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
or
o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from        to

Commission File Number 1-14094

Meadowbrook Insurance Group, Inc.
(Exact name of Registrant as specified in its charter)
 
Michigan    38-2626206
(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 –
 
 
2 - 3
 
4
 
5
 
6
 
7
 
8 - 27
     
ITEM 2 –
28 - 45
     
ITEM 3 –
46 - 47
     
ITEM 4 –
48
     
 
PART II OTHER INFORMATION
 
     
ITEM 1 –
49
     
ITEM 1A –
49
     
ITEM 2 –
49
     
ITEM 3 –
49
     
ITEM 4 –
49
     
ITEM 5 –
49
     
ITEM 6 –
50
     
51


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.
 
 
2

 
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.
 
 
3


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.
 
 
4


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.
 
 
5


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.
 
 
6


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.
 
 
7

 
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.
 
 
8

 
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.
 
 
9


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  

 
10

 
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.
 
 
11

 
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
 
   
Gains
   
Losses
   
Non-Credit
OTTI
 
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
 
   
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 20,510     $ 1,856     $ -     $ -     $ 22,366  
Obligations of states and political subs
    556,265       49,742       (5 )     -       606,002  
Corporate securities
    469,770       40,591       (1,292 )     -       509,069  
Redeemable preferred 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  
 
 
12

 
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.
 
 
13

 
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.
 
 
14

 
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.
 
 
15

 
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 )
 
 
16

 
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:
 
 
17

 
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.
 
 
18

 
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.
 
 
19


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