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 June 30, 2012

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 August 2, 2012, was 49,776,011.

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 Statements 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 - 43

ITEM 3 –	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	44 - 45

ITEM 4 –	CONTROLS AND PROCEDURES	46

PART II – OTHER INFORMATION

ITEM 1 –	LEGAL PROCEEDINGS	47

ITEM 1A –	RISK FACTORS	47

ITEM 2 –	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	47

ITEM 3 –	DEFAULTS UPON SENIOR SECURITIES	47

ITEM 4 –	MINE SAFETY DISCLOSURES	47

ITEM 5 –	OTHER INFORMATION	47

ITEM 6 –	EXHIBITS	48

SIGNATURES		49

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PART 1 - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended June 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands, except share data)
Revenues
Premiums earned
Gross	$	248,581		$	209,676
Ceded		(37,278	)		(28,206	)
Net earned premiums		211,303			181,470
Net commissions and fees		8,552			7,897
Net investment income		13,683			13,765
Realized gains (losses):
Total other-than-temporary impairments on securities		-			-
Portion of loss recognized in other comprehensive income		-			-
Net other-than-temporary impairments on securities recognized in earnings		-			-
Net realized gains excluding other-than-temporary impairments on securities		1,567			1,094
Net realized gains		1,567			1,094
Total revenues		235,105			204,226

Expenses
Losses and loss adjustment expenses		196,976			141,356
Reinsurance recoveries		(31,218	)		(19,953	)
Net losses and loss adjustment expenses		165,758			121,403
Policy acquisition and other underwriting expenses		68,993			62,694
General, selling and administrative expenses		6,327			5,631
General corporate expenses		758			(719	)
Amortization expense		1,307			1,206
Interest expense		2,033			2,082
Total expenses		245,176			192,297
(Loss) income before taxes and equity earnings		(10,071	)		11,929
Federal and state income tax (benefit) expense		(1,782	)		2,323
Equity earnings of affiliates, net of tax		562			173
Equity (losses) earnings of unconsolidated subsidiaries, net of tax		(5	)		1
Net (loss) income	$	(7,732	)	$	9,780

(Losses) Earnings Per Share
Basic	$	(0.15	)	$	0.18
Diluted	$	(0.15	)	$	0.18

Weighted average number of common shares
Basic		50,251,591			53,100,479
Diluted		50,251,591			53,248,573

Dividends paid per common share	$	0.05		$	0.04

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

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MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

For the Six Months Ended June 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands, except share data)
Revenues
Premiums earned
Gross	$	476,027		$	410,362
Ceded		(71,909	)		(58,234	)
Net earned premiums		404,118			352,128
Net commissions and fees		17,517			16,335
Net investment income		27,415			27,337
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		2,299			1,990
Net realized gains		2,299			1,906
Total revenues		451,349			397,706

Expenses
Losses and loss adjustment expenses		358,495			270,079
Reinsurance recoveries		(59,990	)		(43,414	)
Net losses and loss adjustment expenses		298,505			226,665
Policy acquisition and other underwriting expenses		132,106			120,851
General, selling and administrative expenses		12,666			11,875
General corporate expenses		2,131			636
Amortization expense		2,723			2,438
Interest expense		4,010			4,254
Total expenses		452,141			366,719
(Loss) income before taxes and equity earnings		(792	)		30,987
Federal and state income tax expense		73			7,782
Equity earnings of affiliates, net of tax		1,250			1,246
Equity losses of unconsolidated subsidiaries, net of tax		(13	)		(22	)
Net income	$	372		$	24,429

Earnings Per Share
Basic	$	0.01		$	0.46
Diluted	$	0.01		$	0.46

Weighted average number of common shares
Basic		50,583,368			53,175,824
Diluted		50,583,368			53,323,802

Dividends paid per common share	$	0.10		$	0.08

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

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MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Three Months Ended June 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands)

Net (loss) income	$	(7,732	)	$	9,780
Other comprehensive (loss) income, net of tax:
Unrealized gain on securities		7,900			13,528
Unrealized gains in affiliates and unconsolidated subsidiaries		16			50
Increase (decrease) on non-credit other-than-temporary impairments on securities		34			(231	)
Net deferred derivative losses - hedging activity		(413	)		(381	)
Less reclassification adjustment for investment gains included in net income		(1,645	)		(1,070	)
Other comprehensive gains		5,892			11,896
Comprehensive (loss) income	$	(1,840	)	$	21,676

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Six Months Ended June 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands)

Net income	$	372		$	24,429
Other comprehensive income, net of tax:
Unrealized gains on securities		7,732			11,148
Unrealized gains (losses) in affiliates and unconsolidated subsidiaries		165			(1	)
Increase on non-credit other-than-temporary impairments on securities		292			85
Net deferred derivative (losses) gains - hedging activity		(113	)		285
Less reclassification adjustment for investment gains included in net income		(2,356	)		(1,880	)
Other comprehensive gains		5,720			9,637
Comprehensive income	$	6,092		$	34,066

