
2007 compared to 2006:
Net income improved $6.0 million, or 27.0%, to $28.0 million, or $0.85 per diluted share, in 2007, from net income of $22.0 million, or $0.75 per diluted share, in 2006. This improvement primarily reflects growth in underwriting profits and an increase in net investment income. Net investment income increased primarily from an overall increase in average invested assets. Improvements in our overall underwriting results reflect continued favorable development on prior year losses and a slight reduction in the expense ratio. These improvements were partially offset by amortization of intangibles and interest expense associated with our acquisition of the USSU business.
Revenues increased $22.5 million, or 7.1%, to $340.7 million for the year ended December 31, 2007, from $318.2 million for the comparable period in 2006. This increase reflects a $13.3 million, or 5.2%, increase in net earned premiums. The increase in net earned premiums was the result of selective growth consistent with our corporate underwriting guidelines and our controls over price adequacy, partially offset by a reduction in residual market premiums that are assigned to us as a result of a decrease in the estimate of the overall size of the residual market. The increase in revenue was also due to an overall increase infee-for-service revenue, primarily as a result of our acquisition of the USSU business. Total fees received in 2007 as a result of this acquisition were $5.5 million. In addition, the increase in revenue reflects a $4.3 million increase in investment income, primarily the result of overall positive cash flow, a slight increase in yield and to a lesser extent the cash received from our equity offering in July 2007.
44
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
2006 compared to 2005:
Net income improved $4.1 million, or 23.0%, to $22.0 million, or $0.75 per diluted share, in 2006, from net income of $17.9 million, or $0.60 per diluted share, in 2005. This improvement was primarily the result of our selective growth consistent with our corporate underwriting guidelines and our controls over price adequacy. In addition, during 2005 we increased our retention levels on certain reinsurance treaties, which favorably impacted net earned premiums and net income for 2006, compared to 2005. Growth in ourfee-for-service programs also contributed to the overall improvement in net income in comparison to 2005.
Revenues increased $14.2 million, or 4.7%, to $318.2 million for the year ended December 31, 2006, from $304.0 million for the comparable period in 2005. This increase reflects a $4.9 million, or 2.0%, increase in net earned premiums. The increase in net earned premiums was the result of our selective growth consistent with our corporate underwriting guidelines and our controls over price adequacy, as well as the favorable impact from an increase in our retention levels on certain reinsurance treaties effective in 2005. Offsetting the overall increase in net earned premiums for the year ended December 31, 2006, was a reduction in audit related premiums in comparison to 2005. The increase in revenue was also the result of an overall increase infee-for-service revenue, primarily as a result of new managed programs. In addition, the increase in revenue reflects a $4.1 million increase in investment income, primarily due to an increase in average invested assets as a result of improved cashflow from favorable underwriting results, an increase in the duration of our reserves, and proceeds from the junior subordinated debentures issued in the third quarter of 2005. The increase in investment income was also the result of a slight increase in yield.
Specialty Risk Management Operations
The following table sets forth the revenues and results from operations for our specialty risk management operations (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Revenue: | ||||||||||||
Net earned premiums | $ | 268,197 | $ | 254,920 | $ | 249,959 | ||||||
Management fees | 23,963 | 18,714 | 16,741 | |||||||||
Claims fees | 9,025 | 8,776 | 7,113 | |||||||||
Loss control fees | 2,151 | 2,216 | 2,260 | |||||||||
Reinsurance placement | 929 | 735 | 660 | |||||||||
Investment income | 25,487 | 21,115 | 17,692 | |||||||||
Net realized gains | 150 | 69 | 85 | |||||||||
Total revenue | $ | 329,902 | $ | 306,545 | $ | 294,510 | ||||||
Pre-tax income Specialty risk management operations | $ | 47,898 | $ | 38,292 | $ | 29,546 |
2007 compared to 2006:
Revenues from specialty risk management operations increased $23.4 million, or 7.6%, to $329.9 million for the year ended December 31, 2007, from $306.5 million for the comparable period in 2006.
Net earned premiums increased $13.3 million, or 5.2%, to $268.2 million for the year ended December 31, 2007, from $254.9 million in the comparable period in 2006. As previously indicated, this increase was the result of selective growth consistent with our corporate underwriting guidelines and our controls over price adequacy, partially offset by the reduction in residual market premiums and mandatory rate decreases in the Nevada, Florida and Massachusetts workers’ compensation lines of business.
45
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Management fees increased $5.3 million, or 28.0%, to $24.0 million, for the year ended December 31, 2007, from $18.7 million for the comparable period in 2006. This increase was related to fees received as a result of our acquisition of the USSU business. Total fees received in 2007 as a result of the USSU acquisition were $5.5 million. Slightly offsetting these fees was a slight decrease in fees in our Northeast operations. This decrease in fees primarily related to a decrease in premium volume due to reduced rates in the self-insured markets on which the fees are based, because of mandatory rate reductions and an increase in competition.
Claim fees remained relatively flat for 2007 compared to 2006.
Net investment income increased $4.4 million, or 20.7%, to $25.5 million in 2007, from $21.1 million in 2006. Average invested assets increased $79.2 million, or 16.0%, to $573.1 million in 2007, from $493.9 million in 2006. The increase in average invested assets primarily relates to the cash flows from operations, resulting from continued favorable underwriting results, increased fee revenue, and the lengthening of the duration of our reserves. The increase in the duration of our reserves reflects the impact of growth in our excess liability business, which was implemented at the end of 2003. This type of business has a longer duration than the average reserves on our other programs and is now a larger proportion of reserves. In addition, the increase in average invested assets reflects cash flows from our equity offering in July. The invested proceeds from the equity offering added approximately $600,000 to the overall net investment income for the year. The average investment yield for 2007 was 4.61%, compared to 4.47% in 2006. The current pre-tax book yield was 4.5%. The current after-tax book yield was 3.41%, compared to 3.28% in 2006. This increase is primarily the result of the increase in market interest rates, and the purchase of assets of longer duration to take advantage of higher yields. The duration of the investment portfolio is 4.3 years at December 31, 2007, compared to 3.9 years at December 31, 2006.
Specialty risk management operations generated pre-tax income of $47.9 million for the year ended December 31, 2007, compared to pre-tax income of $38.3 million for the year ended December 31, 2006. This increase in pre-tax income primarily reflects expansion of cash margins on our fee revenue, an increase in net investment income, increased underwriting profits, favorable development in prior accident year reserves, and a slightly lower expense ratio. The GAAP combined ratio was 95.4% for the year ended December 31, 2007, compared to 96.8% for the comparable period in 2006.
Net losses and loss adjustment expenses (“LAE”) increased $4.7 million, or 3.2%, to $151.0 million for the year ended December 31, 2007, from $146.3 million for the same period in 2006. Our loss and LAE ratio improved 1.1 percentage points to 61.2% for the year ended December 31, 2007, from 62.3% for the same period in 2006. This ratio is the unconsolidated net loss and LAE in relation to net earned premiums. This improvement reflects the impact of overall favorable development on prior accident year reserves of 1.5 percentage points from the December 31, 2006 reserves. The improvement was primarily within the workers’ compensation and professional liability lines of business, partially offset by an increase in the ultimate loss projections within the general liability line of business. The unfavorable development within the general liability line of business reflects a claim reserving process change for an excess liability program. Additional discussion of our reserve activity is described below within theOther Items — Reservessection.
Our expense ratio for the year ended December 31, 2007 was 34.2%, compared to 34.5% in 2006. This ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premiums.
2006 compared to 2005:
Revenues from specialty risk management operations increased $12.0 million, or 4.1%, to $306.5 million for the year ended December 31, 2006, from $294.5 million for the comparable period in 2005.
Net earned premiums increased $4.9 million, or 2.0%, to $254.9 million for the year ended December 31, 2006, from $250.0 million in the comparable period in 2005. This increase was primarily the result of selective
46
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
growth consistent with our corporate underwriting guidelines and our controls over price adequacy, as well as the favorable impact from an increase in our retention levels on certain reinsurance treaties. Offsetting these increases was an overall decrease in audit related premiums in comparison to 2005, reflecting improvements in the estimation of exposures during the underwriting cycle.
Management fees increased $2.0 million, or 11.8%, to $18.7 million, for the year ended December 31, 2006, from $16.7 million for the comparable period in 2005. This increase was primarily the result of a Florida-based program implemented in the second quarter of 2005. In addition, this increase was the result of growth in a specific New England-based program. Also contributing to the overall increase in management fees was the recognition of $250,000 from a profit-based revenue sharing payment related to a specific managed program.
Claim fees increased $1.7 million, or 23.4%, to $8.8 million, from $7.1 million for the comparable period in 2005. This increase was primarily the result of our 2006 entry into the self-insured workers’ compensation market in Nevada. In addition, this increase was the result of increases in revenue related to a specific Minnesota-based program, as well as a Florida-based program, which was implemented in the second quarter of 2005.
Net investment income increased $4.1 million, or 22.8%, to $22.1 million in 2006, from $18.0 million in 2005. Average invested assets increased $69.6 million, or 16.4%, to $493.9 million in 2006, from $424.3 million in 2005. The increase in average invested assets reflects cash flows from underwriting activities primarily from favorable underwriting results and an increase in the duration of our reserves. The increase in the duration of our reserves reflects the impact of our public entity excess program, which was implemented at the end of 2003. This program has a longer duration than the average reserves on our remaining programs and is a larger proportion of reserves. In addition, the $19.4 million in net proceeds received from capital raised in 2005 through the issuances of debentures increased average invested assets. The average investment yield for 2006 was 4.47%, compared to 4.24% in 2005. The current pre-tax book yield was 4.35%. The current after-tax book yield was 3.28%, compared to 3.06% in 2005. This increase is primarily the result of the shift in our investment portfolio to tax-exempt investments. The duration of the investment portfolio is 3.9 years.
Specialty risk management operations generated pre-tax income of $38.3 million for the year ended December 31, 2006, compared to pre-tax income of $29.5 million for the year ended December 31, 2005. This increase in pre-tax income demonstrates a continued improvement in underwriting results as a result of our controlled growth in premium volume and our continued focus on leveraging of fixed costs. The GAAP combined ratio was 96.8% for the year ended December 31, 2006, compared to 98.7% for the comparable period in 2005.
Net losses and loss adjustment expenses (“LAE”) decreased $5.2 million, or 3.5%, to $146.3 million for the year ended December 31, 2006, from $151.5 million for the same period in 2005. Our loss and LAE ratio improved 2.9 percentage points to 62.3% for the year ended December 31, 2006, from 65.2% for the same period in 2005. This ratio is the unconsolidated net loss and LAE in relation to net earned premiums. The accident year loss ratio remained flat at 63.4% for 2006, compared to 63.3% in 2005. The favorable development in our loss ratio was primarily the result of improvement in frequency and claim settlements within the professional liability line of business. In addition, workers’ compensation residual market experience improved as a result of lower market share assessments and lower loss reserves on the industry pooled experience. Both 2006 and 2005, were adversely impacted by a single large workers’ compensation claim. The increase was $1.5 million and $900,000 in 2006 and 2005, respectively. Excluding the adverse impact of this claim, overall workers’ compensation reflected improvement in claim settlements relative to their collective case reserves. The experience within the general liability line of business also improved due to favorable case reserve settlements in 2006, in comparison to 2005. These improvements were partially offset by a single property claim of $1.9 million within a California-based agricultural program. Allowances within other reserve categories, collectively, did not contribute to the development in 2006, compared to 2005 where
47
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
we experienced approximately $1.3 million in adverse development related to allowances on reinsurance recoverables.
Our expense ratio for the year ended December 31, 2006 was 34.5%, compared to 33.5% in 2005. This ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premiums. The increase in our expense ratio in comparison to 2005 reflects a reduction in an accrual for estimated profit-based ceding commissions on an excess reinsurance treaty for a specific commercial transportation program. This decrease was the result of unfavorable loss development on a limited number of excess of loss claims from prior accident years and added $1.6 million to our expenses, or 0.6 percentage points to our expense ratio for the year, as compared to a favorable impact on the 2005 expense ratio of $1.1 million, or 0.5 percentage points. As of December 31, 2006, the remaining accrual was less than $150,000; therefore, we do not anticipate any further unfavorable adjustments. Offsetting this increase in the expense ratio was a reduction in insurance related assessments primarily related to the guaranty fund in Florida and Nevada.
Agency Operations
The following table sets forth the revenues and results from operations from our agency operations (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Net commission | $ | 11,316 | $ | 12,285 | $ | 11,304 | ||||||
Pre-tax income(1) | $ | 2,087 | $ | 2,609 | $ | 3,241 |
(1) | Our agency operations include an allocation of corporate overhead, which includes expenses associated with accounting, information services, legal, and other corporate services. The corporate overhead allocation excludes those expenses specific to the holding company. For the years ended December 31, 2007, 2006, and 2005, the allocation of corporate overhead to the agency operations segment was $2.8 million, $3.3 million, and $3.2 million, respectively. These balances include an allocation to our Insurance & Benefit Consultants agency business that was previously allocated to specialty risk management operations. For the years ended December 31, 2006 and 2005, pre-tax income for agency operations was overstated and specialty risk management was understated by $342,000 and $102,000, respectively. |
2007 compared to 2006:
Revenue from agency operations, which consists primarily of agency commission revenue, decreased $969,000, or 7.9%, to $11.3 million for the year ended December 31, 2007, from $12.3 million for the comparable period in 2006. This decrease was primarily the result of a reduction in premium on client renewals due to a more competitive pricing environment primarily on larger Michigan accounts.
Agency operations generated pre-tax income, after the allocation of corporate overhead, of $2.1 million for the year ended December 31, 2007, compared to $2.6 million for the comparable period in 2006. The decrease in the pre-tax income was primarily attributable to the decrease in agency commission revenue mentioned above.
2006 compared to 2005:
Revenue from agency operations, which consists primarily of agency commission revenue, increased $1.0 million, or 8.7%, to $12.3 million for the year ended December 31, 2006, from $11.3 million for the comparable period in 2005. This increase was primarily the result of the November 2005 acquisition of a Florida-based retail agency and an increase in profit sharing commissions in comparison to 2005. Offsetting these increases was a decrease in commission revenue as a result of a reduction in premium on client renewals due to a more competitive pricing environment.
48
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Agency operations generated pre-tax income, after the allocation of corporate overhead, of $2.6 million for the year ended December 31, 2006, compared to $3.2 million for the comparable period in 2005. This decrease in pre-tax income in comparison to 2005 was primarily the result of a slight increase in operating expenses coupled with the decrease in commission revenue, as noted above, offset by the favorable impact from the Florida-based retail agency acquisition.
Other Items
Reserves
At December 31, 2007, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $341.5 million. We established a reasonable range of reserves of approximately $314.7 million to $362.4 million. This range was established primarily by considering the various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business (in thousands):
Minimum Reserve | Maximum Reserve | |||||||||||
Line of Business | Range | Range | Selected Reserves | |||||||||
Workers’ Compensation(1) | $ | 155,828 | $ | 172,459 | $ | 166,787 | ||||||
Commercial Multiple Peril / General Liability | 78,918 | 97,506 | 87,812 | |||||||||
Commercial Automobile | 64,534 | 72,542 | 69,426 | |||||||||
Other | 15,459 | 19,884 | 17,516 | |||||||||
Total Net Reserves | $ | 314,739 | $ | 362,391 | $ | 341,541 | ||||||
(1) | Includes Residual Markets |
Reserves are reviewed by our internal actuaries for adequacy on a quarterly basis. When reviewing reserves, we analyze historical data and estimate the impact of numerous factors such as (1) per claim information; (2) industry and our historical loss experience; (3) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (4) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple factors.
The key assumptions used in our selection of ultimate reserves included the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the years ended December 31, 2007, 2006, and 2005.
For the year ended December 31, 2007, we reported a decrease in net ultimate loss estimates for accident years 2006 and prior of $7.1 million, or 2.3% of $302.7 million of net loss and LAE reserves at December 31, 2006. The decrease in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2007 that differed from the projected activity. There were no significant
49
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
changes in the key assumptions utilized in the analysis and calculations of our reserves during 2007 and 2006. The major components of this change in ultimate loss estimates are as follows (in thousands):
Reserves at | Incurred Losses | Paid Losses | Reserves at | |||||||||||||||||||||||||||||
December 31, | Current | Prior | Total | Current | Prior | Total | December 31, | |||||||||||||||||||||||||
Line of Business | 2006 | Year | Years | Incurred | Year | Years | Paid | 2007 | ||||||||||||||||||||||||
Workers’ Compensation | $ | 137,113 | $ | 58,965 | $ | (11,428 | ) | $ | 47,537 | $ | 8,150 | $ | 35,141 | $ | 43,291 | $ | 141,359 | |||||||||||||||
Residual Markets | 26,098 | 9,678 | (3,053 | ) | 6,625 | 3,451 | 3,844 | 7,295 | 25,428 | |||||||||||||||||||||||
Commercial Multiple Peril/General Liability | 63,056 | 28,721 | 12,509 | 41,230 | 683 | 15,791 | 16,474 | 87,812 | ||||||||||||||||||||||||
Commercial Automobile | 54,642 | 45,820 | 847 | 46,667 | 11,691 | 20,192 | 31,883 | 69,426 | ||||||||||||||||||||||||
Other | 21,746 | 14,876 | (5,966 | ) | 8,910 | 6,328 | 6,812 | 13,140 | 17,516 | |||||||||||||||||||||||
Net Reserves | 302,655 | $ | 158,060 | $ | (7,091 | ) | $ | 150,969 | $ | 30,303 | $ | 81,780 | $ | 112,083 | 341,541 | |||||||||||||||||
Reinsurance Recoverable | 198,422 | 198,461 | ||||||||||||||||||||||||||||||
Consolidated | $ | 501,077 | $ | 540,002 | ||||||||||||||||||||||||||||
Re-Estimated | Development | |||||||||||
Reserves at | as a | |||||||||||
Reserves at | December 31, | Percentage of | ||||||||||
December 31, | 2007 | Prior Year | ||||||||||
Line of Business | 2006 | on Prior Years | Reserves | |||||||||
Workers’ Compensation | $ | 137,113 | $ | 125,685 | (8.3 | )% | ||||||
Commercial Multiple Peril/General Liability | 63,056 | 75,565 | 19.8 | % | ||||||||
Commercial Automobile | 54,642 | 55,489 | 1.6 | % | ||||||||
Other | 21,746 | 15,780 | (27.4 | )% | ||||||||
Sub-total | 276,557 | 272,519 | (1.5 | )% | ||||||||
Residual Markets | 26,098 | 23,045 | (11.7 | )% | ||||||||
Total Net Reserves | $ | 302,655 | $ | 295,564 | (2.3 | )% | ||||||
Workers’ Compensation Excluding Residual Markets
The projected net ultimate loss estimate for the workers’ compensation line of business, excluding residual markets, decreased $11.4 million, or 8.3% of net workers’ compensation reserves. This net overall decrease reflects decreases of $1.1 million, $3.8 million, $2.9 million, $557,000, and $1.1 million in accident years 2006, 2005, 2004, 2003, and 2000, respectively. These decreases reflect better than expected experience for many of our workers’ compensation programs, including those in Nevada, Florida, and a multi-state association program. The actual losses on reported claims were less than the prior actuarial projections and, therefore, ultimate loss estimates were reduced. The change in ultimate loss estimates for all other accident years was insignificant.
Commercial Multiple Peril/General Liability
The commercial multiple peril and general liability line of business had an increase in net ultimate loss estimates of $12.5 million, or 19.8% of net commercial multiple peril and general liability reserves. The net increase reflects increases of $2.8 million, $1.6 million, $5.6 million, and $811,000 in the ultimate loss estimates for accident years 2006, 2005, 2004 and 2003, respectively, which were primarily due to larger than
50
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
expected claim emergence in a Florida-based program. The larger than expected claim emergence within this Florida-based program was the result of accelerated claim activity on a handful of incurred losses and greater claims frequency from a claim reserving process change. This may be attributable to more aggressive investigation on possible losses and more dedicated resources on claim handling, resulting in case reserving changes, rather than worsening results. While this program had unfavorable development in prior accident year reserves, the current and inception to date profits remain positive and within our corporate guidelines for return on surplus. The change in ultimate loss estimates for all other accident years was insignificant.
Commercial Automobile
The projected net ultimate loss estimate for the commercial automobile line of business increased $847,000, or 1.6% of net commercial automobile reserves. This net overall increase reflects increases of $2.3 million and $1.5 million in accident years 2005 and 2004, respectively. These increases primarily reflect higher than expected emergence of claim activity in a Southeast-based and West coast-based program. These increases were offset by a decrease of $2.5 million in accident year 2006. The decrease in this accident year reflects favorable development within a West coast-based program and a Southeast-based program. The change in ultimate loss estimates for all other accident years was insignificant.
Other
The projected net ultimate loss estimate for the other lines of business decreased $6.0 million, or 27.4% of net reserves. This net decrease reflects decreases of $1.6 million, $2.2 million, $1.2 million, and $771,000, in the net ultimate loss estimate for accident years 2006, 2005, 2004 and 2003, respectively. These decreases were due to better than expected case reserve development during the calendar year in the professional liability programs. The change in ultimate loss estimates for all other accident years was insignificant.
Residual Markets
The workers’ compensation residual market line of business had a decrease in net ultimate loss estimates of $3.1 million, or 11.7% of net reserves. This decrease reflects reductions of $1.8 million, $958,000, and $490,000 in accident years 2005, 2004 and 2003, respectively. We record loss reserves as reported by the NCCI, plus a provision for the reserves incurred but not yet analyzed and reported to us due to a two quarter lag in reporting. These changes reflect a difference between our estimate of the lag incurred but not reported and the amounts reported by the NCCI in the quarter. The change in ultimate loss estimates for all other accident years was insignificant.
Salaries and Employee Benefits
Salaries and employee benefits increased $1.8 million, or 3.4%, to $56.4 million in 2007, from $54.6 million for the comparable period in 2006. This increase was primarily due to merit increases, our acquisition of the USSU business, and variable compensation attributable to our performance. Overall, our headcount remained flat for 2007.
Salaries and employee benefits increased $3.3 million, or 6.3%, to $54.6 million in 2006, from $51.3 million for the comparable period in 2005. This increase primarily reflects an increase in variable compensation. In addition, this increase was the result of an increase in staffing levels, primarily as a result of the additions of our Florida-based retail agency and our entry into the self-insured workers’ compensation market in Nevada. Excluding those additions, overall staffing levels for 2006 were slightly higher in comparison to 2005.
Additional discussion of our variable compensation plan is described below underVariable Compensation.
51
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Other Administrative Expenses
Other administrative expenses increased $3.5 million, or 12.0%, to $32.3 million in 2007, from $28.8 million in 2006. Other administrative expenses increased in comparison to 2006 as a result of our acquisition of the USSU business, primarily due to the management fee associated with this acquisition. In addition, this increase was the result of information technology initiatives. Offsetting the increases related to the USSU business were decreases related to policyholder dividends, as well as various decreases in other general operating expenses in comparison to 2006.
Other administrative expenses increased $2.0 million, or 7.5%, to $28.8 million in 2006, from $26.8 million in 2005. A portion of this increase was the result of the expenses associated with the additions of our Florida-based agency and our entry into the self-insured workers’ compensation market in Nevada. In addition, the increase in other administrative expenses was the result of information technology enhancements and various increases in other general operating expenses in comparison to 2005.
Salaries and employee benefits and other administrative expenses include both corporate overhead and the holding company expenses included in the non-allocated expenses of our segment information.
Amortization Expense
Amortization expense for 2007, 2006, and 2005 was $1.9 million, $590,000, and $373,000, respectively. Amortization expense per dilutive share for 2007, 2006, and 2005 was $0.06, $0.02, and $0.01, respectively. Amortization expense primarily relates to the customer relationships acquired with the Florida-based agency operation in 2005 and the acquisition of the USSU business in 2007. The increase in amortization expense in 2007 was related to our acquisition of the USSU business.
Interest Expense
Interest expense for 2007, 2006, and 2005 was $6.0 million, $6.0 million, and $3.9 million, respectively. Interest expense is primarily attributable to our debentures, which are described within theLiquidity and Capital Resourcessection of Management’s Discussion and Analysis, as well as our line of credit. Interest expense for 2007 includes interest related to a temporary increase in our line of credit which was associated with borrowings to fund the cash portion of the USSU business acquisition. Upon receipt of the net proceeds from our capital raise in July, we reduced this outstanding balance to zero. The increase in interest expense in 2006, compared to 2005 was related to the issuance of the junior subordinated debentures issued in the third quarter of 2005, as well as an overall increase in the average interest rates.
The average outstanding balance on our line of credit was $8.8 million, $10.6 million, and $9.0 million in 2007, 2006, and 2005, respectively. The average interest rate, excluding our debentures, was approximately 6.7%, 6.5%, and 4.8%, in 2007, 2006, and 2005, respectively.
Income Taxes
Income tax expense, which includes both federal and state taxes, for 2007, 2006 and 2005, was $11.7 million, $9.6 million, and $7.8 million, or 29.8%, 30.5% and 30.2% of income before taxes, respectively. The decrease in our tax rate from 2006 to 2007 primarily reflects a higher level of tax exempt securities in our investment portfolio, slightly offset by a higher level of income within our fee-based operations, which are taxed at a 35% rate. Our tax exempt securities as a percentage of total invested assets were 43.6%, 41.0%, and 29.9% for 2007, 2006, and 2005, respectively.
