Edgar Filing: MEADOWBROOK INSURANCE GROUP INC

form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 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, $0.01 par value, outstanding on November 1, 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 - 45

ITEM 3 –	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	46 - 47

ITEM 4 –	CONTROLS AND PROCEDURES	48

	PART II – OTHER INFORMATION

ITEM 1 –	LEGAL PROCEEDINGS	49

ITEM 1A –	RISK FACTORS	49

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

ITEM 3 –	DEFAULTS UPON SENIOR SECURITIES	49

ITEM 4 –	MINE SAFETY DISCLOSURES	49

ITEM 5 –	OTHER INFORMATION	49

ITEM 6 –	EXHIBITS	50

SIGNATURES		51

Table of Contents

PART 1 - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended September 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands, except share data)
Revenues
Premiums earned
Gross	$	265,619		$	225,219
Ceded		(42,212	)		(31,632	)
Net earned premiums		223,407			193,587
Net commissions and fees		7,410			7,293
Net investment income		13,815			13,502
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		902			363
Net realized gains		902			363
Total revenues		245,534			214,745

Expenses
Losses and loss adjustment expenses		242,847			153,809
Reinsurance recoveries		(30,149	)		(24,853	)
Net losses and loss adjustment expenses		212,698			128,956
Policy acquisition and other underwriting expenses		71,373			64,833
General, selling and administrative expenses		5,745			5,876
General corporate expenses		717			273
Amortization expense		1,372			1,208
Interest expense		2,372			2,066
Total expenses		294,277			203,212
(Loss) income before taxes and equity earnings		(48,743	)		11,533
Federal and state income tax (benefit) expense		(21,357	)		2,531
Equity earnings of affiliates, net of tax		791			649
Equity (losses) earnings of unconsolidated subsidiaries, net of tax		(15	)		(8	)
Net (loss) income	$	(26,610	)	$	9,643

(Losses) Earnings Per Share
Basic	$	(0.53	)	$	0.18
Diluted	$	(0.53	)	$	0.18

Weighted average number of common shares
Basic		49,776,011			52,240,813
Diluted		49,776,011			52,355,581

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 Nine Months Ended September 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands, except share data)
Revenues
Premiums earned
Gross	$	741,646		$	635,581
Ceded		(114,121	)		(89,866	)
Net earned premiums		627,525			545,715
Net commissions and fees		24,927			23,628
Net investment income		41,230			40,839
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		3,201			2,353
Net realized gains		3,201			2,269
Total revenues		696,883			612,451

Expenses
Losses and loss adjustment expenses		601,342			423,889
Reinsurance recoveries		(90,139	)		(68,268	)
Net losses and loss adjustment expenses		511,203			355,621
Policy acquisition and other underwriting expenses		203,479			185,684
General, selling and administrative expenses		18,411			17,751
General corporate expenses		2,848			909
Amortization expense		4,095			3,646
Interest expense		6,382			6,320
Total expenses		746,418			569,931
(Loss) income before taxes and equity earnings		(49,535	)		42,520
Federal and state income tax (benefit) expense		(21,284	)		10,313
Equity earnings of affiliates, net of tax		2,041			1,895
Equity losses of unconsolidated subsidiaries, net of tax		(28	)		(30	)
Net (loss) income	$	(26,238	)	$	34,072

(Losses) Earnings Per Share
Basic	$	(0.52	)	$	0.64
Diluted	$	(0.52	)	$	0.64

Weighted average number of common shares
Basic		50,312,285			52,860,729
Diluted		50,312,285			52,974,390

Dividends paid per common share	$	0.15		$	0.12

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 September 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands)
Net (loss) income	$	(26,610	)	$	9,643
Other comprehensive (loss) income, net of tax:
Unrealized gain on securities		11,921			16,788
Unrealized gains in affiliates and unconsolidated subsidiaries		57			23
Increase on non-credit other-than-temporary impairments on securities		271			74
Net deferred derivative losses - hedging activity		(72	)		(275	)
Less reclassification adjustment for investment gains included in net income		(880	)		(342	)
Other comprehensive gains		11,297			16,268
Comprehensive (loss) income	$	(15,313	)	$	25,911