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

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MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED BALANCE SHEETS

				As Adjusted
	June 30,			December 31,
	2012			2011
	(Unaudited)
	(In thousands, except share data)
ASSETS
Investments
Debt securities available for sale, at fair value (amortized cost of $1,352,554 and $1,252,775)	$	1,466,000		$	1,358,749
Equity securities available for sale, at fair value (cost of $23,065 and $25,176)		25,823			27,174
Cash and cash equivalents		88,159			101,757
Accrued investment income		14,528			13,757
Premiums and agent balances receivable, net		216,485			183,160
Reinsurance recoverable on:
Paid losses		12,788			9,870
Unpaid losses		349,361			315,884
Prepaid reinsurance premiums		37,678			33,754
Deferred policy acquisition costs		80,554			74,467
Goodwill		121,041			120,792
Other intangible assets		32,837			34,483
Other assets		102,351			96,251
Total assets	$	2,547,605		$	2,370,098

LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Losses and loss adjustment expenses	$	1,301,002		$	1,194,977
Unearned premiums		424,760			386,750
Debt		61,000			28,375
Debentures		80,930			80,930
Accounts payable and accrued expenses		39,233			38,716
Funds held and reinsurance balances payable		34,264			25,903
Payable to insurance companies		6,059			4,321
Deferred income taxes, net		8,966			8,453
Other liabilities		16,407			16,522
Total liabilities		1,972,621			1,784,947

Shareholders' Equity
Common stock, $0.01 par value; authorized 75,000,000 shares; 49,776,011 and 51,050,204 shares issued and outstanding		505			520
Additional paid-in capital		272,198			279,005
Retained earnings		229,459			238,539
Note receivable from officer		(752	)		(767	)
Accumulated other comprehensive income		73,574			67,854
Total shareholders' equity		574,984			585,151
Total liabilities and shareholders' equity	$	2,547,605		$	2,370,098

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

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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 Balances December 31, 2011		520			279,005			238,539			(767	)		67,854			585,151
Net income		-			-			372			-			-			372
Dividends declared		-			-			(5,057	)		-			-			(5,057	)
Change in unrealized gain or loss on available for sale securities, net of tax		-			-			-			-			5,351			5,351
Change in valuation allowance on deferred tax assets		-			-			-			-			317			317
Net deferred derivative loss - hedging activity		-			-			-			-			(113	)		(113	)
Stock award		-			194			-			-			-			194
Long term incentive plan; stock award for 2012 plan years		-			106			-			-			-			106
Change in investment of affiliates, net of tax		-			-			-			-			156			156
Change in investment of unconsolidated subsidiaries		-			-			-			-			9			9
Repurchase of 1,267,300 shares of common stock		(15	)		(7,107	)		(4,395	)		-			-			(11,517	)
Note receivable from officer		-			-			-			15			-			15
Balances June 30, 2012	$	505		$	272,198		$	229,459		$	(752	)	$	73,574		$	574,984

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

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MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Six Months Ended June 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands)
Cash Flows From Operating Activities
Net income	$	372		$	24,429
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of other intangible assets		2,723			2,438
Amortization of deferred debenture issuance costs		63			63
Depreciation of furniture, equipment, and building		2,821			2,697
Net amortization of discount and premiums on bonds		2,990			1,829
Gain on sale of investments, net		(2,356	)		(1,880	)
Gain on sale of fixed assets		(44	)		(44	)
Long-term incentive plan expense (benefit)		106			(973	)
Stock award		194			366
Equity earnings of affiliates, net of taxes		(1,250	)		(1,246	)
Equity losses of unconsolidated subsidiaries, net of tax		13			22
Deferred income tax benefit		(2,075	)		(522	)
Goodwill adjustment		(249	)		-
Write-off of book of business		123			-
Changes in operating assets and liabilities:
Decrease (increase) in:
Premiums and agent balances receivable		(33,325	)		(25,634	)
Reinsurance recoverable on paid and unpaid losses		(36,395	)		(11,771	)
Prepaid reinsurance premiums		(3,924	)		(292	)
Deferred policy acquisition costs		(6,087	)		(5,115	)
Other assets		(3,561	)		(285	)
Increase (decrease) in:
Losses and loss adjustment expenses		106,025			60,160
Unearned premiums		38,010			27,257
Payable to insurance companies		1,738			2,373
Funds held and reinsurance balances payable		8,361			2,825
Other liabilities		(1,233	)		(14,826	)
Total adjustments		72,668			37,442
Net cash provided by operating activities		73,040			61,871
Cash Flows From Investing Activities
Purchase of debt securities available for sale		(169,329	)		(133,777	)
Proceeds from sales and maturities of debt securities available for sale		69,247			78,352
Proceeds from sales of equity securities available for sale		2,506			200
Capital expenditures		(958	)		(3,970	)
Acquisition of rights renewals		-			(129	)
Other investing activities		(4,367	)		592
Net cash used in investing activities		(102,901	)		(58,732	)
Cash Flows From Financing Activities
Proceeds from line of credit and FHLBI		40,000			-
Payments on term loan		(7,375	)		(6,500	)
Book overdrafts		197			(1,785	)
Dividends paid on common stock		(5,057	)		(4,262	)
Share repurchases		(11,517	)		(3,904	)
Other financing activities		15			20
Net cash used in financing activities		16,263			(16,431	)
Net decrease in cash and cash equivalents		(13,598	)		(13,292	)
Cash and cash equivalents, beginning of period		101,757			90,414
Cash and cash equivalents, end of period	$	88,159		$	77,122
Supplemental Disclosure of Cash Flow Information:
Interest paid	$	3,695		$	4,070
Net income taxes paid (1)	$	3,476		$	14,678
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
Stock-based employee compensation	$	194		$	366

