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 March 31, 2012
or
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
  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 May 2, 2012, was 50,513,311.
 


 
 

 
 
TABLE OF CONTENTS
 
 
PART I FINANCIAL INFORMATION
Page
     
ITEM 1 –
 
 
2
 
3
 
4
 
5
 
6
 
7-25
     
ITEM 2 –
26-37
     
     
ITEM 3 –
38-39
 
 
 
     
ITEM 4 –
40
     
     
 
PART II OTHER INFORMATION
 
     
ITEM 1 –
41
     
ITEM 1A –
41
     
ITEM 2 –
41
     
ITEM 3 –
41
     
ITEM 4 –
41
     
ITEM 5 –
41
     
ITEM 6 –
42
     
 
43

 
PART 1 - FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended March 31
 
         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands, except share data)
 
Revenues
           
Premiums earned
           
Gross
  $ 227,447     $ 200,686  
Ceded
    (34,632 )     (30,028 )
Net earned premiums
    192,815       170,658  
Net commissions and fees
    8,965       8,438  
Net investment income
    13,732       13,572  
Realized gains (losses):
               
Total other-than-temporary impairments on securities
    -       (84 )
Portion of loss recognized in other comprehensive income
    -       -  
Net other-than-temporary impairments on securities recognized in earnings
    -       (84 )
Net realized gains excluding other-than-temporary impairments on securities
    732       896  
Net realized gains
    732       812  
Total revenues
    216,244       193,480  
                 
Expenses
               
Losses and loss adjustment expenses
    161,519       128,723  
Reinsurance recoveries
    (28,772 )     (23,461 )
Net losses and loss adjustment expenses
    132,747       105,262  
Policy acquisition and other underwriting expenses
    63,113       58,158  
General, selling and administrative expenses
    6,339       6,244  
General corporate expenses
    1,373       1,355  
Amortization expense
    1,416       1,232  
Interest expense
    1,977       2,172  
Total expenses
    206,965       174,423  
Income before taxes and equity earnings
    9,279       19,057  
Federal and state income tax expense
    1,855       5,459  
Equity earnings of affiliates, net of tax
    688       1,073  
Equity losses of unconsolidated subsidiaries, net of tax
    (8 )     (23 )
Net income
  $ 8,104     $ 14,648  
                 
Earnings Per Share
               
Basic
  $ 0.16     $ 0.28  
Diluted
  $ 0.16     $ 0.27  
                 
Weighted average number of common shares
               
Basic
    50,915,145       53,252,007  
Diluted
    50,921,465       53,527,022  
                 
Dividends paid per common share
  $ 0.05     $ 0.04  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Three Months Ended March 31
 
         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands)
 
Net income
  $ 8,104     $ 14,648  
Other comprehensive income, net of tax:
               
Unrealized loss on securities
    (168 )     (2,380 )
Unrealized gains (losses) in affiliates and unconsolidated subsidiaries
    149       (51 )
Increase on non-credit other-than-temporary impairments on securities
    258       316  
Net deferred derivative gains - hedging activity
    300       666  
Less reclassification adjustment for investment gains included in net income
    (711 )     (810 )
Other comprehensive losses
    (172 )     (2,259 )
Comprehensive income
  $ 7,932     $ 12,389  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
 
         
As Adjusted
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
   
(Unaudited)
       
   
(In thousands, except share data)
 
ASSETS
           
Investments
           
Debt securities available for sale, at fair value (amortized cost of $1,333,436 and $1,252,775)
  $ 1,437,157     $ 1,358,749  
Equity securities available for sale, at fair value (cost of $24,959 and $25,176)
    27,883       27,174  
Cash and cash equivalents
    77,170       101,757  
Accrued investment income
    14,371       13,757  
Premiums and agent balances receivable, net
    198,605       183,160  
Reinsurance recoverable on:
               
