Edgar Filing: MEADOWBROOK INSURANCE GROUP INC

form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

_________

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 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, Michigan 48034

(Address, zip code of principal executive offices)

(248) 358-1100

(Registrant’s telephone number, including area code)

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 x No o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No o

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

Large accelerated filer o Accelerated filer x Non-accelerated filer o Smaller Reporting Company o

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

The aggregate number of shares of the Registrant’s Common Stock, $.01 par value, outstanding on November 2, 2011, was 51,050,204.

TABLE OF CONTENTS

	Page
PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS
Consolidated Statements of Income (unaudited)	2-3
Consolidated Statements of Comprehensive Income (unaudited)	4
Consolidated Balance Sheets (unaudited)	5
Consolidated Statement of Shareholders’ Equity (unaudited)	6
Consolidated Statement of Cash Flows (unaudited)	7
Notes to Consolidated Financial Statements (unaudited)	8-27

ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	28-45

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	45-47

ITEM 4 – CONTROLS AND PROCEDURES	48

PART II – OTHER INFORMATION

ITEM 1 – LEGAL PROCEEDINGS	49

ITEM 1A – RISK FACTORS	49

ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	49

ITEM 6 – EXHIBITS	50

SIGNATURES	51

Table of Contents

PART 1 - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended September 30,

	2011			2010
	(Unaudited)
	(In thousands, except share data)
Revenues
Premiums earned
Gross	$	225,219		$	200,918
Ceded		(31,632	)		(29,054	)
Net earned premiums		193,587			171,864
Net commissions and fees		7,293			9,869
Net investment income		13,502			13,715
Realized gains (losses):
Total other-than-temporary impairments on securities		-			(25	)
Portion of loss recognized in other comprehensive income		-			-
Net other-than-temporary impairments on securities recognized in earnings		-			(25	)
Net realized gains excluding other-than-temporary impairments on securities		363			308
Net realized gains		363			283
Total revenues		214,745			195,731

Expenses
Losses and loss adjustment expenses		153,809			122,044
Reinsurance recoveries		(24,853	)		(16,105	)
Net losses and loss adjustment expenses		128,956			105,939
Policy acquisition and other underwriting expenses		64,665			59,013
General, selling and administrative expenses		5,876			5,881
General corporate expenses		273			1,163
Amortization expense		1,208			1,235
Interest expense		2,066			2,405
Total expenses		203,044			175,636
Income before taxes and equity earnings		11,701			20,095
Federal and state income tax expense		2,590			5,500
Equity earnings of affiliates, net of tax		649			425
Equity earnings of unconsolidated subsidiaries, net of tax		(8	)		16
Net income	$	9,752		$	15,036

Earnings Per Share
Basic	$	0.19		$	0.28
Diluted	$	0.19		$	0.28

Weighted average number of common shares
Basic		52,240,813			53,418,314
Diluted		52,355,581			53,698,954

Dividends paid per common share	$	0.04		$	0.04

The accompanying notes are an integral part of the Consolidated Financial Statements.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

For the Nine Months Ended September 30,

	2011			2010
	(Unaudited)
	(In thousands, except share data)
Revenues
Premiums earned
Gross	$	635,581		$	573,320
Ceded		(89,866	)		(87,255	)
Net earned premiums		545,715			486,065
Net commissions and fees		23,628			26,872
Net investment income		40,839			40,198
Realized gains (losses):
Total other-than-temporary impairments on securities		(84	)		(437	)
Portion of loss recognized in other comprehensive income		-			-
Net other-than-temporary impairments on securities recognized in earnings		(84	)		(437	)
Net realized gains excluding other-than-temporary impairments on securities		2,353			878
Net realized gains		2,269			441
Total revenues		612,451			553,576

Expenses
Losses and loss adjustment expenses		423,889			340,941
Reinsurance recoveries		(68,268	)		(48,310	)
Net losses and loss adjustment expenses		355,621			292,631
Policy acquisition and other underwriting expenses		184,553			168,262
General, selling and administrative expenses		17,751			17,108
General corporate expenses		909			4,409
Amortization expense		3,646			3,757
Interest expense		6,320			7,259
Total expenses		568,800			493,426
Income before taxes and equity earnings		43,651			60,150
Federal and state income tax expense		10,709			17,896
Equity earnings of affiliates, net of tax		1,895			1,591
Equity earnings of unconsolidated subsidiaries, net of tax		(30	)		486
Net income	$	34,807		$	44,331

Earnings Per Share
Basic	$	0.66		$	0.82
Diluted	$	0.66		$	0.81

Weighted average number of common shares
Basic		52,860,729			54,229,706
Diluted		52,974,390			54,508,592

Dividends paid per common share	$	0.12		$	0.10

The accompanying notes are an integral part of the Consolidated Financial Statements.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Three Months Ended September 30,

	2011			2010
	(Unaudited)
	(In thousands)
Net income	$	9,752		$	15,036
Other comprehensive income, net of tax:
Unrealized gains on securities		16,788			16,556
Unrealized gains in affiliates and unconsolidated subsidiaries		23			105
Increase on non-credit other-than-temporary impairments on securities		74			333
Net deferred derivative losses - hedging activity		(275	)		(705	)
Less reclassification adjustment for investment gains included in net income		(342	)		(314	)
Other comprehensive gains, net of tax		16,268			15,975
Comprehensive income	$	26,020		$	31,011

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Nine Months Ended September 30,