(1)	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.

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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 six months ended June 30, 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.

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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. Commission adjustments that occur subsequent to the issuance of the policy, because of cancellation typically are recognized when the policy is effectively cancelled. Profit sharing commissions from insurance companies are recognized when determinable, which is when such commissions are received.

Income Taxes

As of June 30, 2012 and December 31, 2011, the Company did not have any unrecognized tax benefits and 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.

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MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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:

	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 and six months ended June 30, 2011 was as follows:

	Three Months Ended June 30, 2011
(In thousands)	As Previously Reported		Adjustment			As Adjusted Reported
Policy acquisition and other underwriting expenses	$	62,450	$	244		$	62,694
Total expenses		192,053		244			192,297
Income before taxes and equity earnings		12,173		(244	)		11,929
Federal and state income tax expense		2,408		(85	)		2,323
Net income		9,939		(159	)		9,780
Comprehensive income		21,835		(159	)		21,676

Earnings per share
Basic	$	0.19	$	(0.01	)	$	0.18
Diluted	$	0.19	$	(0.01	)	$	0.18

	Six Months Ended June 30, 2011
(In thousands)	As Previously Reported		Adjustment			As Adjusted Reported
Policy acquisition and other underwriting expenses	$	119,888	$	963		$	120,851
Total expenses		365,756		963			366,719
Income before taxes and equity earnings		31,950		(963	)		30,987
Federal and state income tax expense		8,119		(337	)		7,782
Net income		25,055		(626	)		24,429
Comprehensive income		34,692		(626	)		34,066

Earnings per share
Basic	$	0.47	$	(0.01	)	$	0.46
Diluted	$	0.47	$	(0.01	)	$	0.46

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MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The effect of adoption of this new guidance on the consolidated cash flows statement for the six months ended June 30, 2011 was as follows:

	Six Months Ended June 30, 2011
(In thousands)	As Previously Reported			Adjustment			As adjusted Reported
Net income	$	25,055		$	(626	)	$	24,429
Deferred income tax expense		(185	)		(337	)		(552	)
Deferred policy acquisition costs		(6,078	)		963			(5,115	)

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, nor is it 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.

Testing Indefinite-Lived Intangible Assets for Impairment

In July 2012, the FASB issued guidance on how to test indefinite-lived intangible assets 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 an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, Intangibles—Goodwill and Other—General Intangibles Other than Goodwill. The guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company is still evaluating the impact of adoption on its financial condition and results of operations.

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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 June 30, 2012 and December 31, 2011 were as follows (in thousands):

	June 30, 2012
	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	$	21,077	$	1,772	$	-		$	-	$	22,849
Obligations of states and political subs		598,436		50,344		(371	)		-		648,409
Corporate securities		547,966		47,728		(525	)		-		595,169
Redeemable preferred stock		1,743		460		-			-		2,203
Residential mortgage-backed securities		134,203		10,294		(112	)		-		144,385
Commercial mortgage-backed securities		37,066		2,633		-			-		39,699
Other asset-backed securities		12,063		1,596		(373	)		-		13,286
Total debt securities available for sale		1,352,554		114,827		(1,381	)		-		1,466,000
Equity Securities:
Perpetual preferred stock		8,302		2,029		(10	)		-		10,321
Common stock		14,763		971		(232	)		-		15,502
Total equity securities available for sale		23,065		3,000		(242	)		-		25,823
Total securities available for sale	$	1,375,619	$	117,827	$	(1,623	)	$	-	$	1,491,823

	December 31, 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	$	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 stock		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

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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 June 30, 2012 and December 31, 2011 were as follows (in thousands):