Paid losses
    12,911       9,870  
Unpaid losses
    330,558       315,884  
Prepaid reinsurance premiums
    38,103       33,754  
Deferred policy acquisition costs
    79,703       74,467  
Goodwill
    120,792       120,792  
Other intangible assets
    34,268       34,483  
Other assets
    94,728       96,251  
Total assets
  $ 2,466,249     $ 2,370,098  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Liabilities
               
Losses and loss adjustment expenses
  $ 1,235,211     $ 1,194,977  
Unearned premiums
    417,258       386,750  
Debt
    49,688       28,375  
Debentures
    80,930       80,930  
Accounts payable and accrued expenses
    41,599       38,716  
Funds held and reinsurance balances payable
    27,547       25,903  
Payable to insurance companies
    3,414       4,321  
Deferred income taxes, net
    7,571       8,453  
Other liabilities
    17,312       16,522  
Total liabilities
    1,880,530       1,784,947  
                 
Shareholders' Equity
               
Common stock, $0.01 stated value; authorized 75,000,000 shares; 50,513,311 and 51,050,204 shares issued and outstanding
    512       520  
Additional paid-in capital
    276,101       279,005  
Retained earnings
    242,183       238,539  
Note receivable from officer
    (759 )     (767 )
Accumulated other comprehensive income
    67,682       67,854  
Total shareholders' equity
    585,719       585,151  
Total liabilities and shareholders' equity
  $ 2,466,249     $ 2,370,098  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
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, 2011 (As previously reported)
  $ 520     $ 279,005     $ 245,816     $ (767 )   $ 67,854     $ 592,428  
Cumulative effect of adjustment resulting from adoption of new accounting guidance
    -       -       (7,277 )     -       -       (7,277 )
As Adjusted Balance December 31, 2011
  $ 520     $ 279,005     $ 238,539     $ (767 )   $ 67,854     $ 585,151  
Net income
    -       -       8,104       -       -       8,104  
Dividends declared
    -       -       (2,532 )     -       -       (2,532 )
Change in unrealized on gain or loss available for sale securities, net of tax
    -       -       -       -       (862 )     (862 )
Change in valuation allowance on deferred tax assets
    -       -       -       -       241       241  
Net deferred derivative gain - hedging activity
    -       -       -       -       300       300  
Stock award
    -       109       -       -       -       109  
Long term incentive plan; stock award for 2012 plan years
    -       53       -       -       -       53  
Change in investment of affiliates, net of tax
    -       -       -       -       162       162  
Change in investment of unconsolidated subsidiaries
    -       -       -       -       (13 )     (13 )
Repurchase of 530,000 shares of common stock
    (8 )     (3,066 )     (1,928 )     -       -       (5,002 )
Note receivable from officer
    -       -       -       8       -       8  
Balances March 31, 2012
  $ 512     $ 276,101     $ 242,183     $ (759 )   $ 67,682     $ 585,719  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended March 31
 
         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands)
 
Cash Flows From Operating Activities
           
Net income
  $ 8,104     $ 14,648  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Amortization of other intangible assets
    1,416       1,232  
Amortization of deferred debenture issuance costs
    31       31  
Depreciation of furniture, equipment, and building
    1,400       1,291  
Net amortization of discount and premiums on bonds
    1,467       816  
Gain on sale of investments, net
    (711 )     (810 )
Gain on sale of fixed assets
    (21 )     (22 )
Long-term incentive plan expense (benefit)
    53       (147 )
Stock award
    109       276  
Equity earnings of affiliates, net of taxes
    (688 )     (1,073 )
Equity losses of unconsolidated subsidiaries, net of tax
    8       23  
Deferred income tax (benefit) expense
    (427 )     153  
Changes in operating assets and liabilities:
               
Decrease (increase) in:
               
Premiums and agent balances receivable
    (15,445 )     (16,593 )
Reinsurance recoverable on paid and unpaid losses
    (17,715 )     (9,545 )
Prepaid reinsurance premiums
    (4,349 )     (1,602 )
Deferred policy acquisition costs
    (5,236 )     (4,979 )
Other assets
    (2,661 )     311  
Increase (decrease) in:
               