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Nine Months Ended September 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands)
Net (loss) income	$	(26,238	)	$	34,072
Other comprehensive (loss) income, net of tax:
Unrealized gains on securities		19,653			27,936
Unrealized gains in affiliates and unconsolidated subsidiaries		222			22
Increase on non-credit other-than-temporary impairments on securities		563			159
Net deferred derivative (losses) gains - hedging activity		(185	)		10
Less reclassification adjustment for investment gains included in net income		(3,236	)		(2,222	)
Other comprehensive gains		17,017			25,905
Comprehensive (loss) income	$	(9,221	)	$	59,977

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
	September 30,			December 31,
	2012			2011
	(Unaudited)
	(In thousands, except share data)
ASSETS
Investments
Debt securities available for sale, at fair value (amortized cost of $1,397,121 and $1,252,775)	$	1,527,482		$	1,358,749
Equity securities available for sale, at fair value (cost of $22,559 and $25,176)		25,615			27,174
Cash and cash equivalents		111,144			101,757
Accrued investment income		15,216			13,757
Premiums and agent balances receivable, net		225,943			183,160
Reinsurance recoverable on:
Paid losses		14,251			9,870
Unpaid losses		366,998			315,884
Prepaid reinsurance premiums		52,756			33,754
Deferred policy acquisition costs		84,372			74,467
Goodwill		121,041			120,792
Other intangible assets		31,465			34,483
Other assets		121,097			96,251
Total assets	$	2,697,380		$	2,370,098

LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Losses and loss adjustment expenses	$	1,409,422		$	1,194,977
Unearned premiums		465,076			386,750
Debt		70,000			28,375
Debentures		80,930			80,930
Accounts payable and accrued expenses		35,923			38,716
Funds held and reinsurance balances payable		43,016			25,903
Payable to insurance companies		3,855			4,321
Deferred income taxes, net		13,489			8,453
Other liabilities		18,342			16,522
Total liabilities		2,140,053			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		272,336			279,005
Retained earnings		200,360			238,539
Note receivable from officer		(745	)		(767	)
Accumulated other comprehensive income		84,871			67,854
Total shareholders' equity		557,327			585,151
Total liabilities and shareholders' equity	$	2,697,380		$	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 loss		-			-			(26,238	)		-			-			(26,238	)
Dividends declared		-			-			(7,546	)		-			-			(7,546	)
Change in unrealized gain or loss on available for sale securities, net of tax		-			-			-			-			16,539			16,539
Change in valuation allowance on deferred tax assets		-			-			-			-			441			441
Net deferred derivative loss - hedging activity		-			-			-			-			(185	)		(185	)
Stock award		-			279			-			-			-			279
Long term incentive plan; stock award for 2012 plan years		-			159			-			-			-			159
Change in investment of affiliates, net of tax		-			-			-			-			197			197
Change in investment of unconsolidated subsidiaries		-			-			-			-			25			25
Repurchase of 1,267,300 shares of common stock		(15	)		(7,107	)		(4,395	)		-			-			(11,517	)
Note receivable from officer		-			-			-			22			-			22
Balances September 30, 2012	$	505		$	272,336		$	200,360		$	(745	)	$	84,871		$	557,327

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 Nine Months Ended September 30,