52
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Liquidity and Capital Resources
Our principal sources of funds, which include both regulated and non-regulated cash flows, are insurance premiums, investment income, proceeds from the maturity and sale of invested assets, risk management fees, and agency commissions. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, other operating expenses, shareholders’ dividends, share repurchases, and debt service. Our regulated sources of funds are insurance premiums, investment income, and proceeds from the maturity and sale of invested assets. These regulated funds are used for the payment of claims, policy acquisition and other underwriting expenses, and taxes relating to the regulated portion of net income. Our non-regulated sources of funds are in the form of commission revenue, outside management fees, and intercompany management fees. Our capital resources include both non-regulated cash flow and excess capital in our Insurance Company Subsidiaries, which is defined as the dividend Star may issue without prior approval from our regulators. We review the excess capital in aggregate to determine the use of such capital. The general uses are as follows, contributions to our Insurance Company Subsidiaries to support premium growth, make select acquisitions, service debt, pay shareholders’ dividends, repurchase shares, investments in technology, or other expenses of the holding company. The following table illustrates net income, excluding interest, depreciation, and amortization, between our regulated and non-regulated subsidiaries, which reconciles to our consolidated statement of income and statement of cash flows (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Net income | $ | 27,992 | $ | 22,034 | $ | 17,910 | ||||||
Regulated Subsidiaries: | ||||||||||||
Net income | $ | 25,595 | $ | 19,712 | $ | 13,508 | ||||||
Adjustments to reconcile net income to net cash provided by operating activities | 696 | 3,033 | 3,003 | |||||||||
Changes in operating assets and liabilities | 55,533 | 46,915 | 59,784 | |||||||||
Total adjustments | 56,229 | 49,948 | 62,787 | |||||||||
Net cash provided by operating activities | $ | 81,824 | $ | 69,660 | $ | 76,295 | ||||||
Non-regulated Subsidiaries: | ||||||||||||
Net income | $ | 2,397 | $ | 2,322 | $ | 4,402 | ||||||
Depreciation | 3,147 | 2,553 | 2,452 | |||||||||
Amortization | 1,930 | 590 | 198 | |||||||||
Interest | 6,030 | 5,976 | 3,856 | |||||||||
Net income, excluding interest, depreciation, and amortization | 13,504 | 11,441 | 10,908 | |||||||||
Adjustments to reconcile net income to net cash provided by operating activities | 5,877 | 3,161 | 4,444 | |||||||||
Changes in operating assets and liabilities | (1,491 | ) | (852 | ) | (3,194 | ) | ||||||
Total adjustments | 4,386 | 2,309 | 1,250 |
53
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Depreciation | (3,147 | ) | (2,553 | ) | (2,452 | ) | ||||||
Amortization | (1,930 | ) | (590 | ) | (198 | ) | ||||||
Interest | (6,030 | ) | (5,976 | ) | (3,856 | ) | ||||||
Net cash provided by operating activities | $ | 6,783 | $ | 4,631 | $ | 5,652 | ||||||
Consolidated total adjustments | 60,615 | 52,257 | 64,037 | |||||||||
Consolidated net cash provided by operating activities | $ | 88,607 | $ | 74,291 | $ | 81,947 | ||||||
Cash flow provided by operations was $88.6 million in 2007, compared to $74.3 million in 2006. Cash flow provided by operations in 2005 was $81.9 million.
2007 compared to 2006:
Regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2007, was $81.8 million, compared to $69.7 million for the comparable period in 2006. This increase is the result of growth in our underwritten business and timing of premium and reinsurance recoverable collections. In addition, an increase in investment income as a result of growth in our investment portfolio contributed to the increase. Partially offsetting these improvements was an increase in payments related to policy acquisition costs and insurance related assessments.
Non-regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2007, was $6.8 million, compared to $4.6 million for the comparable period in 2006. The increase in cash flow from operations is primarily the result of an increase in the collection of commission and fees due to the USSU business acquisition. This increase in cash flow was partially offset by variable compensation payments related to our long-term incentive plan, which were made in the first quarter of 2007 and related to 2006 performance and profitability.
We continue to anticipate a temporary increase in cash outflows related to our investments in technology as we enhance our operating systems and controls. We believe these temporary increases will not affect our liquidity, debt covenants, or other key financial measures.
2006 compared to 2005:
Regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2006, was $69.7 million, compared to $76.3 million for the comparable period in 2005. This decrease was primarily the result of timing in relation to reinsurance payments. This decrease was slightly offset as a result of improved underwriting results, lower paid losses in proportion to incurred losses, and an increase in investment income.
Non-regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2006, was $4.6 million, compared to $5.7 million for the comparable period in 2005. This decrease in cash flow in comparison to 2005 was primarily the result of a decrease in net income. The decrease in net income was primarily attributable to an increase in interest expense related to the issuance of the junior subordinated debentures issued in the third quarter of 2005 and an overall increase in the average interest rates. In addition, the decrease in net income was the result of an increase in administrative costs related to the additions of our Florida-based agency and our entry into the self-insured workers’ compensation market in Nevada, as well as an increase due to information technology enhancements. These increases were offset by an overall increase infee-for-service and agency commission revenue.
54
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Other Items
Long-term Debt
The following table summarizes the principal amounts and variables associated with our long-term debt (in thousands):
Interest | ||||||||||||||||||||
Year of | Year | Rate at | Principal | |||||||||||||||||
Issuance | Description | Callable | Year Due | Interest Rate Terms | 12/31/07 | Amount | ||||||||||||||
2003 | Junior subordinated debentures | 2008 | 2033 | Three-month LIBOR, plus 4.05% | 9.28 | % | $ | 10,310 | ||||||||||||
2004 | Senior debentures | 2009 | 2034 | Three-month LIBOR, plus 4.00% | 8.87 | % | 13,000 | |||||||||||||
2004 | Senior debentures | 2009 | 2034 | Three-month LIBOR, plus 4.20% | 9.23 | % | 12,000 | |||||||||||||
2005 | Junior subordinated debentures | 2010 | 2035 | Three-month LIBOR, plus 3.58% | 8.57 | % | 20,620 | |||||||||||||
Total | $ | 55,930 | ||||||||||||||||||
We received a total of $53.3 million in net proceeds from the issuances of the above long-term debt, of which $26.2 was contributed to the surplus of our Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes. Associated with the issuance of the above long-term debt we incurred approximately $1.7 million in issuance costs for commissions paid to the placement agents in the transactions.
The issuance costs associated with these debentures have been capitalized and are included in other assets on the balance sheet. As of June 30, 2007, these issuance costs were being amortized over a seven year period as a component of interest expense. The seven year amortization period represented management’s best estimate of the estimated useful life of the bonds related to both the senior debentures and junior subordinated debentures. Beginning July 1, 2007, we reevaluated our best estimate and determined a five year amortization period to be a more accurate representation of the estimated useful life. Therefore, this change in amortization period from seven years to five years has been applied prospectively beginning July 1, 2007.
The junior subordinated debentures issued in 2003 and 2005, were issued in conjunction with the issuance of $10.0 million and $20.0 million in mandatory redeemable trust preferred securities to a trust formed by an institutional investor from our unconsolidated subsidiary trusts, respectively.
Since the junior subordinated debentures issued in 2003 are callable in 2008, we will be reviewing the capital strategy associated with refinancing at lower costs through debentures or equity.
Interest Rate Swaps
In October 2005, we entered into two interest rate swap transactions to mitigate our interest rate risk on $5.0 million and $20.0 million of our senior debentures and trust preferred securities, respectively. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedging Activities,”these interest rate swap transactions were recorded at fair value on the balance sheet and the effective portion of the changes in fair value are accounted for within other comprehensive income. The interest differential to be paid or received is accrued and is recognized as an adjustment to interest expense.
The first interest rate swap transaction, which relates to $5.0 million of our $12.0 million issuance of senior debentures, has an effective date of October 6, 2005 and an ending date of May 24, 2009. We are required to make certain quarterly fixed rate payments calculated on a notional amount of $5.0 million,non-amortizing, based on a fixed annual interest rate of 8.925%. The counterparty is obligated to make
55
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
quarterly floating rate payments to us, referencing the same notional amount, based on the three-month LIBOR, plus 4.20%.
The second interest rate swap transaction, which relates to $20.0 million of our $20.0 million issuance of trust preferred securities, has an effective date of October 6, 2005 and ending date of September 16, 2010. We are required to make quarterly fixed rate payments calculated on a notional amount of $20.0 million,non-amortizing, based on a fixed annual interest rate of 8.34%. The counterparty is obligated to make quarterly floating rate payments to us, referencing the same notional amount, based on the three-month LIBOR, plus 3.58%.
In relation to the above interest rate swaps, the net interest income received for the years ended December 31 2007 and 2006, was approximately $172,000 and $67,000, respectively. For the year ended December 31, 2005, the net interest expense incurred was approximately $4,000. The total fair value of the interest rate swaps as of December 31, 2007 and 2006, was approximately ($545,000) and $200,000, respectively. Accumulated other comprehensive income at December 31, 2007 and 2006, included accumulated (loss) income on the cash flow hedge, net of taxes, of approximately ($484,000) and $121,000, respectively.
Revolving Line of Credit
In April 2007, we executed an amendment to our current revolving credit agreement with our bank. The amendments included an extension of the term to September 30, 2010, an increase to the available borrowings of up to $35.0 million, and a reduction of the variable interest rate basis to a range between 75 to 175 basis points above LIBOR. We use the revolving line of credit to meet short-term working capital needs. Under the revolving line of credit, we and certain of our non-regulated subsidiaries pledged security interests in certain property and assets of named subsidiaries.
At December 31, 2007, we did not have an outstanding balance on the revolving line of credit. In July 2007, we completed a secondary equity offering in which we received net proceeds of approximately $58.6 million. Upon receipt of the net proceeds, we reduced our outstanding line of credit balance to zero. At December 31, 2006, we had an outstanding balance of $7.0 million on the revolving line of credit.
The revolving line of credit provides for interest at a variable rate based, at our option, upon either a prime based rate or LIBOR-based rate. In addition, the revolving line of credit also provides for an unused facility fee of 15 basis points on any unused balance. On prime based borrowings, the applicable margin ranges from 75 to 25 basis points below prime. On LIBOR-based borrowings, the applicable margin ranges from 75 to 175 basis points above LIBOR. The margin for all loans is dependent on the sum of non-regulated earnings before interest, taxes, depreciation, amortization, and non-cash impairment charges related to intangible assets for the preceding four quarters, plus dividends paid or payable to us from subsidiaries during such period (“Adjusted EBITDA”). At December 31, 2007, we did not have any LIBOR-based borrowings outstanding. At December 31, 2006, the weighted average interest rate for LIBOR-based borrowings outstanding was 6.7%.
Debt covenants consist of: (1) maintenance of the ratio of Adjusted EBITDA to interest expense of 2.0 to 1.0, (2) minimum net worth of $130.0 million and increasing annually, commencing June 30, 2005, by fifty percent of the prior year’s positive net income, (3) minimum A.M. Best rating of “B”, and (4) on an annual basis, a minimum Risk Based Capital Ratio for Star of 1.75 to 1.00. As of December 31, 2007, we were in compliance with these covenants.
Investment Portfolio
As of December 31, 2007 and 2006, the recorded values of our investment portfolio, including cash and cash equivalents, were $651.6 million and $527.6 million, respectively. The debt securities in the investment
56
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
portfolio, at December 31, 2007, were 97.7% investment grade A− or above bonds as defined by Standard and Poor’s.
While our investment portfolio includes investments in mortgage-backed and agency-backed securities, we do not have any direct exposure to anysub-prime risks. Our asset-backed securities sector comprises only 4.2%, or $26.6 million of our investment portfolio. Within this sector, $2.8 million relates to home equity loans, of which $1.2 million is insured. The remaining $23.8 million primarily relates to credit cards, auto loans, and utility and equipment loans. These asset-backed securities are adequately collateralized, AAA- rated investment quality that we currently expect will continue to perform. Our mortgage-backed securities have no exposure to anysub-prime risks.
Shareholders’ Equity
Shareholders’ equity increased to $301.9 million, or a book value of $8.16 per common share, at December 31, 2007, compared to $201.7 million, or a book value of $6.93 per common share, at December 31, 2006. This per share increase in book value primarily reflects the impact of our equity offering in July 2007,year-to-date earnings, and an increase in unrealized gains, net of deferred income tax, of $4.3 million. Return on beginning equity was 13.9% in 2007, compared to 12.4% in 2006.
On July 19, 2007, we completed a secondary offering of 6,437,500 additional shares of our common stock at a price of $9.65 per share. Including the underwriting discount associated with the offering and other related expenses, we received total net proceeds of approximately $58.6 million. These net proceeds are being utilized to support organic growth within our underwriting operations, to fund select acquisitions and for other general corporate purposes. Upon receipt of the net proceeds, we reduced our outstanding line of credit balance from $22.0 million to zero.
In April 2007, we purchased the business of USSU for a purchase price of $23.0 million. This purchased price was comprised of $13.0 million in cash and $10.0 million in our common stock. Total additional shares issued for the $10.0 million portion of the purchase price were 907,935 shares.
On February 8, 2007, our Board of Directors and the Compensation Committee of the Board of Directors approved the distribution of our LTIP award for the2004-2006 plan years, which included both a cash and stock award. The stock portion of the LTIP award was valued at $2.5 million, which resulted in the issuance of 579,496 shares of our common stock. Of the 579,496 shares issued, 191,570 shares were retired for payment of the participant’s associated withholding taxes related to the compensation recognized by the participant. Refer to Note 2 —Stock Options, Long Term Incentive Plan, and Deferred Compensation Planfor further detail. The retirement of the shares for the associated withholding taxes reduced our paid in capital by $1.8 million.
On October 26, 2007, our Board of Directors authorized management to purchase up to 1,000,000 shares, or approximately 3%, of our common stock in market transactions for a period not to exceed twenty-four months. Our prior plan expired on October 27, 2007. For the years ended December 31, 2007 and 2006, we did not repurchase any common stock under either plan. As of December 31, 2007, we have available up to 1,000,000 shares to be purchased.
On February 8, 2008, our Board of Directors declared a quarterly dividend of $0.02 per common share. The dividend is payable on March 31, 2008, to shareholders of record as of March 14, 2008. Our Board of Directors did not declare any dividends in 2007 or 2006. When evaluating the declaration of a dividend, our Board of Directors considers a variety of factors, including but not limited to, our cash flow, liquidity needs, results of operations and our overall financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from our subsidiaries. We did not receive any dividends from our Insurance Company Subsidiaries in 2007 or 2006.
57
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Acquisition
In April 2007, we acquired the business of USSU for a purchase price of $23.0 million. Under the terms of the Agreement, we acquired the excess workers’ compensation business and other related assets. USSU is based in Cleveland, Ohio, and is a specialty program manager that produces fee based income by underwriting excess workers’ compensation coverage for a select group of insurance companies.
Goodwill associated with this acquisition was approximately $12.0 million. In addition, we recorded an increase to other intangible assets of approximately $9.5 million. These other intangible assets related to customer relationships acquired with the acquisition. We determined that the estimated useful life of the other intangible assets to be approximately five years. As such, we will amortize the $9.5 million in other intangible assets over a five year period.
In addition, we entered into a Management Agreement with the former owners of USSU. Under the terms the Management Agreement, the former owners were responsible for certain aspects of the daily administration and management of the USSU business. Their consideration for the performance of these duties was in the form of a management fee payable by us based on a share of net income before interest, taxes, depreciation, and amortization. We retained the option to terminate the Management Agreement, at our discretion, based on a multiple of the management fee calculated for the trailing twelve months. On January 31, 2008, we exercised this option to purchase the remainder of the economics related to the acquisition of the USSU business, by eliminating the Management Agreement for a payment of $21.5 million, which now completes the transaction. As a result of this purchase, we recorded an increase to other intangible assets of approximately $11.4 million and an increase to goodwill of approximately $10.1 million.
Adjusted Expense Ratio
Included in our GAAP expense ratio is the impact of the margin associated with our fee-based operations. If the profit margin from ourfee-for-service business is recognized as an offset to our underwriting expense, a more realistic picture of our operating efficiency emerges. The following table illustrates our adjusted expense ratio, which reflects the GAAP expense ratio of our insurance company subsidiaries, net of the pre-tax profit, excluding investment income, of ourfee-for-service and agency subsidiaries (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Net earned premiums | $ | 268,197 | $ | 254,920 | $ | 249,959 | ||||||
Less: Consolidated net loss and LAE | 150,969 | 146,293 | 151,542 | |||||||||
Intercompany claim fees | 13,058 | 12,553 | 11,523 | |||||||||
Unconsolidated net loss and LAE | 164,027 | 158,846 | 163,065 | |||||||||
Consolidated policy acquisition and other underwriting expenses | 53,717 | 50,479 | 44,439 | |||||||||
Intercompany administrative and other underwriting fees | 37,890 | 37,442 | 39,231 | |||||||||
Unconsolidated policy acquisition and other underwriting expenses | 91,607 | 87,921 | 83,670 | |||||||||
Underwriting income | $ | 12,563 | $ | 8,153 | $ | 3,224 | ||||||
58
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
GAAP combined ratio as reported | 95.4 | % | 96.8 | % | 98.7 | % | ||||||
Specialty risk management operations pre-tax income | $ | 47,898 | $ | 38,292 | $ | 29,546 | ||||||
Less: Underwriting income | 12,563 | 8,153 | 3,224 | |||||||||
Net investment income and capital gains | 26,550 | 22,144 | 18,142 | |||||||||
Fee-based operations pre-tax income | 8,785 | 7,995 | 8,180 | |||||||||
Agency operations pre-tax income | 2,087 | 2,609 | 3,241 | |||||||||
Totalfee-for-service pre-tax income | $ | 10,872 | $ | 10,604 | $ | 11,421 | ||||||
GAAP expense ratio as reported | 34.2 | % | 34.5 | % | 33.5 | % | ||||||
Adjustment to include pre-tax income from totalfee-for-service income(1) | 4.1 | % | 4.2 | % | 4.6 | % | ||||||
GAAP expense ratio as adjusted | 30.1 | % | 30.3 | % | 28.9 | % | ||||||
GAAP loss and LAE ratio as reported | 61.2 | % | 62.3 | % | 65.2 | % | ||||||
GAAP combined ratio as adjusted | 91.3 | % | 92.6 | % | 94.1 | % | ||||||
Reconciliation of consolidated pre-tax income: | ||||||||||||
Specialty risk management operations pre-tax income: | ||||||||||||
Fee-based operations pre-tax income | $ | 8,785 | $ | 7,995 | $ | 8,180 | ||||||
Underwriting income | 12,563 | 8,153 | 3,224 | |||||||||
Net investment income and capital gains | 26,550 | 22,144 | 18,142 | |||||||||
Total specialty risk management operations pre-tax income | 47,898 | 38,292 | 29,546 | |||||||||
Agency operations pre-tax income | 2,087 | 2,609 | 3,241 | |||||||||
Less: Holding company expenses | 2,638 | 2,830 | 2,892 | |||||||||
Interest expense | 6,030 | 5,976 | 3,856 | |||||||||
Amortization expense | 1,930 | 590 | 373 | |||||||||
Consolidated pre-tax income | $ | 39,387 | $ | 31,505 | $ | 25,666 | ||||||
(1) | Adjustment to include pre-tax income from totalfee-for-service income is calculated by dividing totalfee-for-service income by net earned premiums. |
Regulatory
A significant portion of our consolidated assets represent assets of our Insurance Company Subsidiaries. The State of Michigan Office of Financial and Insurance Services (“OFIS”), restricts the amount of funds that may be transferred to us in the form of dividends, loans or advances. These restrictions in general, are as follows: the maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of each insurance company’s net income (excluding realized capital gains) or ten percent of the insurance company’s surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law that prohibits an insurer from declaring dividends except out of surplus earnings of the company. Earned surplus balances are calculated on a quarterly basis. Since Star is the parent insurance company, its maximum dividend calculation represents the combined Insurance Company Subsidiaries’ surplus. At December 31, 2007, Star’s earned surplus position was positive $33.7 million. At December 31, 2006, Star had positive earned surplus of $13.2 million. Based upon Star’s statutory financial statements as of December 31, 2007, Star would have the potential to pay a dividend of up to $18.8 million without the prior approval of OFIS. No statutory dividends were paid during 2007 or 2006.
59
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Our Insurance Company Subsidiaries are required to maintain certain deposits with regulatory authorities, which totaled $115.2 million and $148.8 million at December 31, 2007 and 2006, respectively.
Contractual Obligations and Commitments
The following table is a summary of our contractual obligations and commitments as of December 31, 2007 (in thousands):
Payments Due by Period | ||||||||||||||||||||
Less Than | One to | Three to | More Than | |||||||||||||||||
Total | One Year | Three Years | Five Years | Five Years | ||||||||||||||||
Non-regulated companies: | ||||||||||||||||||||
Lines of Credit(1) | $ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
Note Payable, non-interest bearing | 4,300 | 2,150 | 2,150 | — | — | |||||||||||||||
Long-Term Debt(2): | ||||||||||||||||||||
Senior debentures due 2034; issued $13.0 million, April 2004 with variable interest | 13,000 | — | — | — | 13,000 | |||||||||||||||
Senior debentures due 2034; issued $12.0 million, May 2004 with variable interest | 12,000 | — | — | — | 12,000 | |||||||||||||||
Junior subordinated debentures due 2035; issued $20.6 million, September 2005, with variable interest | 20,620 | — | — | — | 20,620 | |||||||||||||||
Junior subordinated debentures due 2033; issued $10.3 million, September 2003, with variable interest | 10,310 | — | — | — | 10,310 | |||||||||||||||
Total Long-Term Debt | 60,230 | 2,150 | 2,150 | — | 55,930 | |||||||||||||||
Interest Payable(3) | ||||||||||||||||||||
Interest on Lines of Credit | — | — | — | — | — | |||||||||||||||
Interest on Long-Term Debt: | ||||||||||||||||||||
Senior debentures due 2034; issued $13.0 million, April 2004 with variable interest | 8,071 | 1,153 | 2,306 | 2,306 | 2,306 | |||||||||||||||
Senior debentures due 2034; issued $12.0 million, May 2004 with variable interest | 7,722 | 1,092 | 2,200 | 2,215 | 2,215 | |||||||||||||||
Junior subordinated debentures due 2035; issued $20.6 million, September 2005, with variable interest | 12,231 | 1,721 | 3,442 | 3,534 | 3,534 |
60
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Payments Due by Period | ||||||||||||||||||||
Less Than | One to | Three to | More Than | |||||||||||||||||
Total | One Year | Three Years | Five Years | Five Years | ||||||||||||||||
Junior subordinated debentures due 2033; issued $10.3 million, September 2003, with variable interest | 6,411 | 916 | 1,831 | 1,832 | 1,832 | |||||||||||||||
Total Interest Payable | 34,435 | 4,882 | 9,779 | 9,887 | 9,887 | |||||||||||||||
Operating lease obligations(4) | 16,797 | 4,904 | 6,892 | 3,444 | 1,557 | |||||||||||||||
Regulated companies: | ||||||||||||||||||||
Losses and loss adjustment expenses(5) | 540,002 | 139,109 | 192,243 | 100,231 | 108,419 | |||||||||||||||
Total | $ | 651,464 | $ | 151,045 | $ | 211,064 | $ | 113,562 | $ | 175,793 | ||||||||||
(1) | Relates to our revolving line of credit. | |
(2) | Five year call feature associated with debentures, estimated seven year repayment. | |
(3) | For interest rate terms and actual rates on long-term debt in effect as of December 31, 2007, refer to theLong-term Debtsection withinOther Itemsof theLiquidity and Capital Resourcessection of Management’s Discussion and Analysis. Estimates of interest expense for future periods are based on the most current interest rates in effect: on $13.0 million senior debentures at 8.87%; on $12.0 million senior debentures at 9.23%; on $20.6 million junior subordinated debentures at 8.57%; and on $10.3 million junior subordinated debentures at 8.88%. The assumption that the loans will be repaid at the end of seven years is based on management’s best estimate of the life of the debentures. |
In addition, there are two interest rate swaps associated with our long-term debt. The first interest rate swap relates to $5.0 million of our $12.0 million of senior debentures, which has a fixed interest rate of 8.925% with an ending date of May 24, 2009. The second interest rate swap relates to $20.0 million of our $20.6 million junior subordinated debentures, which has a fixed interest rate of 8.34% with an ending date of September 16, 2010.
(4) | Consists of rental obligations under real estate leases related to branch offices. In addition, includes amounts related to equipment leases. | |
(5) | The loss and loss adjustment expense payments do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of our gross losses and loss adjustment expenses. In addition, we have anticipated cash receipts on reinsurance recoverables on unpaid losses and loss adjustment expenses of $198.5 million, of which we estimate that these payments to be paid for losses and loss adjustment expenses for the periods less than one year, one to three years, three to five years, and more than five years, to be $31.5 million, $69.9 million, $46.1 million, and $51.0 million, respectively, resulting in net losses and loss adjustment expenses of $107.6 million, $122.4 million, $54.1 million, and $57.4 million, respectively. |
We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
Variable Compensation
We have established two variable compensation plans as an incentive for performance of our management team. They consist of an Annual Bonus Plan (“Bonus Plan”) and a Long-Term Incentive Plan (“LTIP”). The
61
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Bonus Plan is a discretionary cash bonus plan premised upon a targeted growth in net after-tax earnings on a year over year basis. Each year, the Compensation Committee and our Board of Directors establish a new target based upon prior year performance and the forecasted performance levels anticipated for the following year. The amount of the bonus pool is established by aggregating the individual targets for each participant, which is a percentage of salary. At the end of the year, the Compensation Committee and the Board of Directors review our performance in relation to performance targets and then establish the total bonus pool to be utilized to pay cash bonuses to the management team based upon overall corporate and individual participant goals.