Losses and loss adjustment expenses
    40,234       26,893  
Unearned premiums
    30,508       24,260  
Payable to insurance companies
    (907 )     (958 )
Funds held and reinsurance balances payable
    1,644       2,957  
Other liabilities
    1,437       (2,545 )
Total adjustments
    30,147       19,969  
Net cash provided by operating activities
    38,251       34,617  
Cash Flows From Investing Activities
               
Purchase of debt securities available for sale
    (111,769 )     (61,779 )
Proceeds from sales and maturities of debt securities available for sale
    35,676       44,606  
Proceeds from sales of equity securities available for sale
    275       -  
Capital expenditures
    (483 )     (1,616 )
Acquisition of rights renewals
    -       (100 )
Other investing activities
    (2,608 )     1,110  
Net cash used in investing activities
    (78,909 )     (17,779 )
Cash Flows From Financing Activities
               
Proceeds from line of credit and FHLBI
    25,000       -  
Payments on term loan
    (3,688 )     (3,250 )
Book overdrafts
    (247 )     (1,248 )
Dividends paid on common stock (1)
    -       -  
Share repurchases
    (5,002 )     -  
Other financing activities
    8       8  
Net cash used in financing activities
    16,071       (4,490 )
Net decrease in cash and cash equivalents
    (24,587 )     12,348  
Cash and cash equivalents, beginning of period
    101,757       90,414  
Cash and cash equivalents, end of period
  $ 77,170     $ 102,762  
Supplemental Disclosure of Cash Flow Information:
               
Interest paid
  $ 1,831     $ 2,048  
Net income taxes paid (2)
  $ (421 )   $ (696 )
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
               
Stock-based employee compensation
  $ 109     $ 276  
 
(1) Dividends of $2,532 and $2,131 were paid on April 5, 2012 and April 5, 2011, respectively.
 
(2) Tax return refunds were received in first quarter of 2012 and 2011 for $475 and $732, respectively.
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
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 ended March 31, 2012 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, 2011.

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.

Assumed premium estimates include business where the Company accepts a portion of the risk from a ceding carrier as well as the mandatory assumed pool business from the National Council on Compensation Insurance ("NCCI"), or residual market business. The majority of the assumed premium is from an established book of workers' compensation business produced by a ceding company in which the Company has an equity stake.
 
 
7

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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 March 31, 2012 and December 31, 2011, the Company did not have any unrecognized tax benefits.  As of March 31, 2012 and December 31, 2011, 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 adopted this guidance retrospectively on January 1, 2012 and has adjusted its previously issued financial information.

The effect of adoption of this new guidance on the consolidated balance sheet and shareholders’ equity statements as of December 31, 2011 was as follows:
 
 
8

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
 
   
December 31, 2011
 
(In thousands)
 
As Previously
Reported
   
Adjustment
   
As Adjusted
Reported
 
Deferred policy acquisition costs
    85,663       (11,196 )     74,467  
Total assets
    2,381,294       (11,196 )     2,370,098  
Deferred income tax, net
    12,372       (3,919 )     8,453  
Total liabilities
    1,788,866       (3,919 )     1,784,947  
Retained earnings
    245,816       (7,277 )     238,539  
Total shareholders' equity
    592,428       (7,277 )     585,151  
Total liabilities and shareholders' equity
    2,381,294       (11,196 )     2,370,098  
 
The effect of adoption of this new guidance on the consolidated income and comprehensive income statements for the three months ended March 31, 2011 was as follows:
 
   
Three Months Ended March 31, 2011
 
(In thousands)
 
As Previously Reported
   
Adjustment
   
As Adjusted Reported
 
Policy acquisition and other underwriting expenses
    57,438       720       58,158  
Total expenses
    173,703       720       174,423  
Income before taxes and equity earnings
    19,777       (720 )     19,057  
Federal and state income tax expense
    5,711       (252 )     5,459  
Net Income
    15,116       (468 )     14,648  
Comprehensive Income
    12,857       (468 )     12,389  
                         
Earnings per share
                       
Basic
  $ 0.28     $ -     $ 0.28  
Diluted
  $ 0.28     $ (0.01 )   $ 0.27  
 
The effect of adoption of this new guidance on the consolidated cash flows statement for the three months ended March 31, 2011 was as follows:

   
Three Months Ended March 31, 2011
 
(In thousands)
 
As Previously Reported
   
Adjustment
   
As Adjusted Reported
 
Net Income     15,116       (468 )     14,648  
Deferred income tax expense
    405       (252 )     153  
Deferred policy acquisition costs
    (5,699 )     720       (4,979 )
 
 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).
 