	2011			2010
	(Unaudited)
	(In thousands)
Net income	$	34,807		$	44,331
Other comprehensive income, net of tax:
Unrealized gains on securities		27,936			34,823
Unrealized gains in affiliates and unconsolidated subsidiaries		22			245
Increase on non-credit other-than-temporary impairments on securities		159			818
Net deferred derivative gains (losses) - hedging activity		10			(1,330	)
Less reclassification adjustment for investment gains included in net income		(2,222	)		(374	)
Other comprehensive gains, net of tax		25,905			34,182
Comprehensive income	$	60,712		$	78,513

The accompanying notes are an integral part of the Consolidated Financial Statements.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED BALANCE SHEETS

	September 30,			December 31,
	2011			2010
	(Unaudited)
	(In thousands, except share data)
ASSETS
Investments
Debt securities available for sale, at fair value (amortized cost of $1,242,614 and $1,170,795)	$	1,339,544		$	1,226,360
Equity securities available for sale, at fair value (cost of $25,176 and $25,632)		26,995			28,483
Cash and cash equivalents		76,348			90,414
Accrued investment income		13,821			13,021
Premiums and agent balances receivable, net		193,695			169,866
Reinsurance recoverable on:
Paid losses		12,981			13,342
Unpaid losses		304,870			280,854
Prepaid reinsurance premiums		34,710			28,208
Deferred policy acquisition costs		88,221			78,755
Deferred income taxes, net		-			5,569
Goodwill		118,842			118,842
Other intangible assets		33,154			36,637
Other assets		98,818			87,290
Total assets	$	2,341,999		$	2,177,641

LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Losses and loss adjustment expenses	$	1,157,453		$	1,065,056
Unearned premiums		397,913			352,585
Debt		27,562			37,750
Debentures		80,930			80,930
Accounts payable and accrued expenses		36,825			38,645
Funds held and reinsurance balances payable		34,233			28,824
Payable to insurance companies		2,809			2,754
Deferred income taxes, net		8,250			-
Other liabilities		15,706			23,996
Total liabilities		1,761,681			1,630,540

Shareholders' Equity
Common stock, $0.01 stated value; authorized 75,000,000 shares; 51,050,204 and 53,236,542 shares issued and outstanding		520			520
Additional paid-in capital		279,727			292,705
Retained earnings		239,565			219,298
Note receivable from officer		(774	)		(797	)
Accumulated other comprehensive income		61,280			35,375
Total shareholders' equity		580,318			547,101
Total liabilities and shareholders' equity	$	2,341,999		$	2,177,641

The accompanying notes are an integral part of the Consolidated Financial Statements.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

	Common Stock		Additional Paid-In Capital			Retained Earnings			Note Receivable from Officer			Accumulated Other Comprehensive Income			Total Shareholders' Equity
	(Unaudited, In thousands)
Balances December 31, 2010	$	520	$	292,705		$	219,298		$	(797	)	$	35,375		$	547,101
Net income		-		-			34,807			-			-			34,807
Dividends declared and paid		-		-			(6,336	)		-			-			(6,336	)
Change in unrealized on available for sale securities, net of tax		-		-			-			-			26,216			26,216
Change in valuation allowance on deferred tax assets		-		-			-			-			(343	)		(343	)
Net deferred derivative gain - hedging activity		-		-			-			-			10			10
Stock award		-		454			-			-			-			454
Long term incentive plan; stock award for 2009-2011 plan years		-		(1,195	)		-			-			-			(1,195	)
Change in investment of affiliates, net of tax		-		-			-			-			22			22
Repurchase of 2,225,000 shares of common stock		-		(12,237	)		(8,204	)		-			-			(20,441	)
Note receivable from officer		-		-			-			23			-			23
Balances September 30, 2011	$	520	$	279,727		$	239,565		$	(774	)	$	61,280		$	580,318

The accompanying notes are an integral part of the Consolidated Financial Statements.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30,

	2011			2010
	(Unaudited)
	(In thousands)
Cash Flows From Operating Activities
Net income	$	34,807		$	44,331
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of other intangible assets		3,646			3,757
Amortization of deferred debenture issuance costs		94			192
Depreciation of furniture, equipment, and building		3,916			4,194
Net amortization of discount and premiums on bonds		3,092			2,405
Gain on sale of investments, net		(2,222	)		(374	)
Gain on sale of fixed assets		(47	)		(66	)
Long-term incentive plan expense		(1,195	)		753
Stock award		454			458
Equity earnings of affiliates, net of taxes		(1,895	)		(1,591	)
Equity loss (earnings) of unconsolidated subsidiaries, net of tax		30			(486	)
Deferred income tax expense		(8,908	)		(1,213	)
Changes in operating assets and liabilities:
Decrease (increase) in:
Premiums and agent balances receivable		(23,829	)		(21,866	)
Reinsurance recoverable on paid and unpaid losses		(23,655	)		(18,405	)
Prepaid reinsurance premiums		(6,502	)		5,483
Deferred policy acquisition costs		(9,466	)		(9,917	)
Other assets		(3,409	)		(3,935	)
Increase (decrease) in:
Losses and loss adjustment expenses		92,397			94,586
Unearned premiums		45,328			27,865
Payable to insurance companies		55			(513	)
Funds held and reinsurance balances payable		5,409			(2,126	)
Other liabilities		(13,225	)		4,515
Total adjustments		60,068			83,716
Net cash provided by operating activities		94,875			128,047
Cash Flows From Investing Activities
Purchase of debt securities available for sale		(170,746	)		(185,759	)
Proceeds from sales and maturities of debt securities available for sale		104,272			84,207
Proceeds from sales of equity securities available for sale		700			1,020
Capital expenditures		(5,606	)		(3,311	)
Acquisition of rights renewals		(164	)		(148	)
Other investing activities		132			(231	)
Net cash used in investing activities		(71,412	)		(104,222	)
Cash Flows From Financing Activities
Payments on term loan		(10,188	)		(8,875	)
Book overdrafts		(593	)		737
Dividends paid on common stock		(6,336	)		(4,878	)
Cash payment for payroll taxes associated with long-term incentive plan net stock issuance		-			(35	)
Share repurchases		(20,441	)		(20,719	)
Other financing activities		29			21
Net cash used in financing activities		(37,529	)		(33,749	)
Net decrease in cash and cash equivalents		(14,066	)		(9,924	)
Cash and cash equivalents, beginning of period		90,414			86,319
Cash and cash equivalents, end of period	$	76,348		$	76,395
Supplemental Disclosure of Cash Flow Information:
Interest paid	$	6,074		$	6,490
Net income taxes paid	$	18,279		$	16,445
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
Stock-based employee compensation	$	454		$	458