The LTIP is intended to provide an incentive to management to improve our performance over a three year period, thereby increasing shareholder value. The LTIP is not discretionary and is based upon a target for an average three year return on beginning equity. If the targets are met and all other terms and conditions are satisfied, the LTIP awards are paid. The LTIP is paid 50% in cash and 50% in stock. A participant’s percentage is established by the Compensation Committee and the Board of Directors in advance of any new three year LTIP award. The stock component of the LTIP is paid based upon the closing stock price at the beginning of the three year LTIP performance period, in accordance with the terms and conditions of the LTIP.
Both the Bonus Plan and the LTIP are administered by the Compensation Committee and all awards are reviewed and approved by the Board of Directors at both inception and at distribution.
Regulatory and Rating Issues
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general, an insurance company must submit a calculation of its RBC formula to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidation proceeding.
At December 31, 2007, each of our Insurance Company Subsidiaries was in excess of any minimum threshold at which corrective action would be required.
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. Our targets for gross and net written premium to statutory surplus are 2.8 to 1.0 and 2.25 to 1.0, respectively. As of December 31, 2007, on a statutory consolidated basis, gross and net premium leverage ratios were 1.8 to 1.0 and 1.5 to 1.0, respectively.
The NAIC’s Insurance Regulatory Information System (“IRIS”) was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies “usual values” for each ratio. Departure from the “usual values” on four or more ratios generally leads to inquiries or possible further review from individual state insurance commissioners. In 2007, our Insurance Company Subsidiaries did not generate any ratios that departed from the “usual value” range.
In April 2007, we received an upgrade of our financial strength rating by A.M. Best Company to “A−” (Excellent), from “B++” (Very Good) for our Insurance Company Subsidiaries.
62
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Reinsurance Considerations
We seek to manage the risk exposure of our Insurance Company Subsidiaries and our clients through the purchase ofexcess-of-loss and quota share reinsurance. Our reinsurance requirements are analyzed on a specific program basis to determine the appropriate retention levels and reinsurance coverage limits. We secure this reinsurance based on the availability, cost, and benefits of various reinsurance alternatives.
Reinsurance does not legally discharge an insurer from its primary liability for the full amount of risks assumed under insurance policies it issues, but it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, we are subject to credit risk with respect to the obligations of our reinsurers.
In regard to ourexcess-of-loss reinsurance, we manage our credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective or existing reinsurers. We generally do not seek collateral where the reinsurer is rated “A−” or better by A. M. Best, has $500 million or more in surplus, and is admitted in the state of Michigan. The following table sets forth information relating to our five largest unaffiliatedexcess-of-loss reinsurers based upon ceded premium as of December 31, 2007:
Reinsurance Premium Ceded | Reinsurance Recoverable | A.M. Best | ||||||||||
Reinsurer | December 31, 2007 | December 31, 2007 | Rating | |||||||||
(In thousands) | (In thousands) | |||||||||||
Employers Reinsurance Corporation | $ | 4,582 | $ | 84,880 | A+ | |||||||
Munich American Reinsurance | 5,653 | 12,269 | A+ | |||||||||
Aspen Insurance UK Ltd. | 5,140 | 11,125 | A | |||||||||
Motors Insurance Company | 4,213 | 11,948 | A− | |||||||||
Lloyds Syndicate Number 4472 | 3,832 | 5,324 | A |
In regard to our risk-sharing partners (client captive orrent-a-captive quota-share non-admitted reinsurers), we manage credit risk on reinsurance recoverables by reviewing the financial stability, capitalization, and credit worthiness of prospective or existing reinsures or partners. We customarily collateralize reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks.
To date, we have not, in the aggregate, experienced material difficulties in collecting reinsurance recoverables.
We have historically maintained an allowance for the potential exposure to uncollectibility of certain reinsurance balances. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. The following table sets forth our exposure to uncollectible reinsurance and related allowances for years ending December 31, 2007 and 2006 (in thousands):
December 31, 2007 | December 31, 2006 | |||||||||||||||||||||||
Non Risk | Risk | Non Risk | Risk | |||||||||||||||||||||
Sharing(1) | Sharing(2) | Total | Sharing(1) | Sharing(2) | Total | |||||||||||||||||||
Gross exposure | $ | 4,959 | $ | 7,150 | $ | 12,109 | $ | 6,863 | $ | 7,952 | $ | 14,815 | ||||||||||||
Collateral or other security | (1 | ) | (3,114 | ) | (3,115 | ) | (170 | ) | (3,453 | ) | (3,623 | ) | ||||||||||||
Allowance | (4,873 | ) | (3,268 | ) | (8,141 | ) | (6,693 | ) | (3,038 | ) | (9,731 | ) | ||||||||||||
Net exposure | $ | 85 | $ | 768 | $ | 853 | $ | — | $ | 1,461 | $ | 1,461 | ||||||||||||
(1) | Balances related to three unaffiliated insurance companies, which are under regulatory liquidation or control, for which allowances have been established; all other admitted reinsurers have an A.M. Best rating of “A−” or better. |
63
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
(2) | Balances related to risk-sharing partners, which have either captive orrent-a-captive quota-share reinsurance contracts with us. |
Intercompany Pooling Agreement
Intercompany pooling or reinsurance agreements are commonly entered into between affiliated insurance companies, so as to allow the companies to utilize the capital and surplus of all of the companies, rather than each individual company. Under pooling arrangements, companies share in the insurance business that is underwritten and allocate the combined premium, losses and related expenses between the companies within the pooling arrangement. The Insurance Company Subsidiaries entered into an Inter-Company Reinsurance Agreement (the “Pooling Agreement”). This Pooling Agreement includes Star, Ameritrust Insurance Corporation (“Ameritrust”), Savers Property and Casualty Insurance Company (“Savers”) and Williamsburg National Insurance Company (“Williamsburg”). Pursuant to the Pooling Agreement, Savers, Ameritrust and Williamsburg have agreed to cede to Star and Star has agreed to reinsure 100% of the liabilities and expenses of Savers, Ameritrust and Williamsburg, relating to all insurance and reinsurance policies issued by them. In return, Star agreed to cede and Savers, Ameritrust and Williamsburg have agreed to reinsure Star for their respective percentages of the liabilities and expenses of Star. Annually, we examine the Pooling Agreement for any changes to the ceded percentage for the liabilities and expenses. Any changes to the Pooling Agreement must be submitted to the applicable regulatory authorities for approval.
Off-Balance Sheet Arrangements
As of December 31, 2007, we have no off-balance sheet arrangements as defined in Item 303(a) (4) ofRegulation S-K.
Convertible Note
In December 2005, we entered into a $6.0 million convertible note receivable with an unaffiliated insurance agency. The effective interest rate of the convertible note is equal to the three-month LIBOR, plus 5.2% and is due December 20, 2010. This agency has been a producer for us for over ten years. As security for the loan, the borrower granted us a security interest in its accounts, cash, general intangibles, and other intangible property. Also, the shareholder then pledged 100% of the common shares of three insurance agencies, the common shares owned by the shareholder in another agency, and has executed a personal guaranty. This note is convertible upon our option based upon a pre-determined formula, beginning in 2008. The conversion feature of this note is considered an embedded derivative pursuant to SFAS No. 133, and therefore is accounted for separately from the note. At December 31, 2007, the estimated fair value of the derivative is not material to the financial statements.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157,“Fair Value Measurements.”SFAS No. 157 defines fair value and establishes a framework for measuring fair value in accordance with generally accepted accounting principles. SFAS No. 157 also requires expanded disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value and (3) the effect of fair value measures on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We will adopt SFAS No. 157 on January 1, 2008. We do not believe the adoption of SFAS No. 157 will have a material impact on our consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115.”SFAS No. 159 permits entities the option to measure many financial instruments and certain other assets and liabilities at fair value on an
64
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
instrument-by-instrument basis as of specified election dates. This election is irrevocable. The objective of SFAS No. 159 is to improve financial reporting and reduce the volatility in reported earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We did not elect the fair value option for existing eligible items under SFAS No. 159; therefore there will be no impact to our consolidated financial condition or results of operations.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations.” SFAS No. 141(R) provides revised guidance on how an acquirer recognizes and measures in its financial statements, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. In addition, it provides revised guidance on the recognition and measurement of goodwill acquired in the business combination. SFAS No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141(R) is effective for business combinations completed on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, or January 1, 2009. We do not expect the provisions of SFAS No. 141(R) to have a material effect on our consolidated financial condition or results of operations.
In December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51.”SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. We will evaluate the impact of SFAS No. 160, but believe the adoption of SFAS No. 160 will not impact our consolidated financial statements.
Related Party Transactions
At December 31, 2007 and 2006, respectively, we held an $870,000 and $871,000 note receivable, including $209,000 of accrued interest at December 31, 2007, from one of our executive officers. Accrued interest at December 31, 2006 was $210,000. This note arose from a transaction in late 1998 in which we loaned the officer funds to exercise 64,718 common stock options to cover the exercise price and the taxes incurred as a result of the exercise. The note bears interest equal to the rate charged pursuant to our revolving credit agreement and is due on demand any time after January 1, 2002. As of December 31, 2007, the rate was 6.2%. The loan is partially collateralized by 64,718 shares of our common stock under a stock pledge agreement. For the years ended December 31, 2007 and 2006, $43,800 and $31,500, respectively, have been paid against the accrued interest on the loan. On June 1, 2001, the officer entered into an employment agreement which provides the note is a non-recourse loan and our sole legal remedy in the event of a default is the right to reclaim the shares pledged under the stock pledge agreement. As of December 31, 2007, the cumulative amount that has been paid against this loan was $162,800. Refer to Note 16 —Related Party Transactionfor further information.
Subsequent Events
U.S. Specialty Underwriters, Inc.
In April 2007, we entered into an agreement to acquire the excess workers’ compensation business of U.S. Specialty Underwriters, Inc. (“USSU”) for a purchase price of $23.0 million. In addition, we entered into a Management Agreement with the former owners of USSU. Under the terms the Management Agreement, the former owners were responsible for certain aspects of the daily administration and management of the USSU business. Their consideration for the performance of these duties was in the form of a management fee payable by us based on a share of net income before interest, taxes, depreciation, and amortization. We retained the option to terminate the Management Agreement, at our discretion, based on a multiple of the management fee calculated for the trailing twelve months.
65
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS — continued
Effective January 31, 2008, we exercised this option to purchase the remainder of the economics related to the acquisition of the USSU business, by eliminating the Management Agreement for a payment of $21.5 million, which now completes the transaction. As a result of this purchase, we recorded an increase to other intangible assets of approximately $11.4 million and an increase to goodwill of approximately $10.1 million.
Merger Agreement with ProCentury Corporation
On February 20, 2008, we executed a definitive merger agreement with ProCentury Corporation (“ProCentury”) for a merger transaction valued at approximately $272.6 million in cash and stock to be paid to ProCentury shareholders. The combined entity will adopt and operate under the Meadowbrook name and will continue to trade on the NYSE under the ticker symbol “MIG”.
Each ProCentury shareholder will have the option to elect to receive cash or Meadowbrook stock, subject to proration so that the maximum total cash consideration will not exceed 45% of the total consideration paid in order to preserve the tax-free exchange of the stock consideration. As long as Meadowbrook’s30-day volume-weighted average price preceding the election date, which will be at least five days before the closing of the transaction, is between $8.00 and $10.50, the exchange ratio will vary such that the stock consideration equals $20.00 per share based on such30-day average price. Above or below this range for Meadowbrook’s stock price, the exchange ratio will be fixed as if the30-day volume-weighted average price preceding the election date equaled $10.50 or $8.00, as applicable. Outstanding options to purchase ProCentury common shares will become fully vested and option holders can either exercise such options and, in connection with the closing, elect to receive the form of merger consideration described above for the ProCentury shares acquired on exercise or agree to have their options cancelled in exchange for a per share cash payment equal to the difference between $20.00 and the exercise price of their options.
We expect to finance the cash portion of the purchase price through a combination of cash and debt. Completion of the transaction is subject to various closing conditions, including the receipt of required regulatory and shareholder approvals. The transaction is expected to be completed in the third quarter of 2008.
66
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Item 7A. | Qualitative and Quantitative Disclosures About Market Risk |
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates as well as other relevant market rate or price changes. The volatility and liquidity in the markets in which the underlying assets are traded directly influence market risk. The following is a discussion of our primary risk exposures and how those exposures are currently managed as of December 31, 2007. Our market risk sensitive instruments are primarily related to fixed income securities, which are available for sale and not held for trading purposes.
Interest rate risk is managed within the context of an asset and liability management strategy where the target duration for the fixed income portfolio is based on the estimate of the liability duration and takes into consideration our surplus. The investment policy guidelines provide for a fixed income portfolio duration of between three and a half and five and a half years. At December 31, 2007, our fixed income portfolio had a modified duration of 4.22, compared to 3.93 at December 31, 2006.
At December 31, 2007, the fair value of our investment portfolio was $610.8 million. Our market risk to the investment portfolio is interest rate risk associated with debt securities. Our exposure to equity price risk is not significant. Our investment philosophy is one of maximizing after-tax earnings and has historically included significant investments in tax-exempt bonds. We continued to increase our holdings of tax-exempt securities based on our return to profitability and our desire to maximize after-tax investment income. For our investment portfolio, there were no significant changes in our primary market risk exposures or in how those exposures are managed compared to the year ended December 31, 2006. We do not anticipate significant changes in our primary market risk exposures or in how those exposures are managed in future reporting periods based upon what is known or expected to be in effect.
A sensitivity analysis is defined as the measurement of potential loss in future earnings, fair values, or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected period. In our sensitivity analysis model, a hypothetical change in market rates is selected that is expected to reflect reasonable possible near-term changes in those rates. “Near term” means a period of up to one year from the date of the consolidated financial statements. In our sensitivity model, we use fair values to measure our potential loss of debt securities assuming an upward parallel shift in interest rates to measure the hypothetical change in fair values. The table below presents our model’s estimate of changes in fair values given a change in interest rates. Dollar values are rounded and in thousands.
Rates Down 100bps | Rates Unchanged | Rates Up 100bps | ||||||||||
Market Value | $ | 637,372 | $ | 610,682 | $ | 582,995 | ||||||
Yield to Maturity or Call | 3.28 | % | 4.28 | % | 5.28 | % | ||||||
Effective Duration | 4.14 | 4.42 | 4.68 |
The other financial instruments, which include cash and cash equivalents, equity securities, premium receivables, reinsurance recoverables, line of credit and other assets and liabilities, when included in the sensitivity model, do not produce a material loss in fair values.
Our debentures are subject to variable interest rates. Thus, our interest expense on these debentures is directly correlated to market interest rates. At December 31, 2007 and 2006, we had debentures of $55.9 million. At this level, a 100 basis point (1%) change in market rates would change annual interest expense by $559,000.
In October 2005, we entered into two interest rate swap transactions to mitigate our interest rate risk on $5.0 million and $20.0 million of our senior debentures and trust preferred securities, respectively. We accrue for these transactions in accordance with SFAS No. 133“Accounting for Derivative Instruments and Hedging Activities,”as subsequently amended. These interest rate swap transactions have been designated as a cash flow hedges and are deemed highly effective hedges under SFAS No. 133. In accordance with SFAS No. 133, these interest rate swap transactions are recorded at fair value on the balance sheet and the effective portion of
67
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
any changes in fair value are accounted for within other comprehensive income. The interest differential to be paid or received is being accrued and is being recognized as an adjustment to interest expense.
In addition, our revolving line of credit under which we can borrow up to $35.0 million is subject to variable interest rates. Thus, our interest expense on the revolving line of credit is directly correlated to market interest rates. At December 31, 2007, we did not have an outstanding balance on this revolving line of credit. At December 31, 2006, we had $7.0 million outstanding on this revolving line of credit. At this level, a 100 basis point (1%) change in market rates would have changed interest expense by $70,000.
Item 8. | Financial Statements and Supplementary Data |
Refer to list of Financial Statement Schedules and Note 19 —Quarterly Financial Data (Unaudited)of the Notes to the Consolidated Financial Statements.
Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
None.
Item 9A. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
Our disclosure controls and procedures (as defined inRule 13a-15(e) under the Securities Exchange Act of 1934, the “Exchange Act”), which we refer to as disclosure controls, are controls and procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this annual report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any control system. A control system, no matter how well conceived and operated, can provide only reasonable assurance that its objectives are met. No evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected.
As of December 31, 2007, an evaluation was carried out under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective to ensure that material information relating to us is made known to management, including our Chief Executive Officer and Chief Financial Officer, particularly during the period when our periodic reports are being prepared.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined inRules 13a-15(f) and15d-15(f) under the Exchange Act). Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal controls over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may be inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal controls
68
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control — Integrated Framework.” Based on our assessment, we concluded that, as of December 31, 2007, our internal controls over financial reporting was effective based on those criteria.
The attestation report of Ernst & Young LLP, our independent registered public accounting firm, regarding internal control over financial reporting is set forth in Item 8 of this Annual Report onForm 10-K under the caption “Report of Independent Registered Public Accounting Firm” and incorporated herein by reference.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting during the most recent quarter ended December 31, 2007, which have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Item 9B. | Other Information |
None.
PART III
Certain information required by Part III is omitted from this Report in that the Registrant will file a definitive Proxy Statement pursuant to Regulation 14A (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this report and certain information included therein is incorporated herein by reference. Only those sections of the Proxy Statement that specifically address the items set forth herein are incorporated by reference.
Item 10. | Directors, Executive Officers, and Corporate Governance |
The information required by this item is included under the captions“Information about the Nominees, the Incumbent Directors and Other Executive Officers,” “Corporate Governance,” “Code of Conduct,,” “Report of the Audit Committee,”and “Section 16(a) Beneficial Ownership Reporting Compliance”of our Proxy Statement relating to our Annual Meeting of Shareholders to be held on May 9, 2008, which is hereby incorporated by reference. Our Code of Conduct can be found on our website www.meadowbrook.com.
Item 11. | Executive Compensation |
The information required by this item is included under the captions“Compensation of Executive Officers,” “Director Compensation,” “Report of the Compensation Committee of the Board on Executive Compensation,”and“Compensation Committee Interlocks and Insider Participation”of our Proxy Statement relating to our Annual Meeting of Shareholders to be held on May 9, 2008, which is hereby incorporated by reference.
Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
The information required by this item is included under the caption“Security Ownership of Certain Beneficial Owners and Management”of our Proxy Statement relating to our Annual Meeting of Shareholders to be held on May 9, 2008, which is hereby incorporated by reference.
69
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Equity Compensation Plan Information | ||||||||||||
Number of Securities | ||||||||||||
Remaining Available for | ||||||||||||
Number of Securities to | Weighted-Average | Future Issuance Under | ||||||||||
be Issued Upon Exercise | Exercise Price of | Equity Compensation | ||||||||||
of Outstanding Options, | Outstanding Options, | Plans (Excluding | ||||||||||
Warrants and Rights | Warrants and Rights | Securities in Column (a)) | ||||||||||
Plan Category | (a) | (b) | (c) | |||||||||
Equity compensation plans approved by security holders | 132,052 | $ | 14.51 | 771,468 | ||||||||
Equity compensation plans not approved by security holders | — | — | — | |||||||||
Total | 132,052 | $ | 14.51 | 771,468 | ||||||||
Item 13. | Certain Relationships and Related Transactions and Director Independence |
The information required by this item is included under the captions “CertainRelationships and Related Party Transactions”and“Independence Determination”of our Proxy Statement relating to our Annual Meeting of Shareholders to be held on May 9, 2008, which is hereby incorporated by reference.
Item 14. | Principal Accountant Fees and Services |
The information required by this item is included under the caption“The Second Proposal on Which You are Voting on Ratification of Appointment of Independent Registered Public Accounting Firm”of our Proxy Statement relating to our Annual Meeting of Shareholders to be held on May 9, 2008, which is hereby incorporated by reference.
70
MEADOWBROOK INSURANCE GROUP, INC.
PART IV
Item 15. | Exhibits, Financial Statement Schedules |
(A) The following documents are filed as part of this Report:
Page | ||||||||
1. | List of Financial Statements: | |||||||
72 | ||||||||
73 | ||||||||
74 | ||||||||
75 | ||||||||
76 | ||||||||
77 | ||||||||
78 | ||||||||
79-109 | ||||||||
2. | Financial Statement Schedules | |||||||
110 | ||||||||
111-114 | ||||||||
115-117 | ||||||||
118 | ||||||||
119 | ||||||||
120 | ||||||||
3. | Exhibits: The Exhibits listed on the accompanying Exhibit Index immediately following the financial statement schedule are filed as part of, or incorporated by reference into, thisForm 10-K | |||||||
Management Services Agreement | ||||||||
Management Services Agreement | ||||||||
Land Contract Amendment | ||||||||
Compliance Program/Code of Conduct | ||||||||
List of Subsidiaries | ||||||||
Consent of Independent Registered Public Accounting Firm | ||||||||
Power of Attorney | ||||||||
Certification of Robert S. Cubbin, Chief Executive Officer, pursuant to Rule 13a-14(a) | ||||||||
Certification of Karen M. Spaun, Chief Financial Officer, pursuant to Rule 13-14(a) | ||||||||
Certification pursuant to Section 906, signed by Robert S. Cubbin, Chief Executive Officer | ||||||||
Certification pursuant to Section 906, signed by Karen M. Spaun, Chief Financial Officer |
71
Table of Contents
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Meadowbrook Insurance Group, Inc.:
We have audited the accompanying consolidated balance sheets of Meadowbrook Insurance Group, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Meadowbrook Insurance Group, Inc. at December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Meadowbrook Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2008 expressed an unqualified opinion thereon.
YoungLLP)">
Detroit, Michigan
March 14, 2008
72
Table of Contents
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of
Meadowbrook Insurance Group, Inc.:
We have audited Meadowbrook Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Meadowbrook Insurance Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Meadowbrook Insurance Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Meadowbrook Insurance Group, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 and our report dated March 14, 2008 expressed an unqualified opinion thereon.
YoungLLP)">
Detroit, Michigan
March 14, 2008
73
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEET
December 31, | ||||||||
2007 | 2006 | |||||||
(In thousands, | ||||||||
except share data) | ||||||||
ASSETS | ||||||||
Investments | ||||||||
Debt securities available for sale, at fair value (amortized cost of $604,829 and $486,213 in 2007 and 2006, respectively) | $ | 610,756 | $ | 484,724 | ||||
Cash and cash equivalents | 40,845 | 42,876 | ||||||
Accrued investment income | 6,473 | 5,884 | ||||||
Premiums and agent balances receivable (net of allowance of $2,747 and $2,948 in 2007 and 2006, respectively) | 87,341 | 85,578 | ||||||
Reinsurance recoverable on: | ||||||||
Paid losses | 1,053 | 4,257 | ||||||
Unpaid losses | 198,461 | 198,422 | ||||||
Prepaid reinsurance premiums | 17,763 | 20,425 | ||||||
Deferred policy acquisition costs | 26,926 | 27,902 | ||||||
Deferred income taxes, net | 14,936 | 15,732 | ||||||
Goodwill | 43,497 | 31,502 | ||||||
Other assets | 65,915 | 51,698 | ||||||
Total assets | $ | 1,113,966 | $ | 969,000 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Liabilities | ||||||||
Losses and loss adjustment expenses | $ | 540,002 | $ | 501,077 | ||||
Unearned premiums | 153,927 | 144,575 | ||||||
Debt | — | 7,000 | ||||||
Debentures | 55,930 | 55,930 | ||||||
Accounts payable and accrued expenses | 22,604 | 25,384 | ||||||
Reinsurance funds held and balances payable | 16,416 | 15,124 | ||||||
Payable to insurance companies | 6,231 | 5,442 | ||||||
Other liabilities | 16,962 | 12,775 | ||||||
Total liabilities | 812,072 | 767,307 | ||||||
Shareholders’ Equity | ||||||||
Common stock, $0.01 stated value; authorized 75,000,000 shares; 36,996,287 and 29,107,818 shares issued and outstanding | 370 | 291 | ||||||
Additional paid-in capital | 194,621 | 126,828 | ||||||
Retained earnings | 104,274 | 76,282 | ||||||
Note receivable from officer | (870 | ) | (871 | ) | ||||
Accumulated other comprehensive income (loss) | 3,499 | (837 | ) | |||||
Total shareholders’ equity | 301,894 | 201,693 | ||||||
Total liabilities and shareholders’ equity | $ | 1,113,966 | $ | 969,000 | ||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
74
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENT OF INCOME
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
(In thousands, except share and per share data) | ||||||||||||
Revenues | ||||||||||||
Premiums earned | ||||||||||||
Gross | $ | 337,099 | $ | 327,287 | $ | 325,522 | ||||||
Ceded | (68,902 | ) | (72,367 | ) | (75,563 | ) | ||||||
Net earned premiums | 268,197 | 254,920 | 249,959 | |||||||||
Net commissions and fees | 45,988 | 41,172 | 35,916 | |||||||||
Net investment income | 26,400 | 22,075 | 17,975 | |||||||||
Net realized gains | 150 | 69 | 167 | |||||||||
Total revenues | 340,735 | 318,236 | 304,017 | |||||||||
Expenses | ||||||||||||
Losses and loss adjustment expenses | 191,885 | 212,383 | 237,775 | |||||||||
Reinsurance recoveries | (40,916 | ) | (66,090 | ) | (86,233 | ) | ||||||
Net losses and loss adjustment expenses | 150,969 | 146,293 | 151,542 | |||||||||
Salaries and employee benefits | 56,433 | 54,569 | 51,331 | |||||||||
Policy acquisition and other underwriting expenses | 53,717 | 50,479 | 44,439 | |||||||||
Other administrative expenses | 32,269 | 28,824 | 26,810 | |||||||||
Amortization expense | 1,930 | 590 | 373 | |||||||||
Interest expense | 6,030 | 5,976 | 3,856 | |||||||||
Total expenses | 301,348 | 286,731 | 278,351 | |||||||||
Income before taxes and equity earnings | 39,387 | 31,505 | 25,666 | |||||||||
Federal and state income tax expense | 11,726 | 9,599 | 7,757 | |||||||||
Equity earnings of affiliates | 331 | 128 | 1 | |||||||||
Net income | $ | 27,992 | $ | 22,034 | $ | 17,910 | ||||||
Earnings Per Share | ||||||||||||
Basic | $ | 0.85 | $ | 0.76 | $ | 0.62 | ||||||
Diluted | $ | 0.85 | $ | 0.75 | $ | 0.60 | ||||||
Weighted average number of common shares | ||||||||||||
Basic | 33,007,200 | 28,963,228 | 28,961,229 | |||||||||
Diluted | 33,101,965 | 29,566,141 | 29,653,067 |
The accompanying notes are an integral part of the Consolidated Financial Statements.