				As Adjusted
	2012			2011
	(Unaudited)
	(In thousands)
Cash Flows From Operating Activities
Net (loss) income	$	(26,238	)	$	34,072
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of other intangible assets		4,095			3,646
Amortization of deferred debenture issuance costs		94			94
Depreciation of furniture, equipment, and building		3,916			3,916
Net amortization of discount and premiums on bonds		4,680			3,092
Gain on sale of investments, net		(3,236	)		(2,222	)
Gain on sale of fixed assets		(66	)		(47	)
Long-term incentive plan expense (benefit)		159			(1,195	)
Stock award		279			454
Equity earnings of affiliates, net of taxes		(2,041	)		(1,895	)
Equity losses of unconsolidated subsidiaries, net of tax		28			30
Deferred income tax benefit		(3,437	)		(9,304	)
Goodwill adjustment		(249	)		-
Write-off of book of business		123			-
Changes in operating assets and liabilities:
(Increase) in:
Premiums and agent balances receivable		(42,783	)		(23,829	)
Reinsurance recoverable on paid and unpaid losses		(55,495	)		(23,655	)
Prepaid reinsurance premiums		(19,002	)		(6,502	)
Deferred policy acquisition costs		(9,905	)		(8,335	)
Other assets		(3,773	)		(3,409	)
Increase (decrease) in:
Losses and loss adjustment expenses		214,445			92,397
Unearned premiums		78,326			45,328
Payable to insurance companies		(466	)		55
Funds held and reinsurance balances payable		17,113			5,409
Other liabilities		(28,676	)		(13,225	)
Total adjustments		154,129			60,803
Net cash provided by operating activities		127,891			94,875
Cash Flows From Investing Activities
Purchase of debt securities available for sale		(242,172	)		(170,746	)
Proceeds from sales and maturities of debt securities available for sale		103,529			104,272
Proceeds from sales of equity securities available for sale		3,090			700
Capital expenditures		(2,183	)		(5,606	)
Acquisition of rights renewals		-			(164	)
Other investing activities		(4,008	)		132
Net cash used in investing activities		(141,744	)		(71,412	)
Cash Flows From Financing Activities
Proceeds from term loan		30,000			-
Proceeds from line of credit		20,000			-
Proceeds from FHLB advance		30,000			-
Payments on term loan		(23,875	)		(10,188	)
Payments on line of credit		(14,500	)		-
Book overdrafts		656			(593	)
Dividends paid on common stock		(7,546	)		(6,336	)
Share repurchases		(11,517	)		(20,441	)
Other financing activities		22			29
Net cash provided by (used in) financing activities		23,240			(37,529	)
Net increase (decrease) in cash and cash equivalents		9,387			(14,066	)
Cash and cash equivalents, beginning of period		101,757			90,414
Cash and cash equivalents, end of period	$	111,144		$	76,348
Supplemental Disclosure of Cash Flow Information:
Interest paid	$	5,951		$	6,074
Net income taxes paid	$	3,510		$	18,279
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
Stock-based employee compensation	$	279		$	454

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 nine months ended September 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 September 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 nine months ended September 30, 2011 was as follows:

	Three Months Ended September 30, 2011
(In thousands)	As Previously Reported		Adj.			As Adjusted Reported
Policy acquisition and other underwriting expenses	$	64,665	$	168		$	64,833
Total expenses		203,044		168			203,212
Income before taxes and equity earnings		11,701		(168	)		11,533
Federal and state income tax expense		2,590		(59	)		2,531
Net income		9,752		(109	)		9,643
Comprehensive income		26,020		(109	)		25,911

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

	Nine Months Ended September 30, 2011
(In thousands)	As Previously Reported		Adj.			As Adjusted Reported
Policy acquisition and other underwriting expenses	$	184,553	$	1,131		$	185,684
Total expenses		568,800		1,131			569,931
Income before taxes and equity earnings		43,651		(1,131	)		42,520
Federal and state income tax expense		10,709		(396	)		10,313
Net income		34,807		(735	)		34,072
Comprehensive income		60,712		(735	)		59,977

Earnings per share
Basic	$	0.66	$	(0.02	)	$	0.64
Diluted	$	0.66	$	(0.02	)	$	0.64

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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 nine months ended September 30, 2011 was as follows:

	Nine Months Ended September 30, 2011
(In thousands)	As Previously Reported			Adjustment			As Adjusted Reported
Net income	$	34,807		$	(735	)	$	34,072
Deferred income tax expense		(8,908	)		(396	)		(9,304	)
Deferred policy acquisition costs		(9,466	)		1,131			(8,335	)

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, but currently does not anticipate it having a material impact.

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

	September 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	$	19,298	$	1,745	$	-		$	-	$	21,043
Obligations of states and political subs		638,724		55,903		-			-		694,627
Corporate securities		566,869		57,765		(63	)		-		624,571
Redeemable preferred stock		1,743		441		-			-		2,184
Residential mortgage-backed securities		124,525		10,222		(1	)		-		134,746
Commercial mortgage-backed securities		35,556		2,877		-			-		38,433
Other asset-backed securities		10,406		1,714		(242	)		-		11,878
Total debt securities available for sale		1,397,121		130,667		(306	)		-		1,527,482
Equity Securities:
Perpetual preferred stock		7,796		1,940		-			-		9,736
Common stock		14,763		1,281		(165	)		-		15,879
Total equity securities available for sale		22,559		3,221		(165	)		-		25,615
Total securities available for sale	$	1,419,680	$	133,888	$	(471	)	$	-	$	1,553,097