The accompanying notes are an integral part of the Consolidated Financial Statements.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – Summary of Significant Accounting Policies

Basis of Presentation and Management Representation

The consolidated financial statements include accounts, after elimination of intercompany accounts and transactions, of Meadowbrook Insurance Group, Inc. (the “Company” or “Meadowbrook”), its wholly owned subsidiary Star Insurance Company (“Star”), and Star’s wholly owned subsidiaries, Savers Property and Casualty Insurance Company (“Savers”), Williamsburg National Insurance Company (“Williamsburg”), and Ameritrust Insurance Corporation (“Ameritrust”). The consolidated financial statements also include Meadowbrook, Inc., Crest Financial Corporation, and their respective subsidiaries. In addition, the consolidated financial statements also include ProCentury Corporation (“ProCentury”) and its wholly owned subsidiaries. ProCentury’s wholly owned subsidiaries consist of Century Surety Company (“Century”) and its wholly owned subsidiary ProCentury Insurance Company (“PIC”). In addition, ProCentury Risk Partners Insurance Company, Ltd., is a wholly owned subsidiary of ProCentury. Star, Savers, Williamsburg, Ameritrust, Century, and PIC are collectively referred to as the Insurance Company Subsidiaries.

In the opinion of management, the consolidated financial statements reflect all normal recurring adjustments necessary to present a fair statement of the results for the interim period. Preparation of financial statements under generally accepted accounting principles (“GAAP”) requires management to make estimates. Actual results could differ from those estimates. The results of operations for the three months and nine months ended September 30, 2011 are not necessarily indicative of the results expected for the full year.

These financial statements and the notes thereto should be read in conjunction with the Company’s audited financial statements and accompanying notes included in its Annual Report on Form 10-K, as filed with the United States Securities and Exchange Commission, for the year ended December 31, 2010.

Revenue Recognition

Premiums written, which include direct, assumed and ceded amounts 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.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Assumed premium estimates are specifically related to an established book of workers compensation business on which the Company has established an equity ownership relationship and 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. 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; therefore, no provision for doubtful accounts is recorded related to the assumed premium estimate.

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 in the future.

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 any sub-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.

Income Taxes

As of September 30, 2011 and December 31, 2010, the Company did not have any unrecognized tax benefits.

Interest costs and penalties related to income taxes are classified as interest expense and other administrative expenses, respectively. As of September 30, 2011 and December 31, 2010, the Company had no accrued interest or penalties related to uncertain tax positions.

Recent Accounting Pronouncements

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts

In October 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to assist in a consistent application of accounting for costs related to acquiring or renewing insurance contracts among industry practice. The new guidance restricts the capitalization of a contract’s acquisition costs to those that are directly related to the successful acquisition of a new or renewing insurance contract. The new guidance is effective for interim and annual reporting periods beginning after December 15, 2011. The Company is still evaluating the impact of adoption on its financial condition and results of operations, but currently does not anticipate it having a material impact.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs

In May 2011, the FASB issued guidance to achieve common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards (IFRSs). The guidance explains how to measure fair value and does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The guidance is to be applied prospectively for interim and annual periods beginning after December 15, 2011. The Company is still evaluating the impact of adoption on its financial condition and results of operations.

Presentation of Comprehensive Income

In June 2011, the FASB issued guidance to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The guidance requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The guidance is to be applied retrospectively and is effective for interim and annual periods beginning after December 15, 2011, with early adoption permitted. The Company has not yet adopted this guidance and will not have a material impact on its financial condition and results of operations.

Testing Goodwill for Impairment

In September 2011, the FASB issued guidance on how to test goodwill for impairment through use of a qualitative approach. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not (defined as having a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles-Goodwill and Other. The guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company is still evaluating the impact of adoption on its financial condition and results of operations.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 2 – Investments

The estimated fair value of investments in securities is determined primarily based upon published market quotations and broker/dealer quotations. The cost or amortized cost, gross unrealized gains, losses, non-credit other-than-temporary impairments (“OTTI”) and estimated fair value of investments in securities classified as available for sale at September 30, 2011 and December 31, 2010 were as follows (in thousands):

	September 30, 2011
	Cost or Amortized Cost		Gross Unrealized								Estimated Fair Value
	Cost or Amortized Cost		Gains		Losses			Non-Credit OTTI			Estimated Fair Value
Debt Securities:
U.S. Government and agencies	$	23,301	$	1,893	$	-		$	-		$	25,194
Obligations of states and political subs		550,708		42,486		(26	)		-			593,168
Corporate securities		450,436		37,531		(1,501	)		-			486,466
Redeemable preferred stocks		1,924		301		-			-			2,225
Residential mortgage-backed securities		163,676		12,635		(27	)		(152	)		176,132
Commercial mortgage-backed securities		37,848		2,258		-			-			40,106
Other asset-backed securities		14,721		2,008		(30	)		(446	)		16,253
Total debt securities available for sale		1,242,614		99,112		(1,584	)		(598	)		1,339,544
Equity Securities:
Perpetual preferred stock		10,413		1,817		(69	)		-			12,161
Common stock		14,763		409		(338	)		-			14,834
Total equity securities available for sale		25,176		2,226		(407	)		-			26,995
Total securities available for sale	$	1,267,790	$	101,338	$	(1,991	)	$	(598	)	$	1,366,539