75
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
(In thousands) | ||||||||||||
Net income | $ | 27,992 | $ | 22,034 | $ | 17,910 | ||||||
Other comprehensive income, net of tax: | ||||||||||||
Unrealized gains (losses) on securities | 4,810 | 152 | (6,023 | ) | ||||||||
Net deferred derivative (loss) gain — hedging activity | (484 | ) | 121 | 9 | ||||||||
Less: reclassification adjustment for gains included in net income | 10 | 20 | 56 | |||||||||
Other comprehensive income (loss) | 4,336 | 293 | (5,958 | ) | ||||||||
Comprehensive income | $ | 32,328 | $ | 22,327 | $ | 11,952 | ||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
76
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
For the Years Ended December 31, 2007, 2006, and 2005 | ||||||||||||||||||||||||
Accumulated | ||||||||||||||||||||||||
Other | ||||||||||||||||||||||||
Additional | Note | Comprehensive | Total | |||||||||||||||||||||
Common | Paid-In | Retained | Receivable | Income | Shareholders’ | |||||||||||||||||||
Stock | Capital | Earnings | from Officer | (Loss) | Equity | |||||||||||||||||||
(In thousands) | ||||||||||||||||||||||||
Balances January 1, 2005 | $ | 290 | $ | 126,085 | $ | 37,175 | $ | (868 | ) | $ | 4,828 | $ | 167,510 | |||||||||||
Unrealized depreciation on available for sale securities | — | — | — | — | (5,967 | ) | (5,967 | ) | ||||||||||||||||
Deconsolidation of subsidiary | — | — | — | — | 9 | 9 | ||||||||||||||||||
Long term incentive plan; stock award | — | 923 | — | — | — | 923 | ||||||||||||||||||
Stock-based employee compensation | — | 41 | — | — | — | 41 | ||||||||||||||||||
Issuance of 382,825 shares of common stock | 4 | 1,193 | — | — | — | 1,197 | ||||||||||||||||||
Retirement of 785,648 shares of common stock | (7 | ) | (3,423 | ) | (837 | ) | — | — | (4,267 | ) | ||||||||||||||
Note receivable from an officer | — | — | — | 9 | — | 9 | ||||||||||||||||||
Net income | — | — | 17,910 | — | — | 17,910 | ||||||||||||||||||
Balances December 31, 2005 | 287 | 124,819 | 54,248 | (859 | ) | (1,130 | ) | 177,365 | ||||||||||||||||
Unrealized depreciation on available for sale securities | — | — | — | — | 172 | 172 | ||||||||||||||||||
Net deferred derivative gain — hedging activity | — | — | — | — | 121 | 121 | ||||||||||||||||||
Long term incentive plan; stock award | — | 897 | — | — | — | 897 | ||||||||||||||||||
Stock-based employee compensation | — | 121 | — | — | — | 121 | ||||||||||||||||||
Issuance of 791,038 shares of common stock | 8 | 4,153 | — | — | — | 4,161 | ||||||||||||||||||
Retirement of 355,229 shares of common stock | (4 | ) | (3,162 | ) | — | — | — | (3,166 | ) | |||||||||||||||
Note receivable from an officer | — | — | — | (12 | ) | — | (12 | ) | ||||||||||||||||
Net income | — | — | 22,034 | — | — | 22,034 | ||||||||||||||||||
Balances December 31, 2006 | 291 | 126,828 | 76,282 | (871 | ) | (837 | ) | 201,693 | ||||||||||||||||
Unrealized appreciation on available for sale securities | — | — | — | — | 4,820 | 4,820 | ||||||||||||||||||
Net deferred derivative gain — hedging activity | — | — | — | — | (484 | ) | (484 | ) | ||||||||||||||||
Long term incentive plan; stock award for2007-2009 plan years | — | 772 | — | — | — | 772 | ||||||||||||||||||
Long term incentive plan; stock award for2004-2006 plan years | 4 | (1,845 | ) | — | — | — | (1,841 | ) | ||||||||||||||||
Stock-based employee compensation | — | 2 | — | — | — | 2 | ||||||||||||||||||
Issuance of 244,574 shares of common stock | 3 | 1,373 | — | — | — | 1,376 | ||||||||||||||||||
Retirement of 89,466 shares of common stock | (1 | ) | (1,020 | ) | — | — | — | (1,021 | ) | |||||||||||||||
Equity offering issuance of 6,437,500 shares of common stock | 64 | 58,520 | — | — | — | 58,584 | ||||||||||||||||||
Issuance of 907,935 shares of common stock for acquisition of business of USSU | 9 | 9,991 | — | — | — | 10,000 | ||||||||||||||||||
Note receivable from an officer | — | — | — | 1 | — | 1 | ||||||||||||||||||
Net income | — | — | 27,992 | — | — | 27,992 | ||||||||||||||||||
Balances December 31, 2007 | $ | 370 | $ | 194,621 | $ | 104,274 | $ | (870 | ) | $ | 3,499 | $ | 301,894 | |||||||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
77
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
(In thousands) | ||||||||||||
Cash Flows From Operating Activities | ||||||||||||
Net income | $ | 27,992 | $ | 22,034 | $ | 17,910 | ||||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||||||
Amortization of other intangible assets | 1,930 | 590 | 198 | |||||||||
Amortization of deferred debenture issuance costs | 353 | 236 | 175 | |||||||||
Depreciation of furniture, equipment, and building | 3,147 | 2,553 | 2,452 | |||||||||
Net accretion of discount and premiums on bonds | 2,707 | 2,646 | 2,395 | |||||||||
Gain on sale of investments | 16 | 30 | 86 | |||||||||
Gain on sale of fixed assets | (88 | ) | (88 | ) | (170 | ) | ||||||
Stock-based employee compensation | 2 | 121 | 41 | |||||||||
Incremental tax benefits from stock options exercised | (728 | ) | (1,532 | ) | — | |||||||
Long term incentive plan expense | 772 | 897 | 923 | |||||||||
Deferred income tax expense | (1,538 | ) | 741 | 1,347 | ||||||||
Changes in operating assets and liabilities: | ||||||||||||
Decrease (increase) in: | ||||||||||||
Premiums and agent balances receivable | 2,111 | (771 | ) | (713 | ) | |||||||
Reinsurance recoverable on paid and unpaid losses | 3,166 | (98 | ) | (33,513 | ) | |||||||
Prepaid reinsurance premiums | 2,662 | 4,162 | 1,488 | |||||||||
Deferred policy acquisition costs | 976 | (1,531 | ) | (1,204 | ) | |||||||
Other assets | 13 | (1,044 | ) | 5,612 | ||||||||
Increase (decrease) in: | ||||||||||||
Losses and loss adjustment expenses | 38,925 | 42,400 | 80,521 | |||||||||
Unearned premiums | 9,352 | 3,585 | 6,688 | |||||||||
Payable to insurance companies | 789 | (1,242 | ) | (307 | ) | |||||||
Reinsurance funds held and balances payable | 1,292 | (116 | ) | (2,591 | ) | |||||||
Other liabilities | (5,244 | ) | 718 | 609 | ||||||||
Total adjustments | 60,615 | 52,257 | 64,037 | |||||||||
Net cash provided by operating activities | 88,607 | 74,291 | 81,947 | |||||||||
Cash Flows From Investing Activities | ||||||||||||
Purchase of debt securities available for sale | (393,676 | ) | (201,920 | ) | (203,789 | ) | ||||||
Proceeds from sale of equity securities available for sale | — | — | 8 | |||||||||
Proceeds from sales and maturities of debt securities available for sale | 272,337 | 116,978 | 122,317 | |||||||||
Capital expenditures | (3,109 | ) | (4,850 | ) | (15,810 | ) | ||||||
Purchase of books of business | (3,344 | ) | (834 | ) | (3,557 | ) | ||||||
Acquisition of U.S. Specialty Underwriters, Inc. | (12,644 | ) | — | — | ||||||||
Proceeds from sale of assets | — | — | 633 | |||||||||
Loan receivable | (310 | ) | (202 | ) | (5,905 | ) | ||||||
Net cash deposited in funds held | 344 | 529 | 501 | |||||||||
Net cash used in investing activities | (140,402 | ) | (90,299 | ) | (105,602 | ) | ||||||
Cash Flows From Financing Activities | ||||||||||||
Proceeds from lines of credit | 19,025 | 14,078 | 14,307 | |||||||||
Payment of lines of credit | (26,025 | ) | (14,078 | ) | (19,451 | ) | ||||||
Book overdrafts | (39 | ) | 142 | 924 | ||||||||
Cash payment for payroll taxes associated with long-term incentive plan net stock issuance | (1,841 | ) | — | — | ||||||||
Net proceeds from debentures | — | — | 19,400 | |||||||||
Stock options exercised | (374 | ) | (538 | ) | 1,092 | |||||||
Share repurchases of common stock | — | — | (4,191 | ) | ||||||||
Incremental tax benefits from stock options exercised | 728 | 1,532 | — | |||||||||
Net proceeds received from public equity offering | 58,585 | — | — | |||||||||
Other financing activities | (295 | ) | (290 | ) | (263 | ) | ||||||
Net cash provided by financing activities | 49,764 | 846 | 11,818 | |||||||||
Net decrease in cash and cash equivalents | (2,031 | ) | (15,162 | ) | (11,837 | ) | ||||||
Cash and cash equivalents, beginning of year | 42,876 | 58,038 | 69,875 | |||||||||
Cash and cash equivalents, end of year | $ | 40,845 | $ | 42,876 | $ | 58,038 | ||||||
Supplemental Disclosure of Cash Flow Information: | ||||||||||||
Interest paid | $ | 5,894 | $ | 5,616 | $ | 3,428 | ||||||
Net income taxes paid | $ | 11,557 | $ | 9,159 | $ | 6,404 | ||||||
Supplemental Disclosure of Non Cash Investing and Financing Activities: | ||||||||||||
Tax benefit from stock options | $ | 728 | $ | 1,532 | $ | 105 | ||||||
Stock-based employee compensation | $ | 2 | $ | 121 | $ | 41 | ||||||
Common stock portion of purchase price for acquisition of U.S. Specialty Underwriters, Inc. | $ | 10,000 | $ | — | $ | — |
The accompanying notes are an integral part of the Consolidated Financial Statements.
78
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
1. | Summary of Significant Accounting Policies |
Basis of Presentation and Principles of Consolidation
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (“GAAP”), which differ from statutory accounting practices prescribed or permitted for insurance companies by regulatory authorities. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
The consolidated financial statements include accounts, after elimination of intercompany accounts and transactions, of Meadowbrook Insurance Group, Inc. (the “Company”), its wholly owned subsidiary Star Insurance Company (“Star”), and Star’s wholly owned subsidiaries, Savers Property and Casualty Insurance Company, Williamsburg National Insurance Company, and Ameritrust Insurance Corporation (which are collectively referred to as the “Insurance Company Subsidiaries”), and Preferred Insurance Company, Ltd. (“PICL”). The consolidated financial statements also include Meadowbrook, Inc., Crest Financial Corporation, and their subsidiaries. As of December 31, 2007, PICL was deregulated under Bermuda law and merged into Meadowbrook, Inc’s subsidiary, Meadowbrook Risk Management, Ltd.
Pursuant to Financial Accounting Standards Board Interpretation Number (“FIN”) 46(R), the Company does not consolidate its subsidiaries, Meadowbrook Capital Trust I and II (the “Trusts”), as they are not variable interest entities and the Company is not the primary beneficiary of the Trusts. The consolidated financial statements, however, include the equity earnings of the Trusts. In addition and in accordance with FIN 46(R), the Company does not consolidate its subsidiary American Indemnity Insurance Company, Ltd. (“American Indemnity”). While the Company and its subsidiary Star are the common shareholders, they are not the primary beneficiaries of American Indemnity. The consolidated financial statements, however, include the equity earnings of American Indemnity.
Business
The Company, through its subsidiaries, is engaged primarily in developing and managing specialty risk management programs for 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 various types of property and casualty insurance coverage, including workers’ compensation, commercial multiple peril, general liability, commercial auto liability, and inland marine. The Company, through its Insurance Company Subsidiaries, issues insurance policies for client risk-sharing and fully insured programs. The Company retains underwriting risk in these insurance programs, which may result in fluctuations in earnings. The Company also operates retail insurance agencies, which primarily place commercial insurance as well as personal property, casualty, life and accident and health insurance, with multiple insurance carriers. The Company does not have significant exposures to environmental/asbestos and catastrophic coverages. Insurance coverage is primarily provided to associations or similar groups of members, commonly referred to as programs.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. While management believes the amounts included in the consolidated financial statements reflect management’s best estimates and assumptions, actual results may differ from those estimates.
79
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Reclassifications
The Company’s Note 5 —Segment Informationof the Notes to Consolidated Financial Statements for the years ended December 31, 2006 and 2005, previously reported, had a change in allocation. The agency operations of the Company’s segment information include an allocation of corporate overhead, which includes expenses associated with accounting, information services, legal, and other corporate services. The Company’s agency Insurance & Benefits Consultants allocation was previously included in specialty risk management operations. The effect of this reclassification was a reduction in agency operations and an increase in specialty risk management operations pre-tax income for the years ended December 31, 2006 and 2005 of $342,000 and $102,000, respectively. The Company’s Note 5 —Segment Informationhas been restated to reflect this reclassification.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid short-term investments. The Company considers all short-term investments purchased with an original maturity of three months or less to be cash equivalents.
Investments
The Company’s investment securities at December 31, 2007 and 2006, are classified as available for sale. Investments classified as available for sale are available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates, tax strategies and asset-liability management strategies, among other reasons. Available for sale securities are reported at fair value, with unrealized gains and losses reported in the accumulated other comprehensive income component of shareholders’ equity, net of deferred taxes.
Realized gains or losses on sale of investments are determined on the basis of specific costs of the investments. Dividend income is recognized when declared and interest income is recognized when earned. Discount or premium on debt securities purchased at other than par value is amortized using the effective yield method. Investments with other than temporary declines in fair value are written down to their estimated net fair value and the related realized losses are recognized in income.
The Company’s investment portfolio includes investments in mortgage-backed and agency-backed securities, however the Company does not have any direct exposure to anysub-prime risks. The Company’s asset-backed securities sector comprises only 4.2%, or $26.6 million of its investment portfolio. Within this sector, $2.8 million relates to home equity loans, of which $1.2 million is insured. The remaining $23.8 million primarily relates to credit cards, auto loans, and utility and equipment loans. These asset-backed securities are adequately collateralized, AAA- rated investment quality that the Company currently expects will continue to perform. The Company’s mortgage-backed securities have no exposure to anysub-prime risks.
Other Than Temporary Impairments of Securities and Unrealized Losses on Investments
The Company’s investment portfolio is primarily invested in debt securities classified as available for sale, with a concentration in fixed income securities of a high quality. The Company’s policy for the valuation of temporarily impaired securities is to determine impairment based on analysis of the following factors: (1) rating downgrade or other credit event (e.g., failure to pay interest when due); (2) financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology or discontinuance of a business segment; (3) prospects for the issuer’s industry segment, and (4) intent and ability of the Company to retain the investment for a period of time sufficient to allow for anticipated recovery in market value. The Company evaluates its investments in securities to determine other than temporary impairment, no less than quarterly. Investments that are deemed
80
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
other than temporarily impaired are written down to their estimated net fair value and the related losses are recognized in operations. There were no impaired investments written down in 2007, 2006, and 2005.
Losses and Loss Adjustment Expenses and Reinsurance Recoverables
The liability for losses and loss adjustment expenses (“LAE”) represent case base estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported losses (“IBNR”) and LAE. In addition, the liability for losses and loss adjustment expenses represents estimates received from ceding reinsurers on assumed business. Such liabilities, by necessity, are based upon estimates and, while management believes the amount of its reserves is adequate, the ultimate liability may be greater or less than the estimate.
Reserves related to the Company’s direct business and assumed business it manages directly, are established through transactions processed through the Company’s internal systems and related controls. Accordingly, case reserves are established on a current basis, therefore there is no delay or lag in reporting of losses from a ceding company, and IBNR is determined utilizing various actuarial methods based upon historical data. Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag and include an estimated reserve based upon actuarial methods for this lag. Assumed business which is subsequently 100% retroceded to participating reinsurers relates to business previously discontinued and now is in run-off. Lastly, in relation to assumed business from other sources, the Company receives case and paid loss data within a forty-five day reporting period and develops estimates for IBNR based on both current and historical data.
In addition to case reserves and in accordance with industry practice, the Company maintains estimates of reserves for losses and LAE incurred but not yet reported. The Company projects an estimate of ultimate losses and LAE expenses at each reporting date. The difference between the projected ultimate loss and LAE reserves and the case loss and LAE reserves, is carried as IBNR reserves. By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, the Company estimates the ultimate liability for losses and LAE, net of reinsurance recoverables.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of incurred but not reported losses and LAE. Such recoverables, by necessity, are based upon estimates and, while management believes that the amount accrued is collectible, the ultimate recoverable may be greater or less than the amount accrued.
The methods for making such estimates and for establishing the loss reserves and reinsurance recoverables are continually reviewed and updated. There were no significant changes in key assumptions during 2007, 2006 and 2005.
Revenue Recognition
Premiums written, which include direct, assumed, and ceded are recognized as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written that are applicable to the unexpired terms of policies in force. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received and actuarial estimates.
For the year ending December 31, 2007, total assumed written premiums were $39.2 million, of which $31.0 million, relates to assumed business the Company manages directly. The remaining $8.2 million of assumed written premiums relates to residual markets and mandatory assumed pool business.
Assumed premium estimates are specifically related to the mandatory assumed pool business from the National Council on Compensation Insurance (“NCCI”), or residual market business. The pool cedes workers’ compensation business to participating companies based upon the individual company’s market share by state.
81
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The activity is reported from the NCCI to participating companies on a two quarter lag. To accommodate this lag, the Company estimates premium and loss activity based on historical and market based results. Historically, the Company has not experienced any material difficulties or disputes in collecting balances from NCCI; and therefore, no provision for doubtful accounts is recorded related to the assumed premium estimate.
In addition, certain premiums are subject to retrospective premium adjustments. Premium is recognized over the term of the insurance contract.
Fee income, which includes risk management consulting, loss control, and claims services, is recognized during the period the services are provided. Depending on the terms of the contract, claims processing fees are recognized as revenue over the estimated life of the claims, or the estimated life of the contract. For those contracts that provide services beyond the expiration or termination of the contract, fees are deferred in an amount equal to management’s estimate of the Company’s obligation to continue to provide services.
Commission income, which includes reinsurance placement, is recorded on the later of the effective date or the billing date of the policies on which they were earned. Commission income is reported net of anysub-producer commission expense. Any commission adjustments that occur subsequent to the earnings process are recognized upon notification from the insurance companies. Profit sharing commissions from insurance companies are recognized when determinable, which is when such commissions are received.
The Company reviews, on an ongoing basis, the collectibility of its receivables and establishes an allowance for estimated uncollectible accounts.
Deferred Policy Acquisition Costs
Commissions and other costs of acquiring insurance business that vary with and are primarily related to the production of new and renewal business are deferred and amortized over the terms of the policies or reinsurance treaties to which they relate. Investment earnings are anticipated in determining the recoverability of such deferred amounts. The Company reduces these costs for premium deficiencies. There were no premium deficiencies for the years ending December 31, 2007, 2006 and 2005.
Participating Policyholder Dividends
The Company’s method for determining policyholder dividends is a combination of subjective and objective decisions, which may include loss ratio analysis for the specific program and the Company’s overall business strategy. The Company determines the total dividends to be paid and then obtains the approval of the Board of Directors to pay up to a certain amount. At December 31, 2007 and 2006, the Company had $1.3 million and $996,000 accrued for policyholder dividends, respectively.
Furniture and Equipment
Furniture and equipment are stated at cost, net of accumulated depreciation, and are depreciated using the straight-line method over the estimated useful lives of the assets, generally three to ten years. Upon sale or retirement, the cost of the asset and related accumulated depreciation are eliminated from their respective accounts, and the resulting gain or loss is included in income. Repairs and maintenance are charged to operations when incurred.
Goodwill and Other Intangible Assets
The Company is required to test, at least annually, all existing goodwill for impairment using a fair value approach, on a reporting unit basis. The Company’s annual assessment date for goodwill impairment testing is October 1st. Also pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 142“Goodwill and Other Intangible Assets,”the Company is required to test for impairment more frequently if events or changes
82
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
in circumstances indicate that the asset might be impaired. In addition, the Company has an other intangible asset which has an indefinite life and is evaluated annually in accordance with SFAS No. 142. The Company’s remaining other intangible assets are being amortized over a five-year period.
Income Taxes
The Company accounts for its income taxes under the asset and liability method. Deferred federal income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities.
At December 31, 2007, the Company had a net deferred tax asset of $14.9 million. Realization of the deferred tax asset is dependent upon generating sufficient taxable income to absorb the applicable reversing temporary differences. At December 31, 2007, management concluded the positive evidence supporting the generation of future taxable income sufficient to recognize the deferred tax asset, without a valuation allowance. This positive evidence includes cumulative pre-tax income of $96.6 million for the three years ended December 31, 2007.
Stock Options
Effective January 1, 2006, the Company adopted SFAS No. 123(R),“Share-Based Payment,”using the modified prospective application transition method. The Company previously adopted the requirements of recording stock options consistent with SFAS 123 and accounting for the change in accounting principle using the prospective method in accordance with SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123.” Under the prospective method, stock-based compensation expense was recognized for awards granted after the beginning of the fiscal year in which the change is made, or January 1, 2003. Upon implementation of SFAS No. 148 in 2003, the Company recognized stock-based compensation expense for awards granted after January 1, 2003.
Prior to the adoption of SFAS No. 148, the Company applied the intrinsic value-based provisions set forth in APB Opinion No. 25. Under the intrinsic value method, compensation expense is determined on the measurement date, which is the first date when both the number of shares the employee is entitled to receive, and the exercise price are known. Compensation expense for each quarter resulting from stock options granted by the Company was determined based upon the difference between the exercise price and the fair market value of the underlying common stock at the date of grant. The Company’s Stock Option Plan requires the exercise price of the grants to be at the current fair market value of the underlying common stock.
Upon adoption of SFAS No. 123(R) on January 1, 2006, the Company was required to recognize as an expense in the financial statements all share-based payments to employees based on their fair values. SFAS No. 123(R) requires forfeitures to be estimated in calculating the expense relating to the share-based payments, as opposed to recognizing any forfeitures and the corresponding reduction in expense as they occur. In addition, SFAS No. 123(R) requires any tax savings resulting from tax deductions in excess of compensation expense be reflected in the financial statements as a cash inflow from financing activities, rather than as an operating cash flow as in prior periods. The pro forma disclosures previously permitted under SFAS 123, are no longer an alternative to financial statement recognition. As indicated, the Company adopted the requirements of SFAS 123(R) using the modified prospective application transition method. The prospective method requires compensation expense to be recorded for all unvested stock options and restricted stock, based upon the previously disclosed SFAS 123 methodology and amounts.
The Company, through its 1995 and 2002 Amended and Restated Stock Option Plans (the “Plans”), may grant options to key executives and other members of management of the Company and its subsidiaries in amounts not to exceed 2,000,000 shares of the Company’s common stock allocated for each plan. The Plans
83
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
are administered by the Compensation Committee (the “Committee”) of the Board of Directors. Option shares may be exercised subject to the terms of the Plans and the terms prescribed by the Committee at the time of grant. Currently, the Plans’ options have either five or ten-year terms and are exercisable and vest in equal increments over the option term. The Company has not issued any new stock options to employees since 2003.
Results for the year ended 2005 have not been restated. If compensation cost for stock option grants had been determined based on a fair value method, net income and earnings per share on a pro forma basis for 2005, would have been as follows (in thousands):
2005 | ||||
Net income, as reported | $ | 17,910 | ||
Add: Stock-based employee compensation expense included in reported income, net of related tax effects | 27 | |||
Deduct: Total stock-based employee compensation expense determined under fair-value-based methods for all awards, net of related tax effects | (108 | ) | ||
Pro forma net income | $ | 17,829 | ||
Earnings per share: | ||||
Basic — as reported | $ | 0.62 | ||
Basic — pro forma | $ | 0.62 | ||
Diluted — as reported | $ | 0.60 | ||
Diluted — pro forma | $ | 0.60 |
Compensation expense of $2,000 and $121,000 has been recorded for the years ended December 31, 2007 and 2006 under SFAS 123(R), respectively. Compensation expense of $41,000 was recorded for the years ended December 31, 2005 under SFAS 148, respectively.