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

	September 30, 2012			December 31, 2011
Unrealized gains	$	133,888		$	110,474
Unrealized losses		(471	)		(1,761	)
Non-credit OTTI		-			(741	)
Net unrealized gains		133,417			107,972
Deferred federal income tax expense		(46,696	)		(37,790	)
Net unrealized gains on investments, net of deferred federal income taxes	$	86,721		$	70,182

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

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
Realized gains (losses):
Debt securities:
Gross realized gains	$	818		$	274		$	2,812		$	2,141
Gross realized losses		(16	)		(22	)		(49	)		(163	)
Total debt securities		802			252			2,763			1,978
Equity securities:
Gross realized gains		78			90			473			244
Gross realized losses		-			-			-			-
Total equity securities		78			90			473			244
Net realized gains	$	880		$	342		$	3,236		$	2,222

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

Proceeds from the sales of fixed maturity securities available for sale were $6.6 million and $1.1 million for the three months ended September 30, 2012 and 2011, respectively. Proceeds from the sales of fixed maturity securities available for sale were $27.0 million and $28.5 million for the nine months ended September 30, 2012 and 2011, respectively.

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MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

At September 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	$	45,884	$	46,446
Due after one year through five years		353,917		377,406
Due after five years through ten years		634,545		713,525
Due after ten years		192,288		205,048
Mortgage-backed securities, collateralized obligations and asset-backed securities		170,487		185,057
	$	1,397,121	$	1,527,482

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

	For the Three Months Ended September 30,				For the Nine Months Ended September 30,
	2012		2011		2012		2011
Net Investment Income Earned From:
Debt securities	$	13,544	$	13,207	$	40,348	$	39,834
Equity Securities		421		452		1,297		1,431
Cash and cash equivalents		197		176		610		567
Total gross investment income		14,162		13,835		42,255		41,832
Less investment expenses		347		333		1,025		993
Net investment income	$	13,815	$	13,502	$	41,230	$	40,839

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 that the Company will be required to sell a debt security before recovery of its amortized cost basis and that 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 that 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 that 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, sales 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 nine months ended September 30, 2012. For the three months and nine months ended September 30, 2011, the Company recorded no credit OTTI loss and a credit OTTI loss of $84,000, respectively. For the three months and nine months ended September 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):

	September 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		-	$	-	$	-			-	$	-	$	-			-	$	-	$	-
Obligations of states and political subs		-		-		-			-		-		-			-		-		-
Corporate securities		3		5,305		(29	)		1		3,071		(34	)		4		8,376		(63	)
Redeemable preferred stock		-		-		-			-		-		-			-		-		-
Residential mortgage-backed securities		1		1		-			1		24		(1	)		2		25		(1	)
Commercial mortgage-backed securities		-		-		-			-		-		-			-		-		-
Other asset-backed securities		3		2,001		(26	)		5		1,348		(216	)		8		3,349		(242	)
Total debt securities		7		7,307		(55	)		7		4,443		(251	)		14		11,750		(306	)
Equity Securities:
Perpetual preferred stock		-		-		-			-		-		-			-		-		-
Common stock		-		-		-			2		4,606		(165	)		2		4,606		(165	)
Total equity securities		-		-		-			2		4,606		(165	)		2		4,606		(165	)
Total securities		7	$	7,307	$	(55	)		9	$	9,049	$	(416	)		16	$	16,356	$	(471	)


	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	)

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MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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 September 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 1.7% 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 0.4% 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 38 securities totaling $6.3 million or 0.4% 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 3 holdings. Benchmarking techniques based upon industry sector, rating and other factors are used on the other 35 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 September 30, 2012 (in thousands):

			Fair Value Measurements Using
	September 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	$	21,043	$	-	$	21,043	$	-
Obligations of states and political subs		694,627		-		694,627		-
Corporate securities		624,571		-		623,449		1,122
Redeemable preferred stock		2,184		2,184		-		-
Residential mortgage-backed securities		134,746		-		134,717		29
Commercial mortgage-backed securities		38,433		-		37,705		728
Other asset-backed securities		11,878		-		7,442		4,436
Total debt securities available for sale		1,527,482		2,184		1,518,983		6,315
Equity Securities:
Perpetual preferred stock		9,736		8,976		760		-
Common stock		15,879		15,879		-		-
Total equity securities available for sale		25,615		24,855		760		-
Total securities available for sale	$	1,553,097	$	27,039	$	1,519,743	$	6,315