	December 31, 2010
	Cost or Amortized Cost		Gross Unrealized								Estimated Fair Value
	Cost or Amortized Cost		Gains		Losses			Non-Credit OTTI			Estimated Fair Value
Debt Securities:
U.S. Government and agencies	$	25,375	$	1,363	$	(24	)	$	-		$	26,714
Obligations of states and political subs		527,080		22,176		(2,125	)		-			547,131
Corporate securities		379,974		21,555		(1,355	)		(3	)		400,171
Redeemable preferred stocks		3,368		1,044		-			-			4,412
Residential mortgage-backed securities		181,966		12,182		(694	)		(151	)		193,303
Commercial mortgage-backed securities		34,942		1,236		(478	)		-			35,700
Other asset-backed securities		18,090		1,476		(33	)		(604	)		18,929
Total debt securities available for sale		1,170,795		61,032		(4,709	)		(758	)		1,226,360
Equity Securities:
Perpetual preferred stock		10,869		2,006		(6	)		-			12,869
Common stock		14,763		1,255		(404	)		-			15,614
Total equity securities available for sale		25,632		3,261		(410	)		-			28,483
Total securities available for sale	$	1,196,427	$	64,293	$	(5,119	)	$	(758	)	$	1,254,843

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Gross unrealized gains, losses, and non-credit OTTI on available for sale securities as of September 30, 2011 and December 31, 2010 were as follows (in thousands):

	September 30, 2011			December 31, 2010
Unrealized gains	$	101,338		$	64,293
Unrealized losses		(1,991	)		(5,119	)
Non-credit OTTI		(598	)		(758	)
Net unrealized gains		98,749			58,416
Deferred federal income tax expense		(34,562	)		(20,445	)
Net unrealized gains on investments, net of deferred federal income taxes	$	64,187		$	37,971

Net realized gains (losses, including OTTI) on securities, for the three months and nine months ended September 30, 2011 and 2010 were as follows (in thousands):

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2011			2010			2011			2010
Realized gains (losses):
Debt securities:
Gross realized gains	$	274		$	257		$	2,141		$	630
Gross realized losses		(22	)		(22	)		(163	)		(390	)
Total debt securities		252			235			1,978			240
Equity securities:
Gross realized gains		90			90			244			206
Gross realized losses		-			(11	)		-			(72	)
Total equity securities		90			79			244			134
Net realized gains	$	342		$	314		$	2,222		$	374

OTTI included in realized losses on securities above	$	-		$	(25	)	$	(84	)	$	(437	)

Proceeds from the sales of fixed maturity securities available for sale were $1.1 million and $0.1 million for the three months ended September 30, 2011 and 2010, respectively. Proceeds from the sales of fixed maturity securities available for sale were $28.5 million and $1.2 million for the nine months ended September 30, 2011 and 2010, respectively.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

At September 30, 2011, 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 certain borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands):

	Available for Sale
	Amortized Cost		Estimated Fair Value
Due in one year or less	$	30,264	$	30,647
Due after one year through five years		270,327		282,478
Due after five years through ten years		599,735		658,912
Due after ten years		126,043		135,016
Mortgage-backed securities, collateralized obligations and asset-backed securities		216,245		232,491
	$	1,242,614	$	1,339,544

Net investment income for the three months and nine months ended September 30, 2011 and 2010 was as follows (in thousands):

	For the Three Months Ended September 30,				For the Nine Months Ended September 30,
	2011		2010		2011		2010
Net Investment Income Earned From:
Debt securities	$	13,207	$	13,232	$	39,834	$	38,783
Equity securities		452		565		1,431		1,626
Cash and cash equivalents		176		196		567		605
Total gross investment income		13,835		13,993		41,832		41,014
Less investment expenses		333		278		993		816
Net investment income	$	13,502	$	13,715	$	40,839	$	40,198

Other-Than-Temporary Impairments of Securities and Unrealized Losses on Investments

Available for sale securities are reviewed for declines in fair value that are determined to be other-than-temporary. For a debt security, if the Company intends to sell a security and it is more likely than not the Company will be required to sell a debt security before recovery of its amortized cost basis and the fair value of the debt security is below amortized cost, the Company concludes that an OTTI has occurred and the amortized cost is written down to current fair value, with a corresponding charge to realized loss in the Consolidated Statements of Income. If the Company does not intend to sell a debt security and it is not more likely than not the Company will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), the Company concludes that an OTTI has occurred. In this instance, accounting guidance requires the bifurcation of the total OTTI into the amount related to the credit loss, which is recognized in earnings and the non-credit OTTI, which is recorded in Other Comprehensive Income as an unrealized non-credit OTTI in the Consolidated Statements of Comprehensive Income.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

When assessing the Company’s intent to sell a debt security, if it is more likely than not the Company will be required to sell a debt security before recovery of its cost basis, facts and circumstances such as, but not limited to, decisions to reposition the security portfolio, sale of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing, are evaluated. In order to determine the amount of the credit loss for a debt security, the Company calculates the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows expected to be recovered. The discount rate is the effective interest rate implicit in the underlying debt security upon issuance. The effective interest rate is the original yield or the coupon if the debt security was previously impaired. If an OTTI exists and there is not sufficient cash flows or other information to determine a recovery value of the security, the Company concludes that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss in the Consolidated Statements of Income.