Long Term Incentive Plan
In 2004, the Company adopted a Long Term Incentive Plan (the “LTIP”). The LTIP provides participants with the opportunity to earn cash and stock awards based upon the achievement of specified financial goals over a three-year performance period with the first performance period commencing January 1, 2004. At the end of a three-year performance period, and if the performance targets for that period are achieved, the Compensation Committee of the Board of Directors shall determine the amount of LTIP awards that are payable to participants in the LTIP for the current performance period. One-half of any LTIP award will be payable in cash and one-half of the award will be payable in the form of a stock award. If the Company achieves the performance targets for the three-year performance period, payment of the cash portion of the award would be made in three annual installments, with the first payment being paid as of the end of the that performance period and the remaining two payments to be paid in the subsequent two years. Any unpaid portion of a cash award is subject to forfeiture if the participant voluntarily leaves the Company or is discharged for cause. The portion of the award to be paid in the form of stock will be issued as of the end of that performance period. The number of shares of Company’s common stock subject to the stock award shall equal the dollar amount of one-half of the LTIP award divided by the fair market value of Company’s common stock on the first date of the beginning of the performance period. The stock awards shall be made subject to the terms and conditions of the LTIP and Plans. The Company accrues awards based upon the criteria set-forth and approved by the Compensation Committee of the Board of Directors, as included in the LTIP.
Deferred Compensation Plan
In 2006, the Company adopted an Executive Nonqualified Excess Plan (the “Excess Plan”). The Excess Plan is intended to be a nonqualified deferred compensation plan that will comply with the provisions of
84
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Section 409A of the Internal Revenue Code. The Company adopted the Excess Plan to provide a means by which certain key management employees may elect to defer receipt of current compensation from the Company in order to provide retirement and other benefits, as provided for in the Excess Plan. The Excess Plan is intended to be an unfunded plan maintained primarily for the purpose of providing deferred compensation benefits for eligible employees.
Earnings Per Share
Basic earnings per share are based on the weighted average number of common shares outstanding during the year, while diluted earnings per share includes the weighted average number of common shares and potential dilution from shares issuable pursuant to stock options using the treasury stock method.
Outstanding options of 98,807, 112,959, and 534,201 for the periods ended December 31, 2007, 2006, and 2005, respectively, have been excluded from the diluted earnings per share, as they were anti-dilutive. Shares issuable pursuant to stock options included in diluted earnings per share were 16,495, 126,660, and 298,851 for the years ended December 31, 2007, 2006, and 2005, respectively. Shares related to the LTIP included in diluted earnings per share were 78,270, 476,252, and 392,988 for the years ended December 31, 2007, 2006 and 2005, respectively.
Comprehensive Income
Comprehensive income (loss) encompasses all changes in shareholders’ equity (except those arising from transactions with shareholders) and includes net income, net unrealized capital gains or losses onavailable-for-sale securities, and net deferred derivative gains or losses on hedging activity.
Derivative Instruments
During 2005, the Company entered into two interest rate swap transactions in order to mitigate its interest rate risk. The Company accounts for these transactions in accordance with SFAS No. 133“Accounting for Derivative Instruments and Hedging Activities,”as subsequently amended. These interest rate swap transactions have been designated as cash flow hedges and are deemed highly effective hedges under SFAS No. 133. Under SFAS No. 133, these interest rate swap transactions are recorded at fair value on the balance sheet and the effective portion of the changes in fair value are accounted for within other comprehensive income. Any portion of the hedge deemed to be ineffective is recognized within the consolidated statements of income. The Company does not use interest rate swaps for trading or other speculative purposes.
In December 2005, the Company entered into a $6.0 million convertible note receivable with an unaffiliated insurance agency. The effective interest rate of the convertible note is equal to the three-month LIBOR, plus 5.2% and is due December 20, 2010. This note is convertible at the option of the Company based upon a pre-determined formula, beginning in 2007. The conversion feature of this note is considered an embedded derivative pursuant to SFAS No. 133, and therefore is accounted for separately from the note. At December 31, 2007, the estimated fair value of the derivative was not material to the financial statements.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157,“Fair Value Measurements.”SFAS No. 157 defines fair value and establishes a framework for measuring fair value in accordance with generally accepted accounting principles. SFAS No. 157 also requires expanded disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value and (3) the effect of fair value measures on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007.
85
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The Company will adopt SFAS No. 157 on January 1, 2008. The Company does not believe the adoption of SFAS No. 157 will have a material impact on its consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115.”SFAS No. 159 permits entities the option to measure many financial instruments and certain other assets and liabilities at fair value on aninstrument-by-instrument basis as of specified election dates. This election is irrevocable. The objective of SFAS No. 159 is to improve financial reporting and reduce the volatility in reported earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company did not elect the fair value option for existing eligible items under SFAS No. 159; therefore there will be no impact to its consolidated financial condition or results of operations.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations.” SFAS No. 141(R) provides revised guidance on how an acquirer recognizes and measures in its financial statements, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. In addition, it provides revised guidance on the recognition and measurement of goodwill acquired in the business combination. SFAS No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141(R) is effective for business combinations completed on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, or January 1, 2009. The Company does not expect the provisions of SFAS No. 141(R) to have a material effect on its consolidated financial condition or results of operations.
In December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51.”SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. The Company will evaluate the impact of SFAS No. 160, but believes the adoption of SFAS No. 160 will not impact its consolidated financial condition or results of operations.
2. | Investments |
The estimated fair value of investments in securities is determined based on published market quotations and broker/dealer quotations. The cost or amortized cost and estimated fair value of investments in securities at December 31, 2007 and 2006 are as follows (in thousands):
December 31, 2007 | ||||||||||||||||
Cost or | Gross | Gross | ||||||||||||||
Amortized | Unrealized | Unrealized | Estimated | |||||||||||||
Cost | Gains | Losses | Fair Value | |||||||||||||
Debt Securities: | ||||||||||||||||
Debt securities issued by the U.S. government and agencies | $ | 53,436 | $ | 1,541 | $ | (29 | ) | $ | 54,948 | |||||||
Obligations of states and political subdivisions | 287,392 | 3,329 | (323 | ) | 290,398 | |||||||||||
Corporate securities | 116,406 | 1,941 | (928 | ) | 117,419 | |||||||||||
Mortgage and asset-backed securities | 147,595 | 1,011 | (615 | ) | 147,991 | |||||||||||
Total Debt Securities available for sale | $ | 604,829 | $ | 7,822 | $ | (1,895 | ) | $ | 610,756 | |||||||
86
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
December 31, 2006 | ||||||||||||||||
Cost or | Gross | Gross | ||||||||||||||
Amortized | Unrealized | Unrealized | Estimated | |||||||||||||
Cost | Gains | Losses | Fair Value | |||||||||||||
Debt Securities: | ||||||||||||||||
Debt securities issued by the U.S. government and agencies | $ | 52,991 | $ | 282 | $ | (521 | ) | $ | 52,752 | |||||||
Obligations of states and political subdivisions | 221,296 | 1,840 | (1,460 | ) | 221,676 | |||||||||||
Corporate securities | 102,365 | 1,368 | (1,515 | ) | 102,218 | |||||||||||
Mortgage and asset-backed securities | 109,561 | 143 | (1,626 | ) | 108,078 | |||||||||||
Total Debt Securities available for sale | $ | 486,213 | $ | 3,633 | $ | (5,122 | ) | $ | 484,724 | |||||||
Gross unrealized appreciation and depreciation on available for sale securities were as follows (in thousands):
December 31, | ||||||||
2007 | 2006 | |||||||
Unrealized appreciation | $ | 7,822 | $ | 3,633 | ||||
Unrealized depreciation | (1,895 | ) | (5,122 | ) | ||||
Net unrealized appreciation (depreciation) | 5,927 | (1,489 | ) | |||||
Deferred federal income tax (expense) benefit | (2,075 | ) | 521 | |||||
Net unrealized appreciation (depreciation) on investments, net of deferred federal income taxes | $ | 3,852 | $ | (968 | ) | |||
The gross realized gains and gross realized losses on the sale of available for sale debt securities were $88,000 and $252,000, respectively, for the year ended December 31, 2007. The proceeds from the sale of debt securities were $222.4 million.
The gross realized gains and gross realized losses on the sale of available for sale debt securities were $0 and $30,000, respectively, for the year ended December 31, 2006. The proceeds from the sale of debt securities were $77.3 million.
The gross realized gains and gross realized losses on the sale of available for sale debt securities were $47,000 and $142,000, respectively, for the year ended December 31, 2005. The gross realized gains and gross realized losses on the sale of available for sale equity securities were $8,000 and $0, respectively, for the year ended December 31, 2005. The proceeds from the sale of debt securities and equity securities were $95.1 million and $8,000, respectively.
At December 31, 2007, the amortized cost and estimated fair value of available for sale debt securities, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because
87
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
certain borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands):
Available for Sale | ||||||||
Amortized | Estimated | |||||||
Cost | Fair Value | |||||||
Due in one year or less | $ | 35,891 | $ | 35,893 | ||||
Due after one year through five years | 172,396 | 174,508 | ||||||
Due after five years through ten years | 184,612 | 187,294 | ||||||
Due after ten years | 64,365 | 65,100 | ||||||
Mortgage-backed securities | 147,565 | 147,961 | ||||||
$ | 604,829 | $ | 610,756 | |||||
Net investment income for the three years ended December 31, 2007, 2006, and 2005 was as follows (in thousands):
2007 | 2006 | 2005 | ||||||||||
Net Investment Income Earned From: | ||||||||||||
Debt securities | $ | 23,746 | $ | 19,376 | $ | 16,080 | ||||||
Equity securities | 25 | — | 37 | |||||||||
Cash and cash equivalents | 3,224 | 3,279 | 2,291 | |||||||||
Total gross investment income | 26,995 | 22,655 | 18,408 | |||||||||
Less investment expenses | 595 | 580 | 433 | |||||||||
Net investment income | $ | 26,400 | $ | 22,075 | $ | 17,975 | ||||||
United States government obligations, municipal bonds, and bank certificates of deposit aggregating $115.2 million and $148.8 million were on deposit at December 31, 2007 and 2006, respectively, with state regulatory authorities or otherwise pledged as required by law or contract.
Other Than Temporary Impairments of Securities and Unrealized Losses on Investments
At December 31, 2007 and 2006, the Company had 160 and 293, securities that were in an unrealized loss position, respectively. These investments each had unrealized losses of less than ten percent of the amortized cost of the investment. At December 31, 2007, 128 of those investments, with an aggregate $122.2 million and $1.3 million fair value and unrealized loss, respectively, have been in an unrealized loss position for more than eighteen months. At December 31, 2006, 128 of those investments, with an aggregate $127.3 million and $3.1 million fair value and unrealized loss, respectively, have been in an unrealized loss position for more than eighteen months. Positive evidence considered in reaching the Company’s conclusion that the investments in an unrealized loss position are not other than temporarily impaired consisted of: 1) there were no specific events which caused concerns; 2) there were no past due interest payments; 3) there has been a rise in market prices; 4) the Company’s ability and intent to retain the investment for a sufficient amount of time to allow an anticipated recovery in value; and 5) changes in market value were considered normal in relation to overall fluctuations in interest rates.
88
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The fair value and amount of unrealized losses segregated by the time period the investment has been in an unrealized loss position were as follows for the years ended (in thousands):
December 31, 2007 | ||||||||||||||||||||||||
Less than 12 months | Greater than 12 months | Total | ||||||||||||||||||||||
Fair Value of | Fair Value of | Fair Value of | ||||||||||||||||||||||
Investments | Investments | Investments | ||||||||||||||||||||||
with | Gross | with | Gross | with | Gross | |||||||||||||||||||
Unrealized | Unrealized | Unrealized | Unrealized | Unrealized | Unrealized | |||||||||||||||||||
Losses | Losses | Losses | Losses | Losses | Losses | |||||||||||||||||||
Debt Securities: | ||||||||||||||||||||||||
Debt securities issued by U.S. government and agencies | $ | — | $ | — | $ | 5,963 | $ | (29 | ) | $ | 5,963 | $ | (29 | ) | ||||||||||
Obligations of states and political subdivisions | 19,400 | (68 | ) | 45,177 | (255 | ) | 64,577 | (323 | ) | |||||||||||||||
Corporate securities | 15,564 | (415 | ) | 30,601 | (513 | ) | 46,165 | (928 | ) | |||||||||||||||
Mortgage and asset backed securities | 9,116 | (95 | ) | 47,963 | (520 | ) | 57,079 | (615 | ) | |||||||||||||||
Totals | $ | 44,080 | $ | (578 | ) | $ | 129,704 | $ | (1,317 | ) | $ | 173,784 | $ | (1,895 | ) | |||||||||
December 31, 2006 | ||||||||||||||||||||||||
Less than 12 months | Greater than 12 months | Total | ||||||||||||||||||||||
Fair Value of | Fair Value of | Fair Value of | ||||||||||||||||||||||
Investments | Investments | Investments | ||||||||||||||||||||||
with | Gross | with | Gross | with | Gross | |||||||||||||||||||
Unrealized | Unrealized | Unrealized | Unrealized | Unrealized | Unrealized | |||||||||||||||||||
Losses | Losses | Losses | Losses | Losses | Losses | |||||||||||||||||||
Debt Securities: | ||||||||||||||||||||||||
Debt securities issued by U.S. government and agencies | $ | 14,586 | $ | (61 | ) | $ | 27,076 | $ | (460 | ) | $ | 41,662 | $ | (521 | ) | |||||||||
Obligations of states and political subdivisions | 45,726 | (210 | ) | 68,958 | (1,250 | ) | 114,684 | (1,460 | ) | |||||||||||||||
Corporate securities | 7,646 | (61 | ) | 55,520 | (1,454 | ) | 63,166 | (1,515 | ) | |||||||||||||||
Mortgage and asset backed securities | 20,462 | (91 | ) | 67,495 | (1,535 | ) | 87,957 | (1,626 | ) | |||||||||||||||
Totals | $ | 88,420 | $ | (423 | ) | $ | 219,049 | $ | (4,699 | ) | $ | 307,469 | $ | (5,122 | ) | |||||||||
3. | Liability for Losses and Loss Adjustment Expenses |
The Company regularly updates its reserve estimates as new information becomes available and further events occur that may impact the resolution of unsettled claims. Changes in prior reserve estimates are
89
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
reflected in results of operations in the year such changes are determined to be needed and recorded. Activity in the reserves for losses and loss adjustment expenses is summarized as follows (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Balance, beginning of year | $ | 501,077 | $ | 458,677 | $ | 378,157 | ||||||
Less reinsurance recoverables | 198,422 | 187,254 | 151,161 | |||||||||
Net balance, beginning of year | 302,655 | 271,423 | 226,996 | |||||||||
Incurred related to: | ||||||||||||
Current year | 158,060 | 149,012 | 146,658 | |||||||||
Prior years | (7,091 | ) | (2,719 | ) | 4,884 | |||||||
Total incurred | 150,969 | 146,293 | 151,542 | |||||||||
Paid related to: | ||||||||||||
Current year | 30,303 | 31,790 | 28,059 | |||||||||
Prior years | 81,780 | 83,271 | 79,056 | |||||||||
Total paid | 112,083 | 115,061 | 107,115 | |||||||||
Net balance, end of year | 341,541 | 302,655 | 271,423 | |||||||||
Plus reinsurance recoverables | 198,461 | 198,422 | 187,254 | |||||||||
Balance, end of year | $ | 540,002 | $ | 501,077 | $ | 458,677 | ||||||
As a result of favorable development on prior accident years’ reserves, the provision for loss and loss adjustment expenses (“LAE”) decreased by $7.1 million and $2.7 million in calendar year 2007 and 2006, respectively. As a result of adverse development on prior accident years’ reserves, the provision for loss and loss adjustment expenses increased by $4.9 million in calendar year 2005.
For the year ended December 31, 2007, the Company reported net favorable development on loss and LAE of $7.1 million, or 2.3% of net loss and LAE reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2007. The $7.1 million of favorable development reflects favorable development of $11.4 million, $6.0 million, and $3.1 million related to workers’ compensation programs, other lines of business, and residual markets, respectively. The 2007 development also reflects adverse development of $12.5 million and $847,000 related to commercial multiple peril and commercial auto programs, respectively.
For the year ended December 31, 2006, the Company reported net favorable development on loss and LAE of $2.7 million, or 1.0% of net loss and LAE reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2006. The $2.7 million of favorable development reflects favorable development of $920,000, $1.8 million, and $848,000 related to workers’ compensation programs, other lines of business, and residual markets, respectively. The 2006 development also reflects adverse development of $283,000 and $596,000 related to commercial multiple peril and commercial auto programs, respectively.
For the year ended December 31, 2005, the Company reported net adverse development on loss and LAE of $4.9 million, or 2.2% of net loss and LAE reserves. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2005. The $4.9 million of adverse development reflects $1.6 million related to workers’ compensation programs, $1.6 million related to other lines of business, $1.1 million related to commercial auto programs, $392,000 related to commercial multiple peril and general liability programs and $179,000 related to residual markets.
90
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
4. | Reinsurance |
Intercompany pooling or reinsurance agreements are commonly entered into between affiliated insurance companies, so as to allow the companies to utilize the capital and surplus of all of the companies, rather than each individual company. Under pooling arrangements, companies share in the insurance business that is underwritten and allocate the combined premium, losses and related expenses between the companies within the pooling arrangement. The Insurance Company Subsidiaries utilize an Inter-Company Reinsurance Agreement (the “Pooling Agreement”). This Pooling Agreement includes Star, Ameritrust Insurance Corporation (“Ameritrust”), Savers Property and Casualty Insurance Company (“Savers”) and Williamsburg National Insurance Company (“Williamsburg”). Pursuant to the Pooling Agreement, Savers, Ameritrust and Williamsburg have agreed to cede to Star and Star has agreed to reinsure 100% of the liabilities and expenses of Savers, Ameritrust and Williamsburg, relating to all insurance and reinsurance policies issued by them. In return, Star agreed to cede and Savers, Ameritrust and Williamsburg have agreed to reinsure Star for their respective percentages of the liabilities and expenses of Star. Annually, the Company examines the Pooling Agreement for any changes to the ceded percentage for the liabilities and expenses. Any changes to the Pooling Agreement must be submitted to the applicable regulatory authorities for approval.
Star, as the lead insurance company under the Pooling Agreement, cedes insurance to reinsurers under pro-rata andexcess-of-loss contracts. These reinsurance arrangements diversify the Company’s business and minimize its exposure to large losses or hazards of an unusual nature. The ceding of insurance does not discharge the original insurer from its primary liability to its policyholder. In the event that all or any of the reinsuring companies are unable to meet their obligations, Star would be liable for such defaulted amounts. Therefore, the Company is subject to credit risk with respect to the obligations of its reinsurers. In order to minimize its exposure to significant losses from reinsurer insolvencies, the Company evaluates the financial condition of its reinsurers and monitors the economic characteristics of the reinsurers on an ongoing basis. The Company also assumes insurance from other domestic insurers and reinsurers. Based upon management’s evaluation, they have concluded the reinsurance agreements entered into by the Company transfer both significant timing and underwriting risk to the reinsurer and, accordingly, are accounted for as reinsurance under the provisions of SFAS No. 113“Accounting and Reporting for Reinsurance for Short-Duration and Long-Duration Contracts.”
The Company receives ceding commissions in conjunction with reinsurance activities. These ceding commissions are offset against the related underwriting expenses and were $10.2 million, $9.2 million, and $13.5 million in 2007, 2006, and 2005, respectively.
At December 31, 2007 and December 31, 2006, the Company had reinsurance recoverables for paid and unpaid losses of $199.5 million and $202.7 million, respectively.
In regard to the Company’sexcess-of-loss reinsurance, the Company manages its credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective and existing risk-sharing partners. The Company generally does not seek collateral where the reinsurer is rated “A−” or better by A.M. Best, has $500 million or more in surplus, and is admitted in the state of Michigan. As of December 31, 2007, the largest unsecured reinsurance recoverable is due from an admitted reinsurer with an “A+” A.M. Best rating and accounts for 42.5% of the total recoverable for paid and unpaid losses.
In regard to the Company’s risk-sharing partners (client captive orrent-a-captive quota-share non-admitted reinsurers), the Company manages credit risk on reinsurance recoverables by reviewing the financial stability, capitalization, and credit worthiness of prospective or existing reinsurers or partners. The Company customarily collateralizes reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks.
91
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
To date, the Company has not, in the aggregate, experienced material difficulties in collecting reinsurance recoverables.
The Company has historically maintained an allowance for the potential exposure to uncollectibility of certain reinsurance balances. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. The following table sets forth the Company’s exposure to uncollectible reinsurance and related allowances as of December 31, 2007 and 2006 (in thousands):
December 31, 2007 | December 31, 2006 | |||||||||||||||||||||||
Non Risk | Risk | Non Risk | Risk | |||||||||||||||||||||
Sharing(1) | Sharing(2) | Total | Sharing(1) | Sharing(2) | Total | |||||||||||||||||||
Gross exposure | $ | 4,959 | $ | 7,150 | $ | 12,109 | $ | 6,863 | $ | 7,952 | $ | 14,815 | ||||||||||||
Collateral or other security | (1 | ) | (3,114 | ) | (3,115 | ) | (170 | ) | (3,453 | ) | (3,623 | ) | ||||||||||||
Allowance | (4,873 | ) | (3,268 | ) | (8,141 | ) | (6,693 | ) | (3,038 | ) | (9,731 | ) | ||||||||||||
Net exposure | $ | 85 | $ | 768 | $ | 853 | $ | — | $ | 1,461 | $ | 1,461 | ||||||||||||
(1) | Balances related to three unaffiliated insurance companies, which are under regulatory liquidation or control, for which allowances have been established; all other admitted reinsurers have an A.M. Best rating of “A−” or better. | |
(2) | Balances related to risk-sharing partners, which have either captive orrent-a-captive quota-share reinsurance contracts with the Company. |
While management believes the above allowances to be adequate, no assurance can be given, however, regarding the future ability of any of the Company’s risk-sharing partners to meet their financial obligations.
The Company maintains anexcess-of-loss reinsurance treaty designed to protect against large or unusual loss and loss adjustment expense activity. The Company determines the appropriate amount of reinsurance primarily based on the Company’s evaluation of the risks accepted, but also considers analysis prepared by consultants and reinsurers and on market conditions including the availability and pricing of reinsurance. To date, there have been no material disputes with the Company’sexcess-of-loss reinsurers. No assurance can be given, however, regarding the future ability of any of the Company’sexcess-of-loss reinsurers to meet their obligations.
Under the workers’ compensation reinsurance treaty, reinsurers are responsible for 100% of each loss in excess of $350,000, up to $5.0 million for each claimant, on losses occurring prior to April 1, 2005. The Company increased its retention from $350,000 to $750,000, for losses occurring on or after April 1, 2005 and to $1.0 million for losses occurring on or after April 1, 2006. In addition, there is coverage for loss events involving more than one claimant up to $50.0 million per occurrence in excess of retentions of $1.0 million. In a loss event involving more than one claimant, the per claimant coverage is $10.0 million in excess of retentions of $1.0 million.
Under the core liability reinsurance treaty, the reinsurers are responsible for 100% of each loss in excess of $350,000, up to $2.0 million per occurrence on policies effective prior to June 1, 2005. The Company increased its retention from $350,000 to $500,000, for losses occurring on policies effective on or after June 1, 2005. The Company also purchased an additional $3.0 million of reinsurance clash coverage in excess of the $2.0 million to cover amounts that may be in excess of the $2.0 million policy limit, such as expenses associated with the settlement of claims or awards in excess of policy limits. Reinsurance clash coverage reinsures a loss when two or more policies are involved in a common occurrence. Effective June 1, 2006, the Company purchased a $5.0 million excess cover to support its umbrella business. This business had previously been reinsured through various semi-automatic agreements and will now be protected by one common treaty.
92
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The Company has no retention when the umbrella limit is in excess of the primary limit, but does warrant it will maintain a minimum liability of $1.0 million if the primary limit does not respond or is exhausted.
The Company has a separate treaty to cover liability specifically related to commercial trucking, where reinsurers are responsible for 100% of each loss in excess of $350,000, up to $1.0 million for losses occurring prior to December 1, 2005. The Company increased its retention from $350,000 to $500,000 for losses occurring on or after December 1, 2005. Effective December 1, 2007, the Company entered into a new $1.0 million in excess of $1.0 million per occurrence layer for additional capacity for its commercial trucking business, which is reinsured 100%. In addition, the Company purchased an additional $1.0 million of reinsurance clash coverage. The Company established a separate treaty to cover liability related to chemical distributors and repackagers, where reinsurers are responsible for 100% of each loss in excess of $500,000, up to $1.0 million, applied separately to general liability and auto liability. This treaty was terminated on a run-off basis on August 1, 2006. The exposures are covered under the core casualty treaty for policies effective August 1, 2006 and after. Additionally, the Company has a separate treaty structure to cover liability related to agricultural business. The reinsurer is responsible for 100% of each loss in excess of $500,000, up to $1.0 million for casualty losses and up to $5.0 million, for property losses occurring on or after May 1, 2006. This treaty also provides an additional $1.0 million of reinsurance clash coverage for the casualty lines.