 
9

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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 adopted this guidance in the first quarter of 2012. The adoption did not have a material impact 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 adopted this guidance in the first quarter of 2012. The adoption of this guidance did not have a material impact on its financial condition and results of operations.
 
 
10

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 2 – Investments

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 March 31, 2012 and December 31, 2011 were as follows (in thousands):
 
   
March 31, 2012
 
   
Cost or
Amortized
Cost
   
Gross Unrealized
   
Estimated
Fair Value
 
   
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 21,487     $ 1,635     $ (5 )   $ -     $ 23,117  
Obligations of states and political subs
    579,015       46,832       (731 )     -       625,116  
Corporate securities
    533,134       42,183       (504 )     -       574,813  
Redeemable preferred stocks
    1,924       431       -       -       2,355  
Residential mortgage-backed securities
    145,929       10,711       (84 )     (107 )     156,449  
Commercial mortgage-backed securities
    38,733       2,189       (70 )     -       40,852  
Other asset-backed securities
    13,214       1,625       (8 )     (376 )     14,455  
Total debt securities available for sale
    1,333,436       105,606       (1,402 )     (483 )     1,437,157  
Equity Securities:
                                       
Perpetual preferred stock
    10,196       2,236       (9 )     -       12,423  
Common stock
    14,763       984       (287 )     -       15,460  
Total equity securities available for sale
    24,959       3,220       (296 )     -       27,883  
Total securities available for sale
  $ 1,358,395     $ 108,826     $ (1,698 )   $ (483 )   $ 1,465,040  
 
   
December 31, 2011
 
   
Cost or
Amortized
Cost
   
Gross Unrealized
   
Estimated
Fair Value
 
   
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 20,510     $ 1,856     $ -     $ -     $ 22,366  
Obligations of states and political subs
    556,265       49,742       (5 )     -       606,002  
Corporate securities
    469,770       40,591       (1,292 )     -       509,069  
Redeemable preferred stocks
    1,924       330       -       -       2,254  
Residential mortgage-backed securities
    152,719       11,534       (40 )     (228 )     163,985  
Commercial mortgage-backed securities
    37,191       2,337       -       -       39,528  
Other asset-backed securities
    14,396       1,695       (33 )     (513 )     15,545  
Total debt securities available for sale
    1,252,775       108,085       (1,370 )     (741 )     1,358,749  
Equity Securities:
                                       
Perpetual preferred stock
    10,413       1,792       (58 )     -       12,147  
Common stock
    14,763       597       (333 )     -       15,027  
Total equity securities available for sale
    25,176       2,389       (391 )     -       27,174  
Total securities available for sale
  $ 1,277,951     $ 110,474     $ (1,761 )   $ (741 )   $ 1,385,923  
 
 
11

 
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 March 31, 2012 and December 31, 2011 were as follows (in thousands):

   
March 31,
2012
   
December 31,
2011
 
Unrealized gains
  $ 108,826     $ 110,474  
Unrealized losses
    (1,698 )     (1,761 )
Non-credit OTTI
    (483 )     (741 )
Net unrealized gains
    106,645       107,972  
Deferred federal income tax expense
    (37,325 )     (37,790 )
Net unrealized gains on investments, net of deferred federal income taxes
  $ 69,320     $ 70,182  
 
Net realized (losses including OTTI) gains on securities, for the three months ended March 31, 2012 and 2011 were as follows (in thousands):