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

●

Historical and implied volatility of the security;

●

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

●

Conditions specifically related to the security such as default rates, loss severities, loan to value ratios, current levels of subordination, third party guarantees, and vintage;

●

Specific conditions in an industry or geographic area;

●

Any changes to the rating of the security by a rating agency;

●

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

●

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

In periods subsequent to the recognition of an OTTI, the security is accounted for as if it had been purchased on the measurement date of the OTTI. Therefore, for a fixed maturity security, the discount or reduced premium is reflected in net investment income over the contractual term of the investment in a manner that produces a constant effective yield.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

For an equity security, if the Company does not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, the Company concludes that an OTTI has occurred, and the cost of the equity security is written down to the current fair value, with a corresponding charge to realized loss within the Consolidated Statements of Income. When assessing the Company’s ability and intent to hold the equity security to recovery, the Company considers, among other things, the severity and duration of the decline in fair value of the equity security, as well as the cause of decline, a fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer.

After reviewing the Company’s investment portfolio in relation to this policy, the Company did not record any credit related OTTI for the three months ended September 30, 2011. The Company recorded $84,000 of credit related OTTI for the nine months ended September 30, 2011. No non-credit related OTTI was recognized for the three months and nine months ended September 30, 2011 in other comprehensive income. For the three months and nine months ended September 30, 2010, the Company recorded an OTTI loss of $25,000 and $437,000, respectively, of which no non-credit related OTTI losses were recognized in other comprehensive income.

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 (in thousands):

	September 30, 2011
	Less than 12 months							Greater than 12 months							Total
	Number of Issues		Fair Value of Investments with Unrealized Losses		Gross Unrealized Losses and Non-Credit OTTI			Number of Issues		Fair Value of Investments with Unrealized Losses		Gross Unrealized Losses and Non-Credit OTTI			Number of Issues		Fair Value of Investments with Unrealized Losses		Gross Unrealized Losses and Non-Credit OTTI
Debt Securities:
U.S. Government and agencies		0	$	-	$	-			-	$	-	$	-			0	$	-	$	-
Obligations of states and political subs		3		2,213		(25	)		1		184		(1	)		4		2,397		(26	)
Corporate securities		27		42,069		(1,501	)		-		-		-			27		42,069		(1,501	)
Redeemable preferred stocks		-		-		-			-		-		-			-		-		-
Residential mortgage-backed securities		3		306		(27	)		1		3,621		(152	)		4		3,927		(179	)
Commercial mortgage-backed securities		1		1,105		-			-		-		-			1		1,105		-
Other asset-backed securities		3		654		(16	)		8		1,301		(460	)		11		1,955		(476	)
Total debt securities		37		46,347		(1,569	)		10		5,106		(613	)		47		51,453		(2,182	)
Equity Securities:
Perpetual preferred stock		2		1,059		(69	)		-		-		-			2		1,059		(69	)
Common stock		1		48		-			3		5,057		(338	)		4		5,105		(338	)
Total equity securities		3		1,107		(69	)		3		5,057		(338	)		6		6,164		(407	)
Total securities		40	$	47,454	$	(1,638	)		13	$	10,163	$	(951	)		53	$	57,617	$	(2,589	)

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

	December 31, 2010
	Less than 12 months							Greater than 12 months							Total
	Number of Issues		Fair Value of Investments with Unrealized Losses		Gross Unrealized Losses and Non-Credit OTTI			Number of Issues		Fair Value of Investments with Unrealized Losses		Gross Unrealized Losses and Non-Credit OTTI			Number of Issues		Fair Value of Investments with Unrealized Losses		Gross Unrealized Losses and Non-Credit OTTI
Debt Securities:
U.S. Government and agencies		3	$	3,381	$	(24	)		-	$	-	$	-			3	$	3,381	$	(24	)
Obligations of states and political subs		36		71,422		(2,119	)		2		679		(6	)		38		72,101		(2,125	)
Corporate securities		40		70,411		(1,358	)		-		-		-			40		70,411		(1,358	)
Redeemable preferred stocks		-		-		-			-		-		-			-		-		-
Residential mortgage-backed securities		5		22,161		(694	)		1		3,631		(151	)		6		25,792		(845	)
Commercial mortgage-backed securities		2		7,052		(183	)		1		311		(295	)		3		7,363		(478	)
Other asset-backed securities		2		1,569		(16	)		12		2,617		(621	)		14		4,186		(637	)
Total debt securities		88		175,996		(4,394	)		16		7,238		(1,073	)		104		183,234		(5,467	)
Equity Securities:
Perpetual preferred stock		1		995		(6	)		-		-		-			1		995		(6	)
Common stock		-		-		-			3		5,063		(404	)		3		5,063		(404	)
Total equity securities		1		995		(6	)		3		5,063		(404	)		4		6,058		(410	)
Total securities		89	$	176,991	$	(4,400	)		19	$	12,301	$	(1,477	)		108	$	189,292	$	(5,877	)

Changes in the amount of credit loss on fixed maturities for which a portion of an OTTI related to other factors was recognized in other comprehensive income were as follows (in thousands):

Balance as of January 1, 2010	$	(547	)
Additional credit impairments on:
Previously impaired securities		(264	)
Securities for which an impairment was not previously recognized		-
Reductions		89
Balance as of December 31, 2010		(722	)
Additional credit impairments on:
Previously impaired securities		(67	)
Securities for which an impairment was not previously recognized		-
Reductions		-
Balance as of September 30, 2011	$	(789	)

NOTE 3 – Fair Value Measurements

According to accounting guidance for fair value measurements and disclosures, fair value is the price that would be received to sell an asset or would be paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. The guidance establishes a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (“observable inputs”) and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (“unobservable inputs”).