Under the property reinsurance treaty, reinsurers are responsible for 100% of the amount of each loss in excess of $500,000, up to $5.0 million per location. In addition, there is coverage for loss events involving multiple locations up to $20.0 million after the Company has incurred $750,000 in loss.
On May 1, 2007, the Company renewed its existing reinsurance agreement that provides reinsurance coverage for policies written in the Company’s public entity excess liability program. The agreement provides reinsurance coverage of $4.0 million in excess of $1.0 million for each occurrence in excess of the policyholder’s self-insured retention.
In addition, the Company renewed its reinsurance agreement that provides $10.0 million in excess of $5.0 million for each occurrence, which is above the underlying $5.0 million of coverage for the Company’s public entity excess liability program. Under this agreement, reinsurers are responsible for 100% of each loss in excess of $5.0 million for all lines, except workers’ compensation, which is covered by the Company’s core catastrophic workers’ compensation treaty structure up to $50.0 million per occurrence.
On December 1, 2007, the Company entered into a reinsurance agreement that provides reinsurance coverage for excess workers’ compensation business. Reinsurers are responsible for 80% of the difference between $2.0 million and the policyholder’s self-insured retention for each occurrence. Reinsurers are then responsible for 100% of $8.0 million in excess of $2.0 million for each occurrence. Coverage in excess of $10.0 million up to $50.0 million per occurrence is covered by the Company’s core catastrophic workers’ compensation treaty.
Additionally, certain small programs have separate reinsurance treaties in place, which limit the Company’s exposure to $350,000 or less.
Facultative reinsurance is purchased for property values in excess of $5.0 million, casualty limits in excess of $2.0 million, or for coverage not covered by a treaty.
93
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Reconciliations of direct to net premiums, on a written and earned basis, for 2007, 2006, and 2005 are as follows (in thousands):
2007 | 2006 | 2005 | ||||||||||||||||||||||
Written | Earned | Written | Earned | Written | Earned | |||||||||||||||||||
Direct | $ | 307,266 | $ | 266,049 | $ | 246,985 | $ | 251,288 | $ | 264,511 | $ | 264,381 | ||||||||||||
Assumed(1) | 39,184 | 71,050 | 83,887 | 75,999 | 67,698 | 61,141 | ||||||||||||||||||
Ceded | (66,239 | ) | (68,902 | ) | (68,204 | ) | (72,367 | ) | (74,075 | ) | (75,563 | ) | ||||||||||||
Net | $ | 280,211 | $ | 268,197 | $ | 262,668 | $ | 254,920 | $ | 258,134 | $ | 249,959 | ||||||||||||
One reinsurer, with a financial strength rating of “A+” (Superior) rated by A.M. Best, accounts for 8.5% of ceded premiums in 2007.
(1) | For the years ending December 31, 2007, 2006, and 2005, $31.0 million, $72.6 million, and $56.0 million, relates to assumed business the Company manages directly, respectively. The related transactions of this business are processed through the Company’s internal systems and related controls. In addition, the Company does not assume any foreign reinsurance. |
5. | Segment Information |
The Company defines its operations as specialty risk management operations and agency operations based upon differences in products and services. The separate financial information of these segments is consistent with the way results are regularly evaluated by management in deciding how to allocate resources and in assessing performance. Intersegment revenue is eliminated upon consolidation. It would be impracticable for the Company to determine the allocation of assets between the two segments.
Specialty Risk Management Operations
The specialty risk management operations segment, which includes insurance company specialty programs andfee-for-service specialty programs, focuses on specialty or niche insurance business. Specialty risk management operations provide 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 various types of property and casualty insurance coverage, including workers’ compensation, commercial multiple peril, general liability, commercial auto liability, and inland marine. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of the Company’s agent-partners. The Company recognizes revenue related to the services and coverages the specialty risk management operations provides within seven categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance placement, investment income, and net realized gains (losses).
Agency Operations
The Company earns commissions through the operation of its retail property and casualty insurance agencies located in Michigan, California, and Florida. The agency operations produce commercial, personal lines, life, and accident and health insurance, for more than fifty unaffiliated insurance carriers. The agency produces an immaterial amount of business for its affiliated Insurance Company Subsidiaries.
94
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The following table sets forth the segment results (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Revenues | ||||||||||||
Net earned premiums | $ | 268,197 | $ | 254,920 | $ | 249,959 | ||||||
Management fees | 23,963 | 18,714 | 16,741 | |||||||||
Claims fees | 9,025 | 8,776 | 7,113 | |||||||||
Loss control fees | 2,151 | 2,216 | 2,260 | |||||||||
Reinsurance placement | 929 | 735 | 660 | |||||||||
Investment income | 25,487 | 21,115 | 17,692 | |||||||||
Net realized gains | 150 | 69 | 85 | |||||||||
Specialty risk management | 329,902 | 306,545 | 294,510 | |||||||||
Agency operations | 11,316 | 12,285 | 11,304 | |||||||||
Holding Company interest income earned | 913 | 960 | 365 | |||||||||
Intersegment revenue | (1,396 | ) | (1,554 | ) | (2,162 | ) | ||||||
Consolidated revenue | $ | 340,735 | $ | 318,236 | $ | 304,017 | ||||||
Pre-tax income: | ||||||||||||
Specialty risk management | $ | 47,898 | $ | 38,292 | $ | 29,546 | ||||||
Agency operations(1) | 2,087 | 2,609 | 3,241 | |||||||||
Non-allocated expenses | (10,598 | ) | (9,396 | ) | (7,121 | ) | ||||||
Consolidated pre-tax income | $ | 39,387 | $ | 31,505 | $ | 25,666 | ||||||
(1) | The Company’s agency operations include an allocation of corporate overhead, which includes expenses associated with accounting, information services, legal, and other corporate services. The corporate overhead allocation excludes those expenses specific to the holding company. For the years ended December 31, 2007, 2006, and 2005, the allocation of corporate overhead to the agency operations segment was $2.8 million, $3.3 million, and $3.2 million, respectively. These balances include an allocation to our Insurance & Benefit Consultants agency business that was previously allocated to specialty risk management operations. For the years ended December 31, 2006 and 2005, pre-tax income for agency operations was overstated and specialty risk management was understated by $342,000 and $102,000, respectively. |
The following table sets forth the non-allocated expenses included in pre-tax income (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Holding company expenses | $ | (2,638 | ) | $ | (2,830 | ) | $ | (2,892 | ) | |||
Amortization | (1,930 | ) | (590 | ) | (373 | ) | ||||||
Interest expense | (6,030 | ) | (5,976 | ) | (3,856 | ) | ||||||
$ | (10,598 | ) | $ | (9,396 | ) | $ | (7,121 | ) | ||||
6. | Debt |
Lines of Credit
In April 2007, the Company executed an amendment to its current revolving credit agreement with its bank. The amendments included an extension of the term to September 30, 2010, an increase to the available borrowings of up to $35.0 million, and a reduction of the variable interest rate basis to a range between 75 to 175 basis points above LIBOR. The Company uses the revolving line of credit to meet short-term working
95
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
capital needs. Under the revolving line of credit, the Company and certain of its non-regulated subsidiaries pledged security interests in certain property and assets of the Company and named subsidiaries.
At December 31, 2007, the Company did not have an outstanding balance on the revolving line of credit. In July 2007, the Company completed a secondary equity offering in which it received net proceeds of approximately $58.6 million. Upon receipt of the net proceeds, the Company reduced its outstanding line of credit balance from $22.0 million to zero. At December 31, 2006, the Company had an outstanding balance of $7.0 million on the revolving line of credit.
The revolving line of credit provides for interest at a variable rate based, at the Company’s option, upon either a prime based rate or LIBOR-based rate. In addition, the revolving line of credit also provides for an unused facility fee of 15 basis points on any unused balance. On prime based borrowings, the applicable margin ranges from 75 to 25 basis points below prime. On LIBOR-based borrowings, the applicable margin ranges from 75 to 175 basis points above LIBOR. The margin for all loans is dependent on the sum of non-regulated earnings before interest, taxes, depreciation, amortization, and non-cash impairment charges related to intangible assets for the preceding four quarters, plus dividends paid or payable to the Company from subsidiaries during such period (“Adjusted EBITDA”). At December 31, 2007, the Company did not have anyLIBOR-based borrowings outstanding. At December 31, 2006, the weighted average interest rate for LIBOR-based borrowings outstanding was 6.7%.
Debt covenants consist of: (1) maintenance of the ratio of Adjusted EBITDA to interest expense of 2.0 to 1.0, (2) minimum net worth of $130.0 million and increasing annually commencing June 30, 2005, by fifty percent of the prior year’s positive net income, (3) minimum A.M. Best rating of “B”, and (4) minimum Risk Based Capital Ratio for Star of 1.75 to 1.00. As of December 31, 2007, the Company was in compliance with these covenants.
Senior Debentures
In April 2004, the Company issued senior debentures in the amount of $13.0 million. The senior debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.0%, which is non-deferrable. At December 31, 2007, the interest rate was 8.87%. The senior debentures are callable by the Company at par after five years from the date of issuance. Associated with this transaction, the Company incurred $390,000 of commissions paid to the placement agents.
In May 2004, the Company issued senior debentures in the amount of $12.0 million. The senior debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.2%, which is non-deferrable. At December 31, 2007, the interest rate was 9.23%. The senior debentures are callable by the Company at par after five years from the date of issuance. Associated with this transaction, the Company incurred $360,000 of commissions paid to the placement agents.
The Company contributed $9.9 million of the proceeds to its Insurance Company Subsidiaries and the remaining proceeds were used for general corporate purposes.
The issuance costs associated with these debentures have been capitalized and are included in other assets on the accompanying balance sheets. From the time of issuance through June 30, 2007, these issuance costs were being amortized over a seven year period as a component of interest expense. The seven year amortization period represented management’s best estimate of the estimated useful life of the bonds related to the senior debentures. Beginning July 1, 2007, the Company reevaluated its best estimate and determined a five year amortization period to be a more accurate representation of the estimated useful life. Therefore, this change in amortization period from seven years to five years has been applied prospectively commencing July 1, 2007.
96
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Junior Subordinated Debentures
In September 2005, Meadowbrook Capital Trust II (the “Trust II”), an unconsolidated subsidiary trust of the Company, issued $20.0 million of mandatorily redeemable trust preferred securities (“TPS”) to a trust formed by an institutional investor. Contemporaneously, the Company issued $20.6 million in junior subordinated debentures, which includes the Company’s investment in the trust of $620,000. These debentures have financial terms similar to those of the TPS, which includes the deferral of interest payments at any time, or fromtime-to-time, for a period not exceeding five years, provided there is no event of default. These debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 3.58%. At December 31, 2007, the interest rate was 8.57%. These debentures are callable by the Company at par beginning in October 2010.
The Company received $19.4 million in net proceeds, after the deduction of approximately $600,000 of commissions paid to the placement agents in the transaction.
The Company contributed $10.0 million of the proceeds from the issuance of these debentures to its Insurance Company Subsidiaries and the remaining proceeds were used for general corporate purposes.
In September 2003, Meadowbrook Capital Trust (the “Trust”), an unconsolidated subsidiary trust of the Company, issued $10.0 million of mandatorily redeemable TPS to a trust formed by an institutional investor. Contemporaneously, the Company issued $10.3 million in junior subordinated debentures, which includes the Company’s investment in the trust of $310,000. These debentures have financial terms similar to those of the TPS, which includes the deferral of interest payments at any time, or fromtime-to-time, for a period not exceeding five years, provided there is no event of default. These debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.05%. At December 31, 2007, the interest rate was 9.28%. These debentures are callable by the Company at par beginning in October 2008.
The Company received $9.7 million in net proceeds, after the deduction of approximately $300,000 of commissions paid to the placement agents in the transaction.
The Company contributed $6.3 million of the proceeds from the issuance of these debentures to its Insurance Company Subsidiaries and the remaining proceeds were used for general corporate purposes.
The junior subordinated debentures are unsecured obligations of the Company and are junior to the right of payment to all senior indebtedness of the Company. The Company has guaranteed that the payments made to both Trusts will be distributed by the Trusts to the holders of the TPS.
The Company estimates that the fair value of the above mentioned junior subordinated debentures and senior debentures issued approximate the gross proceeds of cash received at the time of issuance.
The issuance costs associated with the junior subordinated debentures have been capitalized and are included in other assets on the balance sheet. From the time of issuance through June 30, 2007, these issuance costs were being amortized over a seven year period as a component of interest expense. The seven year amortization period represented management’s best estimate of the estimated useful life of the bonds related to the junior subordinated debentures. Beginning July 1, 2007, the Company reevaluated its best estimate and determined a five year amortization period to be a more accurate representation of the estimated useful life. Therefore, this change in amortization period from seven years to five years has been applied prospectively commencing July 1, 2007.
7. | Derivative Instruments |
In October 2005, the Company entered into two interest rate swap transactions to mitigate its interest rate risk on $5.0 million and $20.0 million of the Company’s senior debentures and trust preferred securities, respectively. The Company accrues for these transactions in accordance with SFAS No. 133“Accounting for
97
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Derivative Instruments and Hedging Activities,”as subsequently amended. These interest rate swap transactions have been designated as cash flow hedges and are deemed highly effective hedges under SFAS No. 133. In accordance with SFAS No. 133, these interest rate swap transactions are recorded at fair value on the balance sheet and the effective portion of the changes in fair value are accounted for within other comprehensive income. The interest differential to be paid or received is being accrued and is being recognized as an adjustment to interest expense.
The first interest rate swap transaction, which relates to $5.0 million of the Company’s $12.0 million issuance of senior debentures, has an effective date of October 6, 2005 and ending date of May 24, 2009.
The Company is required to make certain quarterly fixed rate payments calculated on a notional amount of $5.0 million,non-amortizing, based on a fixed annual interest rate of 8.925%. The counterparty is obligated to make quarterly floating rate payments to the Company, referencing the same notional amount, based on the three-month LIBOR, plus 4.20%.
The second interest rate swap transaction, which relates to $20.0 million of the Company’s $20.0 million issuance of trust preferred securities, has an effective date of October 6, 2005 and ending date of September 16, 2010. The Company is required to make quarterly fixed rate payments calculated on a notional amount of $20.0 million,non-amortizing, based on a fixed annual interest rate of 8.34%. The counterparty is obligated to make quarterly floating rate payments to the Company, referencing the same notional amount, based on the three-month LIBOR, plus 3.58%.
In relation to the above interest rate swaps, the net interest income received for the years ended December 31, 2007 and 2006, was approximately $172,000 and $67,000, respectively. The net interest expense incurred for the year ended December 31, 2005, was approximately $4,000. The total fair value of the interest rate swaps as of December 31, 2007 and 2006 was approximately ($545,000) and $200,000, respectively. Accumulated other comprehensive income at December 31, 2007 and 2006, included accumulated (loss) income on the cash flow hedge, net of taxes, of approximately ($484,000) and $121,000, respectively.
In December 2005, the Company entered into a $6.0 million convertible note receivable with an unaffiliated insurance agency. The effective interest rate of the convertible note is equal to the three-month LIBOR, plus 5.2% and is due December 20, 2010. This agency has been a producer for the Company for over ten years. As security for the loan, the borrower granted the Company a security interest in its accounts, cash, general intangibles, and other intangible property. Also, the shareholder then pledged 100% of the common shares of three insurance agencies, the common shares owned by the shareholder in another agency, and has executed a personal guaranty. This note is convertible at the option of the Company based upon a pre-determined formula, beginning in 2007. The conversion feature of this note is considered an embedded derivative pursuant to SFAS No. 133, and therefore is accounted for separately from the note. At December 31, 2007, the estimated fair value of the derivative was not material to the financial statements.
8. | Regulatory Matters and Rating Issues |
A significant portion of the Company’s consolidated assets represent assets of its Insurance Company Subsidiaries. The State of Michigan Office of Financial and Insurance Services (“OFIS”) restricts the amount of funds that may be transferred to the holding company in the form of dividends, loans or advances. These restrictions in general, are as follows: the maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of each insurance company’s net income (excluding realized capital gains) or ten percent of the insurance company’s surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law that prohibits an insurer from declaring dividends, except out of surplus earnings of the company. Earned surplus balances are calculated on a quarterly basis. Since Star is the parent insurance company, its maximum dividend calculation represents the combined Insurance Company Subsidiaries’ surplus. At December 31, 2007 and 2006, Star’s earned surplus
98
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
position was positive $33.7 million and $13.2 million, respectively. Based upon Star’s statutory financial statements as of December 31, 2007, Star would have the potential to pay a dividend of up to $18.8 million without the prior approval of OFIS. No statutory dividends were paid in 2007 or 2006.
Summarized 2007 and 2006 statutory basis information for the primary insurance subsidiaries, which differs from generally accepted accounting principles, is as follows (in thousands):
2007 | 2006 | |||||||||||||||||||||||||||||||
Star | Savers | Williamsburg | Ameritrust | Star | Savers | Williamsburg | Ameritrust | |||||||||||||||||||||||||
Statutory capital and surplus | $ | 188,381 | $ | 41,633 | $ | 21,846 | $ | 18,989 | $ | 165,107 | $ | 35,914 | $ | 18,979 | $ | 16,463 | ||||||||||||||||
RBC authorized control level | 34,419 | 6,278 | 3,272 | 2,786 | 31,569 | 5,710 | 2,960 | 2,532 | ||||||||||||||||||||||||
Statutory net income | 13,893 | 5,460 | 2,775 | 2,479 | 9,517 | 4,135 | 1,969 | 2,311 |
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. The Company’s targets for gross and net written premium to statutory surplus are 2.8 to 1.0 and 2.25 to 1.0, respectively. As of December 31, 2007, on a statutory combined basis, the gross and net premium leverage ratios were 1.8 to 1.0 and 1.5 to 1.0, respectively.
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general, an insurance company must submit a calculation of its RBC formula to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidation proceeding.
The RBC Model Act provides for four different levels of regulatory attention depending on the ratio of the company’s total adjusted capital, defined as the total of its statutory capital, surplus and asset valuation reserve, to its risk-based capital.
At December 31, 2007, each of our Insurance Company Subsidiaries was in excess of any minimum threshold at which corrective action would be required. At December 31, 2007 and 2006, Star’s statutory surplus was $188.4 million and $165.1 million, respectively.
In April 2007, the Company received an upgrade of its financial strength rating by A.M. Best Company to “A−” (Excellent), from “B++” (Very Good) for its Insurance Company Subsidiaries.
99
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
9. | Deferred Policy Acquisition Costs |
The following table reflects the amounts of policy acquisition costs deferred and amortized (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Balance, beginning of period | $ | 27,902 | $ | 26,371 | $ | 25,167 | ||||||
Acquisition costs deferred | 37,395 | 39,201 | 35,367 | |||||||||
Amortized to expense during the period | (38,371 | ) | (37,670 | ) | (34,163 | ) | ||||||
Balance, end of period | $ | 26,926 | $ | 27,902 | $ | 26,371 | ||||||
The Company reduces deferred policy acquisition costs for premium deficiencies. There were no premium deficiencies at December 31, 2007, 2006, and 2005.
10. | Income Taxes |
The provision for income taxes consists of the following (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Current tax expense | $ | 13,264 | $ | 8,858 | $ | 6,410 | ||||||
Deferred tax (benefit) expense | (1,538 | ) | 741 | 1,347 | ||||||||
Total provision for income tax expense | $ | 11,726 | $ | 9,599 | $ | 7,757 | ||||||
A reconciliation of the Company’s tax provision on income from operations to the U.S. federal income tax rate of 35% is as follows (in thousands):
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Tax provision at statutory rate | $ | 13,760 | $ | 11,027 | $ | 8,982 | ||||||
Tax effect of: | ||||||||||||
Tax exempt interest | (2,832 | ) | (2,021 | ) | (1,291 | ) | ||||||
State income taxes, net of federal benefit | 610 | 352 | 458 | |||||||||
Impact of increase in statutory rate relating to deferred tax assets at December 31, 2005 | — | — | (386 | ) | ||||||||
Other, net | 188 | 241 | (6 | ) | ||||||||
Federal and state income tax expense | $ | 11,726 | $ | 9,599 | $ | 7,757 | ||||||
Effective tax expense rate | 29.8 | % | 30.5 | % | 30.2 | % | ||||||
The current federal statutory tax rate of 35% is based upon $38.4 million, $31.0 million, and $25.0 million of taxable income for 2007, 2006, and 2005, respectively. At December 31, 2007 and 2006, the current taxes receivable were $760,000 and $1.6 million, respectively.
Deferred federal income taxes, under SFAS No. 109,“Accounting for Income Taxes,”reflect the estimated future tax effect of temporary differences between the bases of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations.
100
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The components of deferred tax assets and liabilities as of December 31, 2007 and 2006 are as follows (in thousands):
2007 | 2006 | |||||||||||||||
Deferred | Deferred | Deferred | Deferred | |||||||||||||
Tax | Tax | Tax | Tax | |||||||||||||
Assets | Liabilities | Assets | Liabilities | |||||||||||||
Unpaid losses and loss adjustment expenses | $ | 15,487 | $ | — | $ | 14,557 | $ | — | ||||||||
Unearned premium reserves | 9,540 | — | 8,701 | — | ||||||||||||
Unrealized loss / gains on investments | — | 1,884 | 451 | — | ||||||||||||
Deferred policy acquisition expense | — | 9,424 | — | 9,765 | ||||||||||||
Allowance for doubtful accounts | 959 | — | 1,032 | — | ||||||||||||
Policyholder dividends | 447 | — | 348 | — | ||||||||||||
Net operating loss | 145 | — | — | — | ||||||||||||
Goodwill | — | 2,500 | — | 1,900 | ||||||||||||
Deferred revenue | 76 | — | 152 | — | ||||||||||||
Long term incentive plan | 547 | — | 1,078 | — | ||||||||||||
Amortization of intangible assets | 789 | — | 352 | — | ||||||||||||
Deferred gain on sale-leaseback transaction | 200 | — | 231 | — | ||||||||||||
Other | 554 | — | 495 | — | ||||||||||||
Total deferred taxes | 28,744 | 13,808 | 27,397 | 11,665 | ||||||||||||
Net deferred tax assets | $ | 14,936 | $ | 15,732 | ||||||||||||
Realization of the deferred tax asset is dependent on generating sufficient taxable income to absorb the applicable reversing temporary differences. Refer to Note 1 —Summary of Significant Accounting Policies.
In June 2006, the FASB issued FASB Interpretation No. 48,“Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109”(“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertain tax positions. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition, measurement, and presentation of uncertain tax positions taken or expected to be taken in an income tax return. The Company adopted the provisions of FIN 48 as of January 1, 2007.
As a result of the adoption of FIN 48, the Company identified, evaluated and measured the amount of income tax benefits to be recognized for all income tax positions. The net tax assets recognized under FIN 48 did not differ from the net tax assets recognized prior to adoption, and, therefore, the Company did not record an adjustment.
Interest costs and penalties related to income taxes are classified as interest expense and other administrative expenses, respectively. As of December 31, 2007 and 2006, the Company had no amounts of accrued interest or penalties related to uncertain tax positions.
The Company and its subsidiaries are subject to U.S. federal income tax as well as to income tax of multiple state jurisdictions. Tax returns for all years subsequent to 2002 are subject to future examination by tax authorities.
101
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
11. | Stock Options, Long Term Incentive Plan, and Deferred Compensation Plan |
Stock Options
The Company has two plans under which it has issued stock options, its 1995 and 2002 Amended and Restated Stock Option Plans (the “Plans”). Currently the Plans’ options have either five or ten-year terms and are exercisable and vest in equal increments over the option term. The Company has not issued any new stock options to employees since 2003.
The following is a summary of the Company’s stock option activity and related information for the years ended December 31:
2007 | 2006 | 2005 | ||||||||||||||||||||||
Weighted- | Weighted- | Weighted- | ||||||||||||||||||||||
Average | Average | Average | ||||||||||||||||||||||
Exercise | Exercise | Exercise | ||||||||||||||||||||||
Options | Price | Options | Price | Options | Price | |||||||||||||||||||
Outstanding — beginning of year | 391,678 | $ | 7.38 | 1,605,901 | $ | 5.42 | 2,121,317 | $ | 5.53 | |||||||||||||||
Exercised | (244,574 | ) | $ | 2.65 | (791,038 | ) | $ | 3.32 | (97,825 | ) | $ | 2.90 | ||||||||||||
Expired and/or forfeited | (15,052 | ) | $ | 21.68 | (423,185 | ) | $ | 7.54 | (417,591 | ) | $ | 6.57 | ||||||||||||
Outstanding — end of year | 132,052 | $ | 14.51 | 391,678 | $ | 7.38 | 1,605,901 | $ | 5.42 | |||||||||||||||
Exercisable at end of year | 106,182 | $ | 14.51 | 324,704 | $ | 7.62 | 1,288,296 | $ | 5.65 |
The following table summarizes information about stock options outstanding at December 31, 2007:
Options Outstanding | Options Exercisable | |||||||||||||||||||
Weighted- | Weighted- | Weighted- | ||||||||||||||||||
Average | Average | Average | ||||||||||||||||||
Range of | Remaining | Exercise | Exercise | |||||||||||||||||
Exercise Prices | Options | Life (Years) | Price | Options | Price | |||||||||||||||
$2.173 to $3.507 | 31,745 | 0.9 | $ | 2.17 | 31,745 | $ | 2.17 | |||||||||||||
$6.48 | 1,500 | 2.7 | $ | 6.48 | 1,000 | $ | 6.48 | |||||||||||||
$10.91 to $24.6875 | 98,807 | 1.2 | $ | 18.60 | 73,437 | $ | 23.47 | |||||||||||||
132,052 | 1.1 | $ | 14.51 | 106,182 | $ | 14.51 | ||||||||||||||
Long Term Incentive Plan
In 2004, the Company adopted a Long Term Incentive Plan (the “LTIP”). The LTIP provides participants with the opportunity to earn cash and stock awards based upon the achievement of specified financial goals over a three-year performance period with the first performance period commencing January 1, 2004. At the end of a three-year performance period, and if the performance targets for that period are achieved, the Compensation Committee of the Board of Directors shall determine the amount of LTIP awards that are payable to participants in the LTIP for the current performance period. One-half of any LTIP award will be payable in cash and one-half of the award will be payable in the form of a stock award. If the Company achieves the performance targets for the three-year performance period, payment of the cash portion of the award would be made in three annual installments, with the first payment being paid as of the end of the that performance period and the remaining two payments to be paid in the subsequent two years. Any unpaid portion of a cash award is subject to forfeiture if the participant voluntarily leaves the Company or is discharged for cause. The portion of the award to be paid in the form of stock will be issued as of the end of that performance period. The number of shares of Company’s common stock subject to the stock award shall equal the dollar amount of one-half of the LTIP award divided by the fair market value of Company’s common stock on the first date of the beginning of the performance period. The stock awards shall be made subject to
102
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
the terms and conditions of the LTIP and Plans. The Company accrues awards based upon the criteria set-forth and approved by the Compensation Committee of the Board of Directors, as included in the LTIP.