   
For the Three Months
Ended March 31,
 
   
2012
   
2011
 
Realized (losses) gains:
           
Debt securities:
           
Gross realized gains
  $ 666     $ 923  
Gross realized losses
    (12 )     (113 )
Total debt securities
    654       810  
Equity Securities:
               
Gross realized gains
    57       -  
Gross realized losses
    -       -  
Total equity securities
    57       -  
Net realized gains (losses)
  $ 711     $ 810  
                 
OTTI included in realized losses on securities above
  $ -     $ (84 )
 
Proceeds from the sales of fixed maturity securities available for sale were $10.8 million and $16.3 million for the three months ended March 31, 2012 and 2011, respectively.

 
12

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
At March 31, 2012, 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
  $ 34,773     $
35,248
 
Due after one year through five years
    324,256       341,004  
Due after five years through ten years
    623,764       687,332  
Due after ten years
    152,767       161,817  
Mortgage-backed securities, collateralized obligations and asset-backed securities
    197,876       211,756  
    $ 1,333,436     $ 1,437,157  
 
Net investment income for the three months ended March 31, 2012 and 2011 was as follows (in thousands):

   
For the Three Months
Ended March 31,
 
   
2012
   
2011
 
Net Investment Income Earned From:
           
Debt securities
  $ 13,293     $ 13,192  
Equity Securities
    505       506  
Cash and cash equivalents
    275       216  
Total gross investment income
    14,073       13,914  
Less investment expenses
    341       342  
Net investment income
  $ 13,732     $ 13,572  

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.
 
 
13

 
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.

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
 
 
14

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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 the Company’s review of its investment portfolio in relation to this policy, the Company did not record a credit or a non-credit related OTTI loss for the three months ended March 31, 2012. For the three months ended March 31, 2011, the Company recorded an OTTI loss of $84,000, 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):
 
   
March 31, 2012
 
   
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
    2     $ 1,144     $ (5 )     -     $ -     $ -       2     $ 1,144     $ (5 )
Obligations of states and political subs
    10       29,863       (731 )     -       -       -       10       29,863       (731 )
Corporate securities
    29       58,682       (504 )     -       -       -       29       58,682       (504 )
Redeemable preferred stocks
    -       -       -       -       -       -       -       -       -  
Residential mortgage-backed securities
    3       6,374       (83 )     2       3,554       (108 )     5       9,928       (191 )
Commercial mortgage-backed securities
    2       2,617       (70 )     -       -       -       2       2,617       (70 )
Other asset-backed securities
    4       1,164       (14 )     8       1,435       (370 )     12       2,599       (384 )
Total debt securities
    50       99,844       (1,407 )     10       4,989       (478 )     60       104,833       (1,885 )
Equity Securities:
                                                                       
Perpetual preferred stock
    2       5       (9 )     -       -       -       2       5       (9 )
Common stock
    1       279       (12 )     3       4,897       (275 )     4       5,176       (287 )
Total equity securities
    3       284       (21 )     3       4,897       (275 )     6       5,181       (296 )
Total securities
    53     $ 100,128     $ (1,428 )     13     $ 9,886     $ (753 )     66     $ 110,014     $ (2,181 )
 
 
15

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
   
December 31, 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
    -     $ -     $ -       -     $ -     $ -       -     $ -     $ -  
Obligations of states and political subs
    1       202       (2 )     2       923       (3 )     3       1,125       (5 )
Corporate securities
    15       27,154       (1,292 )     -       -       -       15       27,154       (1,292 )
Redeemable preferred stocks
    -       -       -       -       -       -       -       -       -  
Residential mortgage-backed securities
    4       183       (38 )     2       3,561       (230 )     6       3,744       (268 )
Commercial mortgage-backed securities
    1       683       -       -       -       -       1       683       -  
Other asset-backed securities
    3       1,163       (27 )     8       1,831       (519 )     11       2,994       (546 )
Total debt securities
    24       29,385       (1,359 )     12       6,315       (752 )     36       35,700       (2,111 )
Equity Securities:
                                                                       