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The estimated fair values of the Company’s fixed investment portfolio are based on prices provided by a third party pricing service and a third party investment manager. The prices provided by these services are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The third party pricing service and the third party investment manager provide a single price or quote per security and the Company has not historically adjusted security prices. The Company obtains an understanding of the methods, models and inputs used by the third party pricing service and the third party investment manager, and has controls in place to validate that amounts provided represent fair values. The Company’s control process includes, but is not limited to, initial and ongoing evaluation of the methodologies used, a review of specific securities and an assessment for proper classification within the fair value hierarchy. The hierarchy level assigned to each security in the Company’s available for sale portfolio is based upon its assessment of the transparency and reliability of the inputs used in the valuation as of the measurement date. The three hierarchy levels are defined as follows:

Level 1 – Valuations that are based on unadjusted quoted prices in active markets for identical securities. The fair value of exchange-traded preferred and common equities, and mutual funds included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The fair value measurements that were based on Level 1 inputs comprise 2.1% of the fair value of the total investment portfolio.

Level 2 – Valuations that are based on observable inputs (other than Level 1 prices) such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. The fair value of securities included in the Level 2 category were based on the market values obtained from a third party pricing service that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other observable market information. The third party pricing service monitors market indicators, as well as industry and economic events. The Level 2 category includes corporate bonds, government and agency bonds, asset-backed, residential mortgage-backed and commercial mortgage-backed securities and municipal bonds. The fair value measurements that were based on Level 2 inputs comprise 97.5% of the fair value of the total investment portfolio.

Level 3 – Valuations that are derived from techniques in which one or more of the significant inputs are unobservable and/or involve management judgment and/or are based on non-binding broker quotes. The fair value measurements that were based on Level 3 inputs comprise 0.4% of the fair value of the total investment portfolio.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

For corporate, government and municipal bonds, the third party pricing service utilizes a pricing model with standard inputs that include benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, market bids/offers, and other reference data observable in the marketplace. The model uses the option adjusted spread methodology and is a multi-dimensional relational model. All bonds valued under these techniques are classified as Level 2.

For asset-backed, residential mortgage-backed and commercial mortgage-backed securities, the third party pricing service valuation methodology includes consideration of interest rate movements, new issue data, monthly remittance reports and other pertinent data that is observable in the marketplace. This information is used to determine the cash flows for each tranche and identifies the inputs to be used such as benchmark yields, prepayment assumptions and collateral performance. All asset-backed, residential mortgage-backed and commercial mortgage-backed securities valued under these methods are classified as Level 2.

Also included in Level 2 valuation are interest rate swap agreements the Company utilizes to hedge the floating interest rate on its debt, thereby changing the variable rate exposure to a fixed rate exposure for interest on these obligations. The estimated fair value of the interest rate swaps is obtained from the third party financial institution counterparties and measured using discounted cash flow analysis that incorporates significant observable inputs, including the LIBOR forward curve, derivative counterparty spreads, and measurements of volatility.

The Level 3 securities consist of 12 securities totaling $4.9 million or 0.4% of the total investment portfolio. These primarily represent asset-backed securities and corporate debt securities that have a principal protection feature supported by a U.S. Treasury strip. To fair value these securities, the third party investment manager uses a combination of methods. Non-binding broker/dealer quotes are used on 5 holdings. Benchmarking techniques based upon industry sector, rating and other factors are used on 7 holdings.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis, classified by the valuation hierarchy as of September 30, 2011 (in thousands):

				Fair Value Measurements Using
				Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs			Significant Unobservable Inputs
	Total			(Level 1)		(Level 2)			(Level 3)
Debt Securities:
U.S. Government and agencies	$	25,194		$	-	$	25,194		$	-
Obligations of states and political subs		593,168			-		593,168			-
Corporate securities		486,466			-		485,410			1,056
Redeemable preferred stocks		2,225			2,225		-			-
Residential mortgage-backed securities		176,132			-		176,132			-
Commercial mortgage-backed securities		40,106			-		40,106			-
Other asset-backed securities		16,253			-		12,447			3,806
Total debt securities available for sale		1,339,544			2,225		1,332,457			4,862
Equity Securities:
Perpetual preferred stock		12,161			11,436		725			-
Common stock		14,834			14,834		-			-
Total equity securities available for sale		26,995			26,270		725			-
Total securities available for sale	$	1,366,539		$	28,495	$	1,333,182		$	4,862

Derivatives - interest rate swaps	$	(5,917	)	$	-	$	(5,917	)	$	-

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table presents changes in Level 3 available for sale investments measured at fair value on a recurring basis as of September 30, 2011 (in thousands):

	Fair Value Measurement Using Significant Unobservable Inputs - Level 3
Balance as of January 1, 2010	$	4,161

Total gains or losses (realized/unrealized):
Included in earnings		(3	)
Included in other comprehensive income		463

Purchases		-
Issuances		-
Settlements		(97	)

Transfers in and out of Level 3		(442	)
Balance as of December 31, 2010		4,082

Total gains or losses (realized/unrealized):
Included in earnings		6
Included in other comprehensive income		818

Purchases		-
Issuances		-
Settlements		(11	)

Transfers in and out of Level 3		(33	)
Balance as of September 30, 2011	$	4,862

There were no credit related losses for the period included in earnings attributable to the change in unrealized losses on Level 3 assets still held at the reporting date.