In 2006, the Company achieved its specified financial goals for the2004-2006 plan years. On February 8, 2007, the Company’s Board of Directors and the Compensation Committee of the Board of Directors approved the distribution of the LTIP award for the2004-2006 plan years, which included both a cash and stock award. The total cash distribution was $2.5 million, of which $823,000 was paid out in 2007 with the remainder to be paid out in 2008 and 2009. The stock portion of the LTIP award was valued at $2.5 million, which resulted in the issuance of 579,496 shares of the Company’s common stock. Of the 579,496 shares issued, 191,570 shares were retired for payment of the participant’s associated withholding taxes related to the compensation recognized by the participant. The stock portion of the award was fully expensed as of December 31, 2006. The cash portion of the award is being expensed over a five-year period.
In addition, the Company’s Board of Directors and the Compensation Committee of the Board of Directors approved the new performance targets for the2007-2009 plan years. The Company commenced accruing for the LTIP payout for the2007-2009 plan years as of March 31, 2007.
At December 31, 2007, the Company had $1.6 million and $772,000 accrued for the cash and stock award, respectively, for all plan years under the LTIP. Of the $1.6 million accrued for the cash award, $1.2 million relates to the2004-2006 plan years and the remainder relates to the2007-2009 plan years. As previously indicated, the stock portion for the2004-2006 plan years was fully expensed as of December 31, 2006, thus the $772,000 stock award accrual relates to the2007-2009 plan years. At December 31, 2006, the Company had $1.4 million and $2.5 million accrued for the cash and stock award, respectively. Shares related to the Company’s LTIP included in diluted earnings per share were 78,270 and 476,252 for the years ended December 31, 2007 and 2006, respectively.
Deferred Compensation Plan
In 2006, the Company adopted an Executive Nonqualified Excess Plan (the “Excess Plan”). The Excess Plan is intended to be a nonqualified deferred compensation plan that will comply with the provisions of Section 409A of the Internal Revenue Code. The Company adopted the Excess Plan to provide a means by which certain key management employees may elect to defer receipt of current compensation from the Company in order to provide retirement and other benefits, as provided for in the Excess Plan. The Excess Plan is intended to be an unfunded plan maintained primarily for the purpose of providing deferred compensation benefits for eligible employees. At December 31, 2007 and 2006, the Company had $644,000 and $211,000 accrued for deferred compensation, respectively.
12. | Shareholders’ Equity |
On July 19, 2007, the Company completed a secondary offering of 6,437,500 additional shares of its common stock at a price of $9.65 per share. Including the underwriting discount associated with the offering and other related expenses, the Company received total net proceeds of approximately $58.6 million. These net proceeds are being utilized to support organic growth within its underwriting operations, to fund select acquisitions and for other general corporate purposes. Upon receipt of the net proceeds, the Company reduced its outstanding line of credit balance from $22.0 million to zero.
At December 31, 2007, shareholders’ equity was $301.9 million, or a book value of $8.16 per common share, compared to $201.7 million, or a book value of $6.93 per common share at December 31, 2006.
In April 2007, the Company purchased the business of U.S. Specialty Underwriters, Inc. for a purchase price of $23.0 million. This purchased price was comprised of $13.0 million in cash and $10.0 million in the Company’s common stock. Total additional shares issued for the $10.0 million portion of the purchase price were 907,935 shares.
103
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
On February 8, 2007, the Company’s Board of Directors and the Compensation Committee of the Board of Directors approved the distribution of the Company’s LTIP award for the2004-2006 plan years, which included both a cash and stock award. The stock portion of the LTIP award was valued at $2.5 million, which resulted in the issuance of 579,496 shares of the Company’s common stock. Of the 579,496 shares issued, 191,570 shares were retired for payment of the participant’s associated withholding taxes related to the compensation recognized by the participant. Refer to Note 2 —Stock Options, Long Term Incentive Plan, and Deferred Compensation Planfor further detail. The retirement of the shares for the associated withholding taxes reduced the Company’s paid in capital by $1.8 million.
On October 26, 2007, the Company’s Board of Directors authorized management to purchase up to 1,000,000 shares, or approximately 3%, of its common stock in market transactions for a period not to exceed twenty-four months. The Company’s prior plan expired on October 27, 2007. For the years ended December 31, 2007 and 2006, the Company did not repurchase any common stock under either plan. As of December 31, 2007, the Company has available up to 1,000,000 shares to be purchased.
On February 8, 2008, the Company’s Board of Directors declared a quarterly dividend of $0.02 per common share. The dividend is payable on March 31, 2008, to shareholders of record as of March 14, 2008. The Company’s Board of Directors did not declare any dividends in 2007 or 2006. When evaluating the declaration of a dividend, the Company’s Board of Directors considers a variety of factors, including but not limited to, cash flow, liquidity needs, results of operations and its overall financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from its Insurance Company Subsidiaries. The Company did not receive any dividends from its Insurance Company Subsidiaries in 2007 or 2006. Refer to Note 8 —Regulatory Matters and Rating Issuesfor additional information regarding dividend restrictions.
13. | Goodwill and Other Intangible Assets |
Goodwill
The Company evaluates existing goodwill for impairment on an annual basis as of October 1st, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company carries goodwill on two reporting units within the agency operations segment in the amount of $6.5 million and three reporting units within the specialty risk management operations segment in the amount of $37 million. During 2007, 2006, and 2005, the Company did not record any impairment losses in relation to its existing goodwill.
During the second quarter 2007, the Company purchased certain business assets of U.S. Specialty Underwriters, Inc. (“USSU”) for a total purchase price of approximately $23.0 million. The total purchase price consisted of $12.0 million recognized as goodwill and $9.5 million related to other intangible assets, which is being amortized over five years. There was an immaterial amount of tangible assets related to the acquisition. In 2006, the Company recorded additional goodwill of $700,000 resulting from contingent consideration payments, related to the 2005 acquisition of a Florida-based agency.
The following sets forth the carrying amount of goodwill by business segment (in thousands):
Specialty Risk | ||||||||||||
Management | ||||||||||||
Agency Operations | Operations | Total | ||||||||||
Balance at December 31, 2007 | $ | 6,469 | $ | 37,028 | $ | 43,497 | ||||||
Balance at December 31, 2006 | $ | 6,469 | $ | 25,033 | $ | 31,502 |
104
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Other Intangible Assets
At December 31, 2007 and 2006, the Company had other intangible assets, net of related accumulated amortization, of $17.1 million and $1.8 million, respectively, recorded on the consolidated balance sheet as part of “Other Assets.”
During the second quarter 2007, the Company acquired the USSU book of business as described above. The total purchase price consisted of $9.5 million recognized as other intangible assets.
During the fourth quarter 2007, the Company purchased a book of business for an excess liability and workers’ compensation program for public entities. The total purchase price consisted of $7.5 million recognized as other intangible assets.
At December 31, 2007, the gross carrying amount of other intangible assets was $20.5 million and the accumulated amortization was $3.4 million, respectively. At December 31, 2006, the gross carrying amount of other intangible assets was $3.3 million and the accumulated amortization was $1.5 million. Amortization expense related to other intangible assets for 2007, 2006, and 2005, was $1.9 million, $590,000, and $373,000, respectively.
Amortization expense for the five succeeding years is as follows (in thousands):
2008 | $ | 2,951 | ||
2009 | 2,944 | |||
2010 | 2,900 | |||
2011 | 2,688 | |||
2012 | 1,322 | |||
Total amortization expense | $ | 12,805 | ||
14. | Commitments and Contingencies |
The Company has certain operating lease agreements for its offices and equipment. A majority of the Company’s lease agreements contain renewal options and rent escalation clauses. At December 31, 2007, future minimum rental payments required under non-cancelable long-term operating leases are as follows (in thousands):
2008 | $ | 4,904 | ||
2009 | 4,665 | |||
2010 | 2,227 | |||
2011 | 1,896 | |||
2012 | 1,548 | |||
Thereafter | 1,557 | |||
Total minimum lease commitments | $ | 16,797 | ||
Rent expense for the years ended December 31, 2007, 2006, and 2005, amounted to $2.7 million, $2.4 million, and $2.2 million, respectively.
Most states require admitted property and casualty insurers to become members of insolvency funds or associations, which generally protect policyholders against the insolvency of such insurers. Members of the fund or association must contribute to the payment of certain claims made against insolvent insurers. Maximum contributions required by law in any one year vary between 1% and 2% of annual premium written by a member in that state. Assessments from insolvency funds were $156,000, $306,000, and $664,000,
105
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
respectively, for 2007, 2006, and 2005. Most of these payments are recoverable through future policy surcharges and premium tax reductions.
The Company’s Insurance Company Subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. Among the pools participated in are those established in certain states to provide windstorm and other similar types of property coverage. These pools typically require all companies writing applicable lines of insurance in the state for which the pool has been established to fund deficiencies experienced by the pool based upon each company’s relative premium writings in that state, with any excess funding typically distributed to the participating companies on the same basis. To the extent that reinsurance treaties do not cover these assessments, they may have an adverse effect on the Company. Total assessments paid to all such facilities were $2.6 million, $3.1 million, and $3.0 million, respectively, for 2007, 2006, and 2005.
The Company, and its subsidiaries, are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, the Company vigorously defends such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, the Company has established provisions against these items, which are believed to be adequate in light of current information and legal advice. In accordance with SFAS No. 5,“Accounting for Contingencies,”if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is estimable; an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets. Period expenses related to the defense of such claims are included in other operating expenses in the accompanying consolidated statements of income. Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, the Company does not expect the outcome of the claims, lawsuits and proceedings to which the Company is subject to, either individually, or in the aggregate, will have a material adverse effect on the Company’s financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters.
15. | Sale-Leaseback Transaction |
In 2004, the Company entered into an agreement with an unaffiliated third party to sell its property in Cerritos, California, owned by Savers and subsequently leaseback the property to Meadowbrook, Inc. There were no future commitments, obligations, provisions, or circumstances included in either the sale contract or the lease contract that would result in the Company’s continuing involvement; therefore, the assets associated with the property were removed from the Company’s consolidated balance sheets.
The sale proceeds were $2.9 million and the net book value of the property was $1.9 million. Direct costs associated with the transaction were $158,000. In conjunction with the sale, a deferred gain of $880,000 was recorded and is being amortized over the ten-year term of the operating lease. At December 31, 2007 and 2006, the Company had a deferred gain of $572,000 and $660,000, respectively, on the consolidated balance sheet in “Other Liabilities.” Total amortization of the gain for 2007, 2006, and 2005 was $88,000, $88,000, and $88,000, respectively, for a total accumulated amortization of $308,000 as of December 31, 2007.
106
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
16. | Related Party Transactions |
At December 31, 2007 and 2006, respectively, the Company held an $870,000 and $871,000 note receivable, including $209,000 of accrued interest at December 31, 2007, from an executive officer of the Company. Accrued interest at December 31, 2006 was $210,000. This note arose from a transaction in late 1998 in which the Company loaned the officer funds to exercise 64,718 common stock options to cover the exercise price and the taxes incurred as a result of the exercise. The note bears interest equal to the rate charged pursuant to the Company’s revolving credit agreement and is due on demand any time after January 1, 2002. As of December 31, 2007, the rate was 6.2%. The loan is partially collateralized by 64,718 shares of the Company’s common stock under a stock pledge agreement. For the years ended December 31, 2007 and 2006, $43,800 and $31,500, respectively, have been paid against the loan. As of December 31, 2007, the cumulative amount that has been paid against this loan was $162,800.
On June 1, 2001, the Company and the officer entered into an employment agreement, which provides the note is a non-recourse loan and the Company’s sole legal remedy in the event of a default is the right to reclaim the shares pledged under the stock pledge agreement. Also, if there is a change in control of the Company and the officer is terminated or if the officer is terminated without cause, the note is cancelled and deemed paid in full. In these events, the officer may also retain the pledged shares of the Company, or, at the officer’s discretion, sell these shares back to the Company at the then current market price or their book value, whichever is greater.
If the officer is terminated by the Company for cause, the note is cancelled and considered paid in full. In this case, however, the officer forfeits the pledged shares of the Company, or, at the Company’s discretion, must sell these shares back to the Company for a nominal amount.
If the officer terminates his employment during the term of the agreement, the Company could demand full repayment of the note. If the note was not paid by the officer on the demand of the Company, the Company’s only recourse is to reclaim the shares of the Company that were pledged under the stock pledge agreement.
17. | Employee Benefit Plans |
Company employees over the age of 201/2 who have completed six months of service are eligible for participation in The Meadowbrook, Inc. 401(k) Profit Sharing Plan (the “401(k) Plan”). The 401(k) Plan provides for matching contributionsand/or profit sharing contributions at the discretion of the Board of Directors of Meadowbrook, Inc. In 2007, 2006, and 2005, the matching contributions were $928,000, $852,000, and $806,000, respectively. There were no profit sharing contributions in 2007, 2006, and 2005.
18. | Fair Value of Financial Instruments |
SFAS No. 107,“Disclosures about Fair Value of Financial Instruments,”requires companies to disclose the fair value information about their financial instruments. This standard excludes certain insurance related financial assets and liabilities and all nonfinancial instruments from its disclosure requirements.
Due to the short-term nature of cash and cash equivalents, premiums and agent balances receivable, and accrued interest, their estimated fair value approximates their carrying value. Since debt and equity securities are recorded in the financial statements at their estimated fair market value as securities available for sale under SFAS No. 115“Accounting for Certain Investments in Debt and Equity Securities,”their carrying value is their estimated fair value. The senior debentures, junior subordinated debentures, and the Company’s line of credit bear variable rate interest, so their estimated fair value approximates their carrying value. In addition, the Company’s derivative instruments, as disclosed in Note 7 —Derivative Instruments, are recorded in accordance with SFAS No. 133“Accounting for Derivative Instruments and Hedging Activities,”and therefore are recorded at fair value.
107
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
19. | Quarterly Financial Data (Unaudited) |
The following is a summary of unaudited quarterly results of operations for 2007 and 2006 (in thousands, except per share and ratio data):
1st | 2nd | 3rd | 4th | |||||||||||||
Quarter | Quarter | Quarter | Quarter | |||||||||||||
2007: | ||||||||||||||||
Gross premiums written | $ | 89,504 | $ | 78,000 | $ | 90,729 | $ | 88,218 | ||||||||
Net premiums written | 71,972 | 65,670 | 73,203 | 69,366 | ||||||||||||
Net premiums earned | 65,204 | 67,191 | 67,337 | 68,465 | ||||||||||||
Net commissions and fees | 11,551 | 10,743 | 13,319 | 10,375 | ||||||||||||
Net investment income and realized gains/losses | 6,150 | 6,249 | 6,588 | 7,263 | ||||||||||||
Net losses and LAE incurred | 36,646 | 39,707 | 37,015 | 37,601 | ||||||||||||
Policy acquisition and other underwriting expenses | 13,643 | 13,169 | 12,927 | 13,978 | ||||||||||||
Other administrative expenses | 7,393 | 7,598 | 8,890 | 8,087 | ||||||||||||
Salaries and employee benefits | 13,532 | 12,900 | 15,750 | 14,251 | ||||||||||||
Amortization expense | 144 | 543 | 622 | 621 | ||||||||||||
Interest expense | 1,488 | 1,667 | 1,476 | 1,400 | ||||||||||||
Net income | 6,923 | 6,186 | 7,555 | 7,328 | ||||||||||||
Diluted earnings per share | $ | 0.23 | $ | 0.20 | $ | 0.21 | $ | 0.20 | ||||||||
GAAP combined ratio(1) | 96.3 | % | 97.4 | % | 93.8 | % | 94.0 | % | ||||||||
2006: | ||||||||||||||||
Gross premiums written | $ | 89,010 | $ | 74,261 | $ | 85,827 | $ | 81,774 | ||||||||
Net premiums written | 69,381 | 59,205 | 68,905 | 65,177 | ||||||||||||
Net premiums earned | 63,124 | 64,514 | 63,688 | 63,594 | ||||||||||||
Net commissions and fees | 11,289 | 10,698 | 9,612 | 9,573 | ||||||||||||
Net investment income and realized gains/losses | 5,232 | 5,405 | 5,612 | 5,895 | ||||||||||||
Net losses and LAE incurred | 37,043 | 37,146 | 36,129 | 35,975 | ||||||||||||
Policy acquisition and other underwriting expenses | 11,424 | 13,180 | 13,059 | 12,816 | ||||||||||||
Other administrative expenses | 7,794 | 7,133 | 6,766 | 7,130 | ||||||||||||
Salaries and employee benefits | 13,368 | 13,846 | 14,183 | 13,172 | ||||||||||||
Amortization expense | 165 | 142 | 142 | 142 | ||||||||||||
Interest expense | 1,388 | 1,499 | 1,558 | 1,531 | ||||||||||||
Net income | 5,625 | 5,375 | 5,093 | 5,941 | ||||||||||||
Diluted earnings per share | $ | 0.19 | $ | 0.18 | $ | 0.17 | $ | 0.20 | ||||||||
GAAP combined ratio(1) | 96.2 | % | 97.2 | % | 97.2 | % | 96.6 | % |
(1) | Management uses the GAAP combined ratio and its components to assess and benchmark underwriting performance. The GAAP combined ratio is the sum of the GAAP loss and loss adjustment expense ratio and the GAAP expense ratio. The GAAP loss and loss adjustment expense ratio is the unconsolidated net incurred loss and loss adjustment expense in relation to net earned premium. The GAAP expense ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premium. |
108
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
20. | Subsequent Events |
U.S. Specialty Underwriters, Inc.
In April 2007, the Company entered into an agreement to acquire the excess workers’ compensation business of U.S. Specialty Underwriters, Inc. (“USSU”) for a purchase price of $23.0 million. In addition, the Company entered into a Management Agreement with the former owners of USSU. Under the terms the Management Agreement, the former owners were responsible for certain aspects of the daily administration and management of the USSU business. Their consideration for the performance of these duties was in the form of a management fee payable by the Company based on a share of net income before interest, taxes, depreciation, and amortization. The Company retained the option to terminate the Management Agreement, at its discretion, based on a multiple of the management fee calculated for the trailing twelve months.
Effective January 31, 2008, the Company exercised its option to purchase the remainder of the economics related to the acquisition of the USSU business, by eliminating the Management Agreement for a payment of $21.5 million, which now completes the transaction. As a result of this purchase, the Company recorded an increase to other intangible assets of approximately $11.4 million and an increase to goodwill of approximately $10.1 million.
Merger Agreement with ProCentury Corporation
On February 20, 2008, the Company executed a definitive merger agreement with ProCentury Corporation (“ProCentury”) for a merger transaction valued at approximately $272.6 million in cash and stock to be paid to ProCentury shareholders. The combined entity will adopt and operate under the Meadowbrook name and will continue to trade on the NYSE under the ticker symbol “MIG”.
Each ProCentury shareholder will have the option to elect to receive cash or Meadowbrook stock, subject to proration so that the maximum total cash consideration will not exceed 45% of the total consideration paid in order to preserve the tax-free exchange of the stock consideration. As long as Meadowbrook’s30-day volume-weighted average price preceding the election date, which will be at least five days before the closing of the transaction, is between $8.00 and $10.50, the exchange ratio will vary such that the stock consideration equals $20.00 per share based on such30-day average price. Above or below this range for Meadowbrook’s stock price, the exchange ratio will be fixed as if the30-day volume-weighted average price preceding the election date equaled $10.50 or $8.00, as applicable. Outstanding options to purchase ProCentury common shares will become fully vested and option holders can either exercise such options and, in connection with the closing, elect to receive the form of merger consideration described above for the ProCentury shares acquired on exercise or agree to have their options cancelled in exchange for a per share cash payment equal to the difference between $20.00 and the exercise price of their options.
The Company expects to finance the cash portion of the purchase price through a combination of cash and debt. Completion of the transaction is subject to various closing conditions, including the receipt of required regulatory approvals and approval by the Company’s and ProCentury’s shareholders. The transaction is expected to be completed in the third quarter of 2008.
109
Table of Contents
SCHEDULE I
MEADOWBROOK INSURANCE GROUP, INC.
SUMMARY OF INVESTMENTS — OTHER THAN INVESTMENTS IN RELATED PARTIES
As of December 31, 2007
(In thousands)
Amount at | ||||||||||||
Which | ||||||||||||
Shown in | ||||||||||||
the Balance | ||||||||||||
Type of Investment | Cost | Value | Sheet | |||||||||
Fixed Maturities: | ||||||||||||
US government and government agencies and authorities | $ | 53,436 | $ | 54,948 | $ | 54,948 | ||||||
States and political subdivisions | 287,392 | 290,398 | 290,398 | |||||||||
Corporate securities | 116,406 | 117,419 | 117,419 | |||||||||
Mortgage and asset-backed securities | 147,595 | 147,991 | 147,991 | |||||||||
Total Investments | $ | 604,829 | $ | 610,756 | $ | 610,756 | ||||||
110
Table of Contents
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
BALANCE SHEET
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
BALANCE SHEET
December 31, | ||||||||
2007 | 2006 | |||||||
(In thousands) | ||||||||
ASSETS | ||||||||
Investments | $ | 32,643 | $ | — | ||||
Investment in subsidiaries | 317,544 | 252,428 | ||||||
Cash and cash equivalents | 492 | 64 | ||||||
Goodwill | 3,024 | 3,024 | ||||||
Other assets | 27,811 | 28,137 | ||||||
Total assets | $ | 381,514 | $ | 283,653 | ||||
LIABILITIES | ||||||||
Other liabilities | $ | 2,231 | $ | 2,311 | ||||
Payable to subsidiaries | 21,459 | 16,719 | ||||||
Debt | — | 7,000 | ||||||
Debentures | 55,930 | 55,930 | ||||||
Total liabilities | 79,620 | 81,960 | ||||||
SHAREHOLDERS’ EQUITY | ||||||||
Common stock | 370 | 291 | ||||||
Additional paid-in capital | 194,621 | 126,828 | ||||||
Retained earnings | 104,274 | 76,282 | ||||||
Note receivable from officer | (870 | ) | (871 | ) | ||||
Accumulated other comprehensive loss | 3,499 | (837 | ) | |||||
Total shareholders’ equity | 301,894 | 201,693 | ||||||
Total liabilities and shareholders’ equity | $ | 381,514 | $ | 283,653 | ||||
111
Table of Contents
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
INCOME STATEMENT
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
INCOME STATEMENT
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Revenue | $ | 3,318 | $ | 2,690 | $ | 2,198 | ||||||
Operating expenses: | ||||||||||||
Interest expense | 6,558 | 6,375 | 4,233 | |||||||||
Other expenses | 4,332 | 3,970 | 3,540 | |||||||||
Total operating expenses | 10,890 | 10,345 | 7,773 | |||||||||
Loss before income taxes and subsidiary equity | (7,572 | ) | (7,654 | ) | (5,575 | ) | ||||||
Federal and state income tax benefit | (2,878 | ) | (2,878 | ) | (2,203 | ) | ||||||
Loss before subsidiary equity earnings | (4,694 | ) | (4,776 | ) | (3,372 | ) | ||||||
Subsidiary equity earnings | 32,686 | 26,810 | 21,282 | |||||||||
Net income | 27,992 | $ | 22,034 | $ | 17,910 | |||||||
112
Table of Contents
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
STATEMENT OF COMPREHENSIVE INCOME
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
STATEMENT OF COMPREHENSIVE INCOME
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Net income | $ | 27,992 | $ | 22,034 | $ | 17,910 | ||||||
Other comprehensive income, net of tax: | ||||||||||||
Unrealized gains (losses) on securities: | 4,810 | 152 | (6,023 | ) | ||||||||
Net deferred derivative (loss) gain — hedging activity | (484 | ) | 121 | 9 | ||||||||
Less: reclassification adjustment for gains included in net income | 10 | 20 | 56 | |||||||||
Other comprehensive income (loss) | 4,336 | 293 | (5,958 | ) | ||||||||
Comprehensive income | $ | 32,328 | $ | 22,327 | $ | 11,952 | ||||||
113
Table of Contents
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
STATEMENT OF CASH FLOWS
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
STATEMENT OF CASH FLOWS
For the Years Ended December 31, | ||||||||||||
2007 | 2006 | 2005 | ||||||||||
Net cash provided by (used in) operating activities: | $ | 1,320 | $ | (1,488 | ) | $ | (8,437 | ) | ||||
Cash Flow from Investing Activities: | ||||||||||||
Net purchase of investments | (32,643 | ) | — | — | ||||||||
Dividends from subsidiaries | 1,729 | 4,629 | 6,089 | |||||||||
Investment in subsidiaries | (19,350 | ) | (4,600 | ) | (15,600 | ) | ||||||
Net cash (used in) provided by investing activities | (50,264 | ) | 29 | (9,511 | ) | |||||||
Cash Flow from Financing Activities: | ||||||||||||
Proceeds from borrowings | 19,025 | 12,500 | 9,500 | |||||||||
Principal payments on borrowings | (26,025 | ) | (10,500 | ) | (13,544 | ) | ||||||
Net proceeds from issuance of debentures | — | — | 19,400 | |||||||||
Stock options exercised | (374 | ) | (538 | ) | 1,092 | |||||||
Share repurchases of common stock | — | — | (4,191 | ) | ||||||||
Payroll taxes associated with long-term incentive plan stock issuance | (1,841 | ) | — | — | ||||||||
Net proceeds from public equity offering | 58,585 | — | — | |||||||||
Other financing activities | 1 | (12 | ) | 9 | ||||||||
Net cash provided by financing activities | 49,371 | 1,450 | 12,266 | |||||||||
Increase (decrease) in cash and cash equivalents | 428 | (9 | ) | (5,682 | ) | |||||||
Cash and cash equivalents, beginning of year | 64 | 73 | 5,755 | |||||||||
Cash and cash equivalents, end of year | $ | 492 | $ | 64 | $ | 73 | ||||||
Supplemental Disclosure for Non-cash Investing and Financing Activities | ||||||||||||
Common stock portion of purchase price for acquisition of U.S. Specialty Underwriters, Inc. | $ | 10,000 | $ | — | $ | — |
114
Table of Contents
SCHEDULE III
MEADOWBROOK INSURANCE GROUP, INC.