Perpetual preferred stock
    3       1,079       (58 )     -       -       -       3       1,079       (58 )
Common stock
    1       279       (12 )     3       4,851       (321 )     4       5,130       (333 )
Total equity securities
    4       1,358       (70 )     3       4,851       (321 )     7       6,209       (391 )
Total securities
    28     $ 30,743     $ (1,429 )     15     $ 11,166     $ (1,073 )     43     $ 41,909     $ (2,502 )

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 December 31, 2011
  $ (789 )
Additional credit impairments on:
       
Previously impaired securities
    -  
Securities for which an impairment was not previously recognized
    -  
Reductions
    -  
Balance as of March 31, 2012
  $ (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”).

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:
 
 
16

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 2.0% 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 97.7% 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 0.3% of the fair value of the total investment portfolio.

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.
 
 
17

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 13 securities totaling $4.6 million or 0.3% 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 4 holdings.  Benchmarking techniques based upon industry sector, rating and other factors are used on 9 holdings.
 
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 March 31, 2012 (in thousands):
 
 
18

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

         
Fair Value Measurements Using
 
   
March 31,
2012
   
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
  $ 23,117     $ -     $ 23,117     $ -  
Obligations of states and political subs
    625,116       -       625,116       -  
Corporate securities
    574,813       -       573,806       1,007  
Redeemable preferred stocks
    2,355       2,355       -       -  
Residential mortgage-backed securities
    156,449       -       156,449       -  
Commercial mortgage-backed securities
    40,852       -       40,852       -  
Other asset-backed securities
    14,455       -       10,853       3,602  
Total debt securities available for sale
    1,437,157       2,355       1,430,193       4,609  
Equity Securities:
                               
Perpetual preferred stock
    12,423       11,665       758       -  
Common stock
    15,460       15,460       -       -  
Total equity securities available for sale
    27,883       27,125       758       -  
Total securities available for sale
  $ 1,465,040     $ 29,480     $ 1,430,951     $ 4,609  
                                 
Derivatives - interest rate swaps
  $ (4,582 )   $ -     $ (4,582 )   $ -  

The following table presents changes in Level 3 available for sale investments measured at fair value on a recurring basis as of March 31, 2012 (in thousands):

   
Fair Value
Measurement
Using
Significant
Unobservable
Inputs - Level 3
 
Balance as of December 31, 2011
  $ 4,659  
         
Total gains or losses (realized/unrealized):
       
Included in earnings
    18  
Included in other comprehensive income
    (66 )
         
Purchases
    -  
Issuances
    -  
Settlements
    (2 )
         
Transfers in and out of Level 3
       
Balance as of March 31, 2012
  $ 4,609  
 
 
19

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
There were no credit 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 March 31, 2012, there was one asset-backed security transferred into Level 3 from Level 2 as fair value was no longer determined using market inputs that could be directly or indirectly observable. There were no transfers between Level 1 and Level 2 during the quarter ended March 31, 2012.
 
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 March 31, 2012, the outstanding balance on its term loan facility was $20.2 million.  The Company had a $9.5 million outstanding balance on its revolving credit facility as of March 31, 2012, and $0.5 million in letters of credit had been issued as of March 31, 2012.  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, 2011, the Company had an outstanding balance of $23.9 million on its term loan and a $4.5 million outstanding balance on its revolving credit facility. There was $0.5 million in letters of credit that had been issued as of December 31, 2011.

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 March 31, 2012, 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 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 rating of “B++.”  As of March 31, 2012, the Company was in compliance with these debt covenants.
 
 
20

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

During 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 at relatively low borrowing rates, providing a source of liquidity. The aggregate investment of approximately $1.2 million by these subsidiaries provides the ability to borrow up to 20 times the total amount of the FHLBI common stock purchased, or the borrowing capacity of up to approximately $24 million from the FHLBI. As of March 31, 2012, the Company had borrowed $20 million from the FHLBI after pledging as collateral the carrying value of $21.7 million in residential mortgage-backed securities (“RMBS”). The Company retains all the rights regarding the collateralized RMBS.