The Company’s policy on recognizing transfers between hierarchy levels is applied at the end of a reporting period. During the quarter ended September 30, 2011, there were no transfers between levels.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4 – Debt

Credit Facilities

On July 31, 2008, the Company executed $100 million in senior credit facilities (the “Credit Facilities”). The Credit Facilities included a $65.0 million term loan facility, which was fully funded upon the closing of its Merger with ProCentury and a $35.0 million revolving credit facility, which was partially funded upon closing of the Merger. The revolving credit facility includes a letter of credit facility with a sublimit. The total amount of credit available under the revolving credit facility is $35.0 million, which may include up to $15 million in letters of credit. As of September 30, 2011, the outstanding balance on its term loan facility was $27.6 million. The Company had a zero outstanding balance on its revolving credit facility as of September 30, 2011, and $0.5 million in letters of credit had been issued as of September 30, 2011. The undrawn portion of the revolving credit facility is available to finance working capital and for general corporate purposes, including but not limited to, surplus contributions to its Insurance Company Subsidiaries to support premium growth or strategic acquisitions. At December 31, 2010, the Company had an outstanding balance of $37.8 million on its term loan and had a zero outstanding balance on its revolving credit facility.

The principal amount outstanding under the Credit Facilities provides for interest at LIBOR, plus the applicable margin, or at the Company’s option, the base rate. The base rate is defined as the higher of the lending bank’s prime rate or the Federal Funds rate, plus 0.50%, plus the applicable margin. The applicable margin is determined by the consolidated indebtedness to consolidated total capital ratio. In addition, the Credit Facilities provide for an unused facility fee ranging between twenty basis points and forty basis points, based on our consolidated leverage ratio as defined by the Credit Facilities. At September 30, 2011, the interest rate on the Company’s term loan was 5.70%, which consisted of a fixed rate of 3.95%, as described in Note 5 ~ Derivative Instruments, plus an applicable margin of 1.75%.

The debt financial covenants applicable to the Credit Facilities consist of: (1) minimum consolidated net worth starting at eighty percent of pro forma consolidated net worth after giving effect to the acquisition of ProCentury, with quarterly increases thereafter, (2) minimum Risk Based Capital Ratio for Star and Century Surety of 1.75 to 1.00, (3) maximum permitted consolidated leverage ratio of 0.35 to 1.00, (4) minimum consolidated debt service coverage ratio of 1.25 to 1.00, and (5) minimum A.M. Best Company rating of “B++.” As of September 30, 2011, the Company was in compliance with these debt covenants.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

During the second quarter of 2011, several of the Company's insurance subsidiaries (Star, Williamsburg, and Ameritrust) became members of the Federal Home Loan Bank of Indianapolis ("FHLBI"). As a member of the FHLBI, these subsidiaries have the ability to borrow on a collateralized basis, providing a source of liquidity. The aggregate investment of approximately $0.5 million by these subsidiaries provides the ability to borrow up to 20 times the total amount of the FHLBI common stock purchased. As of September 30, 2011, based on the subsidiaries’ common stock investment, the Company had the borrowing capacity of up to approximately $10 million from the FHLBI. As of September 30, 2011, the Company did not have any borrowings outstanding from the FHLBI.

Debentures

The following table summarizes the principal amounts and variables associated with the Company’s debentures (in thousands):

Year of Issuance	Description	Year Callable	Year Due	Interest Rate Terms	Interest Rate at September 30, 2011 (1)			Principal Amount

2003	Junior subordinated debentures	2008	2033	Three-month LIBOR, plus 4.05%		4.42	%	$	10,310
2004	Senior debentures	2009	2034	Three-month LIBOR, plus 4.00%		4.29	%		13,000
2004	Senior debentures	2009	2034	Three-month LIBOR, plus 4.20%		4.51	%		12,000
2005	Junior subordinated debentures	2010	2035	Three-month LIBOR, plus 3.58%		3.93	%		20,620
	Junior subordinated debentures (2)	2007	2032	Three-month LIBOR, plus 4.00%		4.33	%		15,000
	Junior subordinated debentures (2)	2008	2033	Three-month LIBOR, plus 4.10%		4.39	%		10,000
					Total			$	80,930

(1) The underlying three-month LIBOR rate varies as a result of the interest rate reset dates used in determining the three-month LIBOR rate, which varies for each long-term debt item each quarter.

(2)Represents the junior subordinated debentures acquired in conjunction with the ProCentury Merger on July 31, 2008.

Excluding the junior subordinated debentures acquired in conjunction with the ProCentury Merger, the Company received a total of $53.3 million in net proceeds from the issuance of the above long-term debt, of which $26.2 million was contributed to the surplus of its Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes. Associated with the issuance of the above long-term debt, the Company 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, the Company re-evaluated 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 beginning July 1, 2007.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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 the Company’s unconsolidated subsidiary trusts, Meadowbrook Capital Trust I and Meadowbrook Capital Trust II, respectively.

The junior subordinated debentures acquired in the ProCentury Merger were issued in conjunction with the issuance of $15.0 million and $10.0 million in floating rate trust preferred securities to a trust formed from the Company’s unconsolidated trust, ProFinance Statutory Trust I and ProFinance Statutory Trust II. The Company also acquired the remaining unamortized portion of the capitalized issuance costs associated with these debentures. The remaining unamortized portion of the issuance costs acquired was $625,000. These issuance costs are included in other assets on the balance sheet. The remaining balance is being amortized over a five year period beginning August 1, 2008, as a component of interest expense.

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 the four trusts mentioned above will be distributed to the holders of the respective trust preferred securities.

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.