	June 30, 2012			December 31, 2011
Unrealized gains	$	117,827		$	110,474
Unrealized losses		(1,623	)		(1,761	)
Non-credit OTTI		-			(741	)
Net unrealized gains		116,204			107,972
Deferred federal income tax expense		(40,671	)		(37,790	)
Net unrealized gains on investments, net of deferred federal income taxes	$	75,533		$	70,182

Net realized gains (losses including OTTI) on securities, for the three months and six months ended June 30, 2012 and 2011 were as follows (in thousands):

	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2012			2011			2012			2011
Realized gains (losses):
Debt securities:
Gross realized gains	$	1,328		$	942		$	1,994		$	1,866
Gross realized losses		(21	)		(27	)		(33	)		(141	)
Total debt securities		1,307			915			1,961			1,725
Equity securities:
Gross realized gains		338			154			395			154
Gross realized losses		-			-			-			-
Total equity securities		338			154			395			154
Net realized gains	$	1,645		$	1,069		$	2,356		$	1,879

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

Proceeds from the sales of fixed maturity securities available for sale were $9.6 million and $11.1 million for the three months ended June 30, 2012 and 2011, respectively. Proceeds from the sales of fixed maturity securities available for sale were $20.4 million and $27.4 million for the six months ended June 30, 2012 and 2011, respectively.

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MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

At June 30, 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	$	31,634	$	32,007
Due after one year through five years		329,713		346,905
Due after five years through ten years		634,506		705,493
Due after ten years		173,369		184,225
Mortgage-backed securities, collateralized obligations and asset-backed securities		183,332		197,370
	$	1,352,554	$	1,466,000

Net investment income for the three months and six months ended June 30, 2012 and 2011 was as follows (in thousands):

	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2012		2011		2012		2011
Net Investment Income Earned From:
Debt securities	$	13,507	$	13,436	$	26,800	$	26,628
Equity Securities		370		473		876		979
Cash and cash equivalents		143		174		417		390
Total gross investment income		14,020		14,083		28,093		27,997
Less investment expenses		337		318		678		660
Net investment income	$	13,683	$	13,765	$	27,415	$	27,337

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.

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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 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, the cause of the decline and a fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer.

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MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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 or six months ended June 30, 2012. For the three months and six months ended June 30, 2011, the Company recorded no credit OTTI loss and a credit OTTI loss of $84,000, respectively. For the three months and six months ended June 30, 2011, no non-credit related OTTI losses were recognized by the Company 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):

	June 30, 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		1	$	151	$	-			-	$	-	$	-			1	$	151	$	-
Obligations of states and political subs		13		39,769		(371	)		-		-		-			13		39,769		(371	)
Corporate securities		10		24,653		(481	)		1		3,005		(44	)		11		27,658		(525	)
Redeemable preferred stock		-		-		-			-		-		-			-		-		-
Residential mortgage-backed securities		2		93		-			3		3,538		(112	)		5		3,631		(112	)
Commercial mortgage-backed securities		-		-		-			-		-		-			-		-		-
Other asset-backed securities		1		1,120		(7	)		9		1,406		(366	)		10		2,526		(373	)
Total debt securities		27		65,786		(859	)		13		7,949		(522	)		40		73,735		(1,381	)
Equity Securities:
Perpetual preferred stock		2		4		(10	)		-		-		-			2		4		(10	)
Common stock		1		279		(11	)		3		4,932		(221	)		4		5,211		(232	)
Total equity securities		3		283		(21	)		3		4,932		(221	)		6		5,215		(242	)
Total securities		30	$	66,069	$	(880	)		16	$	12,881	$	(743	)		46	$	78,950	$	(1,623	)

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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 stock		-		-		-			-		-		-			-		-		-
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 June 30, 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 in the sale of an asset or would be paid in the transfer of 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:

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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 1.8% 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 97.9% 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.

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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 $4.8 million or 0.3% of the fair value 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 1 holding. Benchmarking techniques based upon industry sector, rating and other factors are used on the other12 holdings.

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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 June 30, 2012 (in thousands):

			Fair Value Measurements Using
	June 30, 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	$	22,849	$	-	$	22,849	$	-
Obligations of states and political subs		648,409		-		648,409		-
Corporate securities		595,169		-		594,045		1,124
Redeemable preferred stock		2,203		2,203		-		-
Residential mortgage-backed securities		144,385		-		144,385		-
Commercial mortgage-backed securities		39,699		-		39,699		-
Other asset-backed securities		13,286		-		9,657		3,629
Total debt securities available for sale		1,466,000		2,203		1,459,044		4,753
Equity Securities:
Perpetual preferred stock		10,321		9,582		739		-
Common stock		15,502		15,502		-		-
Total equity securities available for sale		25,823		25,084		739		-
Total securities available for sale	$	1,491,823	$	27,287	$	1,459,783	$