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 March 31,
2012 (1)
   
Principal
Amount
 
                     
2003
Junior subordinated debentures
2008
2033
Three-month LIBOR, plus 4.05%
    4.52 %   $ 10,310  
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.00%
    4.50 %     13,000  
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.20%
    4.69 %     12,000  
2005
Junior subordinated debentures
2010
2035
Three-month LIBOR, plus 3.58%
    4.05 %     20,620  
 
Junior subordinated debentures (2)
2007
2032
Three-month LIBOR, plus 4.00%
    4.48 %     15,000  
 
Junior subordinated debentures (2)
2008
2033
Three-month LIBOR, plus 4.10%
    4.60 %     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 issuances 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.
 
 
21

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 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 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 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
 
 
22

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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.

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
March 31,
 2012
 
                   
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 %     20,188  
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 March 31, 2012 and 2011, was approximately $0.8 million and $1.0 million, respectively.

As of March 31, 2012 and December 31, 2011, the total fair value of the interest rate swaps was an unrealized loss of $4.6 million and $5.0 million, respectively. At March 31, 2012 and December 31, 2011, accumulated other comprehensive income included accumulated loss on the cash flow hedge, net of taxes, of approximately $3.0 million and $3.3 million, respectively.
 
In March 2012, the Company replaced its existing $5.6 million convertible note and $664,000 demand note receivables with an unaffiliated insurance agency into new debt instruments with a related limited liability company. The new instruments were effective January 1, 2012 and consist of a $2 million convertible note and a $4.2 million term loan. The interest rate on of the convertible note is 3% and, absent an event of default, is due January 1, 2022. This note is convertible at the option of the Company based upon a pre-determined formula. The interest rate of the term loan is 5.5% and, absent an event of default, is due April 30, 2016. As security for the note and term loan, the borrower granted the Company a first lien on all of its accounts receivable, cash, general intangibles, and other assets. As additional collateral for the note and term loan, the Company obtained guaranties of payment and performance from certain affiliated companies of the borrower, as well as related individuals, which guaranties are secured by additional collateral.
 
 
23

 
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 $46,000 and $132,000 of restricted stock awards compensation expense for the three months ended March 31, 2012 and 2011, respectively.

On February 23, 2012 and 2011 the Company issued 1,500 non-restricted stock awards to each member of the Board of Directors, which vested immediately. The Company recorded approximately $149,000 and $150,000 of non-restricted stock awards compensation expense for the three months ended March 31, 2012 and 2011, respectively.

NOTE 7 – Shareholders’ Equity

At March 31, 2012, shareholders’ equity was $585.7 million, or a book value of $11.60 per common share, compared to $585.2 million, or a book value of $11.46 per common share, at December 31, 2011.

On October 28, 2011, 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 ended March 31, 2012, the Company purchased and retired approximately 0.5 million shares of common stock for a total cost of approximately $5.0 million. For the three months ended March 31, 2011, there were no share repurchases.

For the three months ended March 31, 2012, the Company had $2.5 million of cash dividends payable on April 5, 2012.  For the three months ended March 31, 2011, cash dividends paid to common shareholders totaled $2.1 million.  On April 26, 2012, the Company’s Board of Directors declared a quarterly dividend of $0.05 per common share.  The dividend is payable on May 29, 2012, to shareholders of record as of May 11, 2012.

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.
 
 
24

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 ended March 31 (in thousands, except per share amounts):

   
For the Three Months
Ended March 31,
 
         
As Adjusted
 
   
2012
   
2011
 
Net income
  $ 8,104     $ 14,648  
                 
Common shares:
               
Basic
               
Weighted average shares outstanding
    50,915,145       53,252,007  
                 
Diluted
               
Weighted average shares outstanding
    50,915,145       53,252,007  
Dilutive effect of:
               
Share awards under long term incentive plan
    6,320       275,015  
Total
    50,921,465       53,527,022  
                 
Net income per common share
               
Basic
  $ 0.16