SUPPLEMENTARY INSURANCE INFORMATION
December 31, 2007
(In thousands)
Future Policy | ||||||||||||||||||||
Benefits, Losses, | Other Policy | |||||||||||||||||||
Deferred Policy | Claims & Loss | Unearned | Claims & | Premium | ||||||||||||||||
Acquisition Costs | Expenses | Premium | Benefits Payable | Revenue | ||||||||||||||||
Speciality Risk Management Operations | $ | 26,926 | $ | 540,002 | $ | 153,927 | — | $ | 268,197 | |||||||||||
Agency Operations | — | — | — | — | — | |||||||||||||||
Other | — | — | — | — | — | |||||||||||||||
$ | 26,926 | $ | 540,002 | $ | 153,927 | — | $ | 268,197 | ||||||||||||
Benefits, Claims, | ||||||||||||||||||||
Net | Losses & | Amortization of | Other | |||||||||||||||||
Investment | Settlement | Deferred Policy | Operating | Premium | ||||||||||||||||
Income | Expenses | Acquisition Costs | Expenses | Written | ||||||||||||||||
Speciality Risk Management Operations | $ | 25,487 | $ | 150,969 | $ | 38,371 | $ | 92,664 | $ | 280,211 | ||||||||||
Agency Operations | — | — | — | 9,229 | — | |||||||||||||||
Other | 913 | — | — | 10,115 | — | |||||||||||||||
$ | 26,400 | $ | 150,969 | $ | 38,371 | $ | 112,008 | $ | 280,211 | |||||||||||
115
Table of Contents
SCHEDULE III
MEADOWBROOK INSURANCE GROUP, INC.
SUPPLEMENTARY INSURANCE INFORMATION
December 31, 2006
(In thousands)
Future Policy | ||||||||||||||||||||
Benefits, Losses, | Other Policy | |||||||||||||||||||
Deferred Policy | Claims & Loss | Unearned | Claims & | Premium | ||||||||||||||||
Acquisition Costs | Expenses | Premium | Benefits Payable | Revenue | ||||||||||||||||
Speciality Risk Management Operations | $ | 27,902 | $ | 501,077 | $ | 144,575 | — | $ | 254,920 | |||||||||||
Agency Operations | — | — | — | — | — | |||||||||||||||
Other | — | — | — | — | — | |||||||||||||||
$ | 27,902 | $ | 501,077 | $ | 144,575 | — | $ | 254,920 | ||||||||||||
Benefits, Claims, | ||||||||||||||||||||
Net | Losses & | Amortization of | Other | |||||||||||||||||
Investment | Settlement | Deferred Policy | Operating | Premium | ||||||||||||||||
Income | Expenses | Acquisition Costs | Expenses | Written | ||||||||||||||||
Speciality Risk Management Operations | $ | 21,115 | $ | 146,293 | $ | 37,670 | $ | 84,632 | $ | 262,668 | ||||||||||
Agency Operations | — | — | — | 9,334 | — | |||||||||||||||
Other | 960 | — | — | 8,802 | — | |||||||||||||||
$ | 22,075 | $ | 146,293 | $ | 37,670 | $ | 102,768 | $ | 262,668 | |||||||||||
116
Table of Contents
SCHEDULE III
MEADOWBROOK INSURANCE GROUP, INC.
SUPPLEMENTARY INSURANCE INFORMATION
December 31, 2005
(In thousands)
Future Policy | ||||||||||||||||||||
Benefits, Losses, | Other Policy | |||||||||||||||||||
Deferred Policy | Claims & Loss | Unearned | Claims & | Premium | ||||||||||||||||
Acquisition Costs | Expenses | Premium | Benefits Payable | Revenue | ||||||||||||||||
Speciality Risk Management Operations | $ | 26,371 | $ | 458,677 | $ | 140,990 | — | $ | 249,959 | |||||||||||
Agency Operations | — | — | — | — | — | |||||||||||||||
Other | — | — | — | — | — | |||||||||||||||
$ | 26,371 | $ | 458,677 | $ | 140,990 | — | $ | 249,959 | ||||||||||||
Benefits, Claims, | ||||||||||||||||||||
Net | Losses & | Amortization of | Other | |||||||||||||||||
Investment | Settlement | Deferred Policy | Operating | Premium | ||||||||||||||||
Income | Expenses | Acquisition Costs | Expenses | Written | ||||||||||||||||
Speciality Risk Management Operations | $ | 17,692 | $ | 151,542 | $ | 34,163 | $ | 79,361 | $ | 258,134 | ||||||||||
Agency Operations | — | — | — | 7,961 | — | |||||||||||||||
Other | 283 | — | — | 5,324 | — | |||||||||||||||
$ | 17,975 | $ | 151,542 | $ | 34,163 | $ | 92,646 | $ | 258,134 | |||||||||||
117
Table of Contents
SCHEDULE IV
MEADOWBROOK INSURANCE GROUP, INC.
REINSURANCE
For the Years Ended December 31,
(In thousands)
MEADOWBROOK INSURANCE GROUP, INC.
REINSURANCE
For the Years Ended December 31,
(In thousands)
Assumed | Percentage | |||||||||||||||||||
Ceded to | from | of Amount | ||||||||||||||||||
Gross | Other | Other | Net | Assumed | ||||||||||||||||
Amount | Companies | Companies | Amount | to Net | ||||||||||||||||
Property and Liability Insurance | ||||||||||||||||||||
2007 | $ | 266,049 | $ | 68,902 | $ | 71,050 | $ | 268,197 | 26.49 | % | ||||||||||
2006 | $ | 251,288 | $ | 72,367 | $ | 75,999 | $ | 254,920 | 29.81 | % | ||||||||||
2005 | $ | 264,381 | $ | 75,563 | $ | 61,141 | $ | 249,959 | 24.46 | % |
118
Table of Contents
SCHEDULE V
MEADOWBROOK INSURANCE GROUP, INC.
VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31,
(In thousands)
MEADOWBROOK INSURANCE GROUP, INC.
VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31,
(In thousands)
Additions | Deductions | |||||||||||||||||||
Balance at | Charged to | Charged to | from | Balance at | ||||||||||||||||
Beginning | Costs and | Other | Allowance | End of | ||||||||||||||||
of Period | Expense | Accounts | Account | Period | ||||||||||||||||
Allowance for doubtful accounts | ||||||||||||||||||||
2007 | $ | 2,948 | $ | 716 | — | $ | 917 | $ | 2,747 | |||||||||||
2006 | $ | 3,901 | $ | 593 | — | $ | 1,546 | $ | 2,948 | |||||||||||
2005 | $ | 4,336 | $ | 704 | — | $ | 1,139 | $ | 3,901 |
119
Table of Contents
SCHEDULE VI
MEADOWBROOK INSURANCE GROUP, INC.
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND
CASUALTY INSURANCE OPERATIONS
MEADOWBROOK INSURANCE GROUP, INC.
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND
CASUALTY INSURANCE OPERATIONS
For the Years Ended December 31, | ||||||||||||||||||||||||
(In thousands) | ||||||||||||||||||||||||
Reserves for | ||||||||||||||||||||||||
Deferred | Losses and | Discount, if any, | ||||||||||||||||||||||
Policy | Loss | deducted from | Net | Net | ||||||||||||||||||||
Acquisition | Adjustment | previous | Unearned | Premiums | Investment | |||||||||||||||||||
Affiliation with Registrant | Costs | Expenses(2) | column(1) | Premiums(2) | Earned | Income | ||||||||||||||||||
(a) Consolidated Property and Casualty Subsidiaries | ||||||||||||||||||||||||
2007 | $ | 26,926 | $ | 540,002 | — | $ | 153,927 | $ | 268,197 | $ | 25,487 | |||||||||||||
2006 | $ | 27,902 | $ | 501,077 | — | $ | 144,575 | $ | 254,920 | $ | 21,115 | |||||||||||||
2005 | $ | 26,371 | $ | 458,677 | — | $ | 140,990 | $ | 249,959 | $ | 17,692 |
Amortization of | Paid losses | |||||||||||||||||||
Losses and loss | deferred policy | and loss | Net | |||||||||||||||||
adjustment expense | acquisition | adjustment | Premiums | |||||||||||||||||
Current Year | Prior Years | expenses | expenses | Written | ||||||||||||||||
2007 | $ | 158,061 | $ | (7,091 | ) | $ | 38,371 | $ | 112,084 | $ | 280,211 | |||||||||
2006 | $ | 149,012 | $ | (2,719 | ) | $ | 37,670 | $ | 115,061 | $ | 262,668 | |||||||||
2005 | $ | 146,658 | $ | 4,884 | $ | 34,163 | $ | 107,115 | $ | 258,134 |
(1) | The Company does not employ any discounting techniques. | |
(2) | Reserves for losses and loss adjustment expenses are shown gross of $198.5 million, $198.4 million and $187.3 million of reinsurance recoverable on unpaid losses in 2007, 2006 and 2005, respectively. Unearned premiums are shown gross of ceded unearned premiums of $17.8 million, $20.4 million and $24.6 million in 2007, 2006 and 2005, respectively. |
120
Table of Contents
MEADOWBROOK INSURANCE GROUP, INC.
Exhibit Index
Exhibit | Filing | |||||||
No. | Description | Basis | ||||||
2 | .1 | Agreement and Plan of Merger, between Meadowbrook Insurance Group, Inc., MBKPC Corp., a wholly-owned subsidiary of Meadowbrook, and ProCentury Corporation, dated February 20, 2008 | (21) | |||||
3 | .1 | Amended and Restated Articles of Incorporation of the Company | (20) | |||||
3 | .2 | Amended and Restated Bylaws of the Company | ||||||
4 | .1 | Junior Subordinated Indenture between Meadowbrook Insurance Group, Inc., and JP Morgan Chase Bank, dated September 30, 2003 | (6) | |||||
4 | .2 | Junior Subordinated Indenture between Meadowbrook Insurance Group, Inc. and LaSalle Bank National Association, dated as of September 16, 2005 | (13) | |||||
10 | .1 | Meadowbrook Insurance Group, Inc. Amended and Restated 1995 Stock Option Plan | (8) | |||||
10 | .2 | Meadowbrook, Inc. 401(k) and Profit Sharing Plan Trust, amended and restated December 31, 1994 | (1) | |||||
10 | .3 | Demand Note dated November 9, 1998 among the Company and Robert S. Cubbin and Kathleen D. Cubbin and Stock Pledge Agreement | (4) | |||||
10 | .4 | Meadowbrook Insurance Group, Inc. Amended and Restated 2002 Stock Option Plan | (8) | |||||
10 | .5 | Agency Agreement by and between Meadowbrook, Inc., Preferred Insurance Agency, Inc., TPA Insurance Agency, Inc., Preferred Comp Insurance Agency of New Hampshire, TPA Insurance Agency of New Hampshire, Inc., Meadowbrook of Nevada, Inc., d/b/a Meadowbrook Insurance Services, Meadowbrook of Florida, Inc., Association Self-Insurance Services, Inc., Commercial Carriers Insurance Agency, Inc., and Star Insurance Company, Savers Property and Casualty Insurance Company, Williamsburg National Insurance Company, and Ameritrust Insurance Corporation, dated January 1, 2003 | (5) | |||||
10 | .6 | Purchase Agreement among Meadowbrook Insurance Group, Inc., Meadowbrook Capital Trust I, and Dekania CDO I, Ltd., dated September 30, 2003 | (6) | |||||
10 | .7 | Amended and Restated Trust Agreement among Meadowbrook Insurance Group, Inc., JP Morgan Chase Bank, Chase Manhattan Bank USA, National Association, and The Administrative Trustees Named Herein, dated September 30, 2003 | (6) | |||||
10 | .8 | Guaranty Agreement between Meadowbrook Insurance Group, Inc., and JP Morgan Chase Bank, dated September 30, 2003 | (6) | |||||
10 | .9 | Employment Agreement between the Company and Robert S. Cubbin, dated January 1, 2004 | (7) | |||||
10 | .10 | Employment Agreement between the Company and Michael G. Costello, dated January 1, 2004 | (7) | |||||
10 | .11 | Meadowbrook Insurance Group, Inc. Long Term Incentive Plan | (10) | |||||
10 | .12 | Indenture between Meadowbrook Insurance Group, Inc. and JPMorgan Chase Bank, as Trustee, dated April 29, 2004 | (10) | |||||
10 | .13 | Indenture between Meadowbrook Insurance Group, Inc. and Wilmington Trust Company, as Trustee, dated May 26, 2004 | (10) | |||||
10 | .14 | Land Contract between Meadowbrook Insurance Group, Inc. and MB Center II LLC, dated July 15, 2004 | (10) | |||||
10 | .15 | Loan Agreement by and between Ameritrust Insurance Corporation, Savers Property and Casualty Insurance Company, Star Insurance Company, Williamsburg National Insurance Company, Meadowbrook Insurance Group, Inc., and Meadowbrook, Inc., dated September 1, 2004 | (11) | |||||
10 | .16 | Credit Agreement among Meadowbrook Insurance Group, Inc. and Standard Federal Bank National Association dated as of November 12, 2004 | (9) |
121
Table of Contents
Exhibit | Filing | |||||||
No. | Description | Basis | ||||||
10 | .17 | Revolving Note among Meadowbrook Insurance Group, Inc. and Standard Federal Bank National Association dated as of November 12, 2004 | (9) | |||||
10 | .18 | Security Agreement among Meadowbrook Insurance Group, Inc. and Standard Federal Bank National Association dated as of November 12, 2004 | (9) | |||||
10 | .19 | Form of Nonqualified Stock Option Agreement under the Meadowbrook Insurance Group, Inc., Stock Option Plan, dated February 21, 2003 | (11) | |||||
10 | .20 | Lease Agreement between Meadowbrook Insurance Group, Inc. and Meadowbrook, Inc., dated December 6, 2004 | (11) | |||||
10 | .21 | Master Lease Agreement between LaSalle National Leasing Corporation and Meadowbrook Insurance Group, Inc., dated December 30, 2004 | (11) | |||||
10 | .22 | Promissory Note between Meadowbrook Insurance Group, Inc. and Star Insurance Company, dated January 1, 2005 | (11) | |||||
10 | .23 | Commercial Mortgage between Meadowbrook Insurance Group, Inc. and Star Insurance Company, dated January 1, 2005 | (11) | |||||
10 | .24 | Assignment of Leases and Rents between Meadowbrook Insurance Group, Inc. and Star Insurance Company, dated January 1, 2005 | (11) | |||||
10 | .25 | Form of At-Will Employment and Severance Agreement by and among Meadowbrook, Inc., Meadowbrook Insurance Group, Inc., and Karen M. Spaun, Stephen Belden, Robert C. Spring, Archie S. McIntyre, Arthur C. Pletz, Randolph W. Fort, Angelo L. Williams, Susan L. Cubbin, and Kenn R. Allen, dated January 1, 2005, Steven C. Divine dated March 1, 2006, and James M. Mahoney and Joseph E. Mattingly dated August 1, 2007 | (11) | |||||
10 | .26 | Amendment to Demand Note Addendum among the Company and Robert S. Cubbin and Kathleen D. Cubbin, dated February 17, 2005 | (11) | |||||
10 | .27 | Reciprocal Easement and Operation Agreement between Meadowbrook Insurance Group, Inc. and MB Center II, LLC, dated May 9, 2005 | (12) | |||||
10 | .28 | First Amendment to Land Contract between MB Center II, LLC and Meadowbrook Insurance Group, Inc., dated May 20, 2005 | (12) | |||||
10 | .29 | Amendment to Credit Agreement between Meadowbrook Insurance Group, Inc. and Standard Federal Bank National Association, dated May 20, 2005 | (12) | |||||
10 | .30 | Second Amendment to Credit Agreement between Meadowbrook Insurance Group, Inc. and Standard Federal Bank National Association, dated September 8, 2005 | (14) | |||||
10 | .31 | Purchase Agreement among Meadowbrook Insurance Group, Inc., Meadowbrook Capital Trust II, and Merrill Lynch International, dated as of September 16, 2005 | (13) | |||||
10 | .32 | Amended and Restated Trust Agreement among Meadowbrook Insurance Group, Inc., LaSalle Bank National Association, Christiana Bank & Trust Company, and The Administrative Trustees Named Herein, dated as of September 16, 2005 | (13) | |||||
10 | .33 | Guarantee Agreement between Meadowbrook Insurance Group, Inc., and LaSalle Bank National Association, dated as of September 16, 2005 | (13) | |||||
10 | .34 | Convertible Note between Meadowbrook Insurance Group, Inc. and Renaissance Insurance Group, LLC, dated December 20, 2005 | (16) | |||||
10 | .35 | Third Amendment to Credit Agreement between Meadowbrook Insurance Group, Inc. and LaSalle Bank Midwest National Association, dated December 28, 2005 | (16) | |||||
10 | .36 | Inter-Company Reinsurance Agreement by and between Star Insurance Company and Ameritrust Insurance Company, Savers Property and Casualty Insurance Company, and Williamsburg National Insurance Company, dated January 1, 2006 | (16) | |||||
10 | .37 | Employment Agreement between Meadowbrook, Inc., and Meadowbrook Insurance Group, Inc. and Merton J. Segal, dated January 1, 2006 | (15) | |||||
10 | .38 | Executive Nonqualified Excess Plan, Plan Document, effective May 1, 2006 | (17) | |||||
10 | .39 | Executive Nonqualified Excess Plan Adoption Agreement, effective May 1, 2006 | (17) |
122
Table of Contents
Exhibit | Filing | |||||||
No. | Description | Basis | ||||||
10 | .40 | Executive Nonqualified Excess Plan, Rabbi Trust Agreement, between Meadowbrook, Inc. and Delaware Charter Guarantee & Trust Company, conducting business as Principal Trust Company, dated March 30, 2006 | (18) | |||||
10 | .41 | Fourth Amendment to Credit Agreement between Meadowbrook Insurance Group, Inc., Meadowbrook, Inc., Crest Financial Corporation, and LaSalle Bank Midwest National Association, dated April 10, 2007 | (19) | |||||
10 | .42 | First Amendment to Promissory Note between Meadowbrook Insurance Group, Inc. and LaSalle Bank Midwest National Association, dated April 10, 2007 | (19) | |||||
10 | .45 | Management Services Agreement by and between Meadowbrook Insurance Group, Inc., Meadowbrook, Inc., and Star Insurance Company, Williamsburg National Insurance Co., and Ameritrust Insurance Corporation, dated October 1, 2007 | ||||||
10 | .46 | Management Services Agreement by and between Savers Property and Casualty Insurance Company and Meadowbrook, Inc., dated October 1, 2007 | ||||||
10 | .47 | Amendment to Land Contract, between Meadowbrook Insurance Group, Inc., and MB Center II, LLC, dated January 31, 2008. | ||||||
14 | Compliance Program/Code of Conduct | |||||||
21 | List of Subsidiaries | |||||||
23 | Consent of Independent Registered Public Accounting Firm | |||||||
24 | Power of Attorney | |||||||
28 | .1 | Star Insurance Company’s 2007 Schedule P | (2) | |||||
28 | .2 | Savers Property & Casualty Insurance Company’s 2007 Schedule P | (2) | |||||
28 | .3 | Williamsburg National Insurance Company’s 2007 Schedule P | (2) | |||||
28 | .4 | Ameritrust Insurance Corporation’s 2007 Schedule P | (2) | |||||
31 | .1 | Certification of Robert S. Cubbin, Chief Executive Officer of the Corporation, pursuant to Securities Exchange ActRule 13a-14(a) | ||||||
31 | .2 | Certification of Karen M. Spaun, Chief Financial Officer of the Corporation, pursuant to Securities Exchange ActRule 13a-14(a) | ||||||
32 | .1 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Robert S. Cubbin, Chief Executive Officer of the Corporation | ||||||
32 | .2 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Karen M. Spaun, Chief Financial Officer of the Corporation | ||||||
99 | .1 | Rights Agreement, dated as of September 30, 1999, by and between Meadowbrook Insurance Group, Inc. and First Chicago Trust Company of New York, including the Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B and C, respectively | (3) |
(1) | Incorporated by reference toForm S-1 Registration Statement (No.33-2626206) of Meadowbrook Insurance Group, Inc. declared effective November 20, 1995. | |
(2) | Submitted in paper format under separate cover; see Form SE filing. | |
(3) | Incorporated by reference to Exhibit 99.1 to the Company’sForm 8-A filed with the Securities and Exchange Commission on October 12, 1999. | |
(4) | Filed as Exhibit toForm 10-K for the year ending December 31, 1998. | |
(5) | Filed as Exhibit toForm 10-K for the year ending December 31, 2002. | |
(6) | Filed as Exhibit toForm 10-Q for the period ending September 30, 2003. | |
(7) | Filed as Exhibit toForm 10-K for the year ending December 31, 2003 | |
(8) | Filed as Appendix to Meadowbrook Insurance Group, Inc. 2004 Proxy Statement. | |
(9) | Filed as Exhibit to Current Report onForm 8-K filed on November 18, 2004. |
123
Table of Contents
(10) | Filed as Exhibit toForm 10-Q for the period ending June 30, 2004. | |
(11) | Filed as Exhibit toForm 10-K for the year ending December 31, 2004. | |
(12) | Filed as Exhibit toForm 10-Q for the period ending June 30, 2005. | |
(13) | Filed as Exhibit to Current Report onForm 8-K filed on September 22, 2005. | |
(14) | Filed as Exhibit toForm 10-Q for the period ending September 30, 2005. | |
(15) | Filed as Exhibit to Current Report onForm 8-K filed on March 9, 2006. | |
(16) | Filed as Exhibit toForm 10-K for the year ending December 31, 2005. | |
(17) | Filed as Exhibit to Current Report onForm 8-K filed on May 31, 2006. | |
(18) | Filed as Exhibit toForm 10-Q for the period ending June 30, 2006. | |
(19) | Filed as Exhibit to Current Report onForm 8-K filed on April 12, 2007. | |
(20) | Filed as Exhibit toForm 10-Q for the period ending June 30, 2007. | |
(21) | Filed as Exhibit to Current Report onForm 8-K filed on February 22, 2008. |
124
Table of Contents
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in Southfield, Michigan.
Meadowbrook Insurance Group, Inc
By:
Robert S. Cubbin
Chief Executive Officer
(Principal Executive Officer)
Chief Executive Officer
(Principal Executive Officer)
By:
Karen M. Spaun
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)
Dated: March 17, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature | Title | Date | ||||
** Merton J. Segal | Chairman and Director | March 17, 2008 | ||||
Robert S. Cubbin | President, Chief Executive Officer and Director (Principal Executive Officer) | March 17, 2008 | ||||
** Joseph S. Dresner | Director | March 17, 2008 | ||||
** Hugh W. Greenberg | Director | March 17, 2008 | ||||
** Florine Mark | Director | March 17, 2008 | ||||
** Robert H. Naftaly | Director | March 17, 2008 |
125
Table of Contents
Signature | Title | Date | ||||
** David K. Page | Director | March 17, 2008 | ||||
** Robert W. Sturgis | Director | March 17, 2008 | ||||
** Bruce E. Thal | Director | March 17, 2008 | ||||
** Herbert Tyner | Director | March 17, 2008 | ||||
**By: Robert S. Cubbin Attorney-in-fact |
126