NOTE 5 – Derivative Instruments

The Company has entered into interest rate swap transactions to mitigate its interest rate risk on its existing debt obligations. These interest rate swap transactions have been designated as cash flow hedges and are deemed highly effective hedges. 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 accrued and recognized as an adjustment to interest expense.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table summarizes the rates and amounts associated with the Company’s interest rate swaps (in thousands):

Effective Date	Expiration Date	Debt Instrument	Counterparty Interest Rate Terms	Fixed Rate			Fixed Amount at September 30, 2011

4/23/2008	6/30/2013	Junior subordinated debentures	Three-month LIBOR, plus 4.05%		8.020	%	$	10,000
4/29/2008	4/29/2013	Senior debentures	Three-month LIBOR, plus 4.00%		7.940	%		13,000
7/31/2008	7/31/2013	Term loan (1)	Three-month LIBOR		3.950	%		27,562
8/15/2008	8/15/2013	Junior subordinated debentures (2)	Three-month LIBOR		3.780	%		10,000
9/4/2008	9/4/2013	Junior subordinated debentures (2)	Three-month LIBOR		3.790	%		15,000
9/8/2010	5/24/2016	Senior debentures	Three-month LIBOR, plus 4.20%		6.248	%		5,000
9/16/2010	9/15/2015	Junior subordinated debentures	Three-month LIBOR, plus 3.58%		6.160	%		10,000
9/16/2010	9/15/2015	Junior subordinated debentures	Three-month LIBOR, plus 3.58%		6.190	%		10,000
5/24/2011	5/24/2016	Senior debentures	Three-month LIBOR, plus 4.20%		6.472	%		7,000

(1) The Company is required to make fixed rate interest payments on the current balance of the term loan, amortizing in accordance with the term loan amortization schedule. The Company fixed only the variable interest portion of the loan. The actual interest payments associated with the term loan also include an additional rate of 1.75% in accordance with the credit agreement.

(2) The Company fixed only the variable interest portion of the debt. The actual interest payments associated with the debentures also include an additional rate of 4.10% and 4.00% on the $10.0 million and $15.0 million debentures, respectively.

In relation to the above interest rate swaps, the net interest expense incurred for the three months ended September 30, 2011 and 2010, was approximately $0.9 million and $1.1 million, respectively. The net interest expense incurred for the nine months ended September 30, 2011 and 2010, was approximately $2.8 million and $3.4 million, respectively.

As of September 30, 2011 and December 31, 2010, the total fair value of the interest rate swaps were approximately ($5.9 million). Accumulated other comprehensive income at September 30, 2011 and December 31, 2010, included accumulated loss on the cash flow hedge, net of taxes, of approximately $3.8 million and $3.9 million, respectively.

In May 2010, the Company amended its existing $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 June 30, 2014. The insurance agency has been a producer for the Company for several 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, pledged as collateral are 100% of the common shares of the holding company and its subsidiary insurance agencies, the common shares owned by the shareholder in another agency, and the shareholder also executed a personal guaranty. This note is convertible at the option of the Company based upon a pre-determined formula.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6 – Restricted and Non-Restricted Stock Awards

On February 23, 2011 and 2010, the Company issued 28,500 and 202,500 restricted stock awards, respectively, to executives of the Company, out of its 2002 Amended and Restated Stock Option Plan (the “Plan”). The restricted stock awards vest over a four year period, with the first twenty percent vesting immediately on the date issued (i.e., February 23) and the remaining eighty percent vesting annually on a straight line basis over the requisite four year service period. The unvested restricted stock awards are subject to forfeiture in the event the employee is terminated for “Good Cause” or voluntarily resigns their employment without “Good Reason” as provided for in the employee’s respective employment agreements. The Company recorded approximately $87,000 and $72,000 of restricted stock awards compensation expense for the three months ended September 30, 2011 and 2010, respectively. The Company recorded approximately $305,000 and $453,000 of restricted stock awards compensation expense for the nine months ended September 30, 2011 and 2010, respectively.

On February 23, 2011, the Company issued 1,500 non-restricted stock awards to each outside member of the Board of Directors, which vested immediately. The Company recorded zero and $150,000 of non-restricted stock awards compensation expense for the three months and nine months ended September 30, 2011, respectively. No non-restricted stock awards were issued to the directors in 2010.

NOTE 7 – Shareholders’ Equity

At September 30, 2011, shareholders’ equity was $580.3 million, or a book value of $11.37 per common share, compared to $547.1 million, or a book value of $10.28 per common share, at December 31, 2010.

On February 12, 2010, the Company’s Board of Directors approved a Share Repurchase Plan authorizing management to purchase up to 5.0 million shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months. For the three months and nine months ended September 30, 2011, the Company purchased and retired 1.8 million and 2.2 million shares of common stock for a total cost of approximately $16.5 million and $20.4 million, respectively. For the year ended December 31, 2010, the Company purchased and retired approximately 2.5 million shares of common stock for a total cost of approximately $19.6 million.

At the Company’s regularly scheduled Board of Directors meeting on October 28, 2011, it authorized management to purchase up to 5.0 million shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months. This Share Repurchase Plan replaced the existing plan, which was previously authorized in February 2010.

Table of Contents

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

For the period ended September 30, 2011, the Company paid dividends to its common shareholders of $6.3 million. For the year ended December 31, 2010, the Company paid dividends to its common shareholders of $7.0 million. On October 27, 2011, the Company’s Board of Directors declared a quarterly dividend of $0.05 per common share. The dividend is payable on November 28, 2011, to shareholders of record as of November 11, 2011.

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, 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 its Insurance Company Subsidiaries.

NOTE 8– 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 awards using the treasury stock method.

The following table is a reconciliation of the income and share data used in the basic and diluted earnings per share computations for the three months an