UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
FORM 10-Q

T QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
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 T 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 T 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 T 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 T

The aggregate number of shares of the Registrant’s Common Stock, $.01 par value, outstanding on November 5, 2013, was 49,887,200.
 
TABLE OF CONTENTS

 
 
Page
 
 
 
PART I – FINANCIAL INFORMATION
 
 
 
ITEM 1 –
2-7
 
2-3
 
4
 
5
 
6
 
7
 
8-26
 
 
 
ITEM 2 –
27-41
 
 
 
ITEM 3 –
41-42
 
 
 
ITEM 4 –
43
 
 
 
PART II – OTHER INFORMATION
 
 
 
ITEM 1 –
 44
 
 
 
ITEM 1A –
44
 
 
 
ITEM 2 –
44
 
 
 
ITEM 3 –
44
 
 
 
ITEM 4 –
44
 
 
 
ITEM 5 –
44
 
 
 
ITEM 6 –
45
 
 
 
46

PART 1 - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended September 30,

 
  
2013
    
2012
  
 
  
(Unaudited)
  
 
  
(In thousands, except share data)
  
Revenues
  
   
 
Premiums earned
  
   
 
Gross
  
$
260,273
    
$
265,619
  
Ceded
    
(79,217
)
    
(42,212
)
Net earned premiums
    
181,056
      
223,407
  
Net commissions and fees
    
10,458
      
7,410
  
Net investment income
    
11,695
      
13,815
  
Realized gains:
                
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
    
675
      
902
  
Net realized gains
    
675
      
902
  
Total revenues
    
203,884
      
245,534
  
 
                
Expenses
                
Losses and loss adjustment expenses
    
197,314
      
242,847
  
Reinsurance recoveries
    
(65,067
)
    
(30,149
)
Net losses and loss adjustment expenses
    
132,247
      
212,698
  
Policy acquisition and other underwriting expenses
    
54,228
      
71,373
  
General, selling and administrative expenses
    
7,026
      
5,745
  
General corporate expenses
    
1,025
      
717
  
Amortization expense
    
1,037
      
1,372
  
Interest expense
    
3,581
      
2,372
  
Total expenses
    
199,144
      
294,277
  
Income (loss) before taxes and equity earnings
    
4,740
      
(48,743
)
Federal and state income tax expense (benefit)
    
356
      
(21,357
)
Equity earnings of affiliates, net of tax
    
1,164
      
791
  
Equity losses of unconsolidated subsidiaries, net of tax
    
(32
)
    
(15
)
Net income (loss)
  
$
5,516
    
$
(26,610
)
 
                
Earnings (Losses) Per Share
                
Basic
  
$
0.11
    
$
(0.53
)
Diluted
  
$
0.11
    
$
(0.53
)
 
                
Weighted average number of common shares
                
Basic
    
49,887,200
      
49,776,011
  
Diluted
    
49,933,540
      
49,776,011
  
 
                
Dividends paid per common share
  
$
0.02
    
$
0.05
  

The accompanying notes are an integral part of the Consolidated Financial Statements.
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Nine Months Ended September 30,

 
  
2013
    
2012
  
 
  
(Unaudited)
  
 
  
(In thousands, except share data)
  
Revenues
  
   
 
Premiums earned
  
   
 
Gross
  
$
789,468
    
$
741,646
  
Ceded
    
(262,043
)
    
(114,121
)
Net earned premiums
    
527,425
      
627,525
  
Net commissions and fees
    
28,631
      
24,927
  
Net investment income
    
34,603
      
41,230
  
Realized gains:
                
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
    
3,860
      
3,201
  
Net realized gains
    
3,860
      
3,201
  
Total revenues
    
594,519
      
696,883
  
 
                
Expenses
                
Losses and loss adjustment expenses
    
590,095
      
601,342
  
Reinsurance recoveries
    
(190,661
)
    
(90,139
)
Net losses and loss adjustment expenses
    
399,434
      
511,203
  
Policy acquisition and other underwriting expenses
    
163,283
      
203,479
  
General, selling and administrative expenses
    
18,950
      
18,411
  
General corporate expenses
    
3,301
      
2,848
  
Amortization expense
    
3,146
      
4,095
  
Goodwill impairment expense
    
115,397
      
-
  
Interest expense
    
9,431
      
6,382
  
Total expenses
    
712,942
      
746,418
  
Loss before taxes and equity earnings
    
(118,423
)
    
(49,535
)
Federal and state income tax benefit
    
(15,412
)
    
(21,284
)
Equity earnings of affiliates, net of tax
    
2,547
      
2,041
  
Equity income (losses) of unconsolidated subsidiaries, net of tax
    
4
      
(28
)
Net loss
  
$
(100,460
)
  
$
(26,238
)
 
                
Losses Per Share
                
Basic
  
$
(2.01
)
  
$
(0.52
)
Diluted
  
$
(2.01
)
  
$
(0.52
)
 
                
Weighted average number of common shares
                
Basic
    
49,866,326
      
50,312,285
  
Diluted
    
49,866,326
      
50,312,285
  
 
                
Dividends paid per common share
  
$
0.06
    
$
0.15
  

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

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Three Months Ended September 30,

 
  
2013
    
2012
  
 
  
(Unaudited)
  
 
  
(In thousands)
  
Net income (loss)
  
$
5,516
    
$
(26,610
)
Other comprehensive income (loss), net of tax:
                
Unrealized gains on securities
    
3,243
      
11,612
  
Unrealized (losses) gains in affiliates and unconsolidated subsidiaries
    
(316
)
    
57
  
Increase in non-credit other-than-temporary impairments on securities
    
-
      
271
  
Net deferred derivative gains (losses) - hedging activity
    
140
      
(72
)
Less reclassification adjustment for investment gains included in net income
    
(457
)
    
(571
)
Other comprehensive  gains, net of tax
    
2,610
      
11,297
  
Comprehensive income (loss)
  
$
8,126
    
$
(15,313
)

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Nine Months Ended September 30,

 
  
2013
    
2012
  
 
  
(Unaudited)
  
 
  
(In thousands)
  
Net loss
  
$
(100,460
)
  
$
(26,238
)
Other comprehensive (loss) income, net of tax:
                
Unrealized (losses) gains on securities
    
(32,026
)
    
18,520
  
Unrealized (losses) gains in affiliates and unconsolidated subsidiaries
    
(254
)
    
222
  
Increase on non-credit other-than-temporary impairments on securities
    
-
      
563
  
Net deferred derivative gains (losses) - hedging activity
    
3,178
      
(185
)
Less reclassification adjustment for investment gains included in net income
    
(2,534
)
    
(2,103
)
Other comprehensive (loss) gains, net of tax
    
(31,636
)
    
17,017
  
Comprehensive loss
  
$
(132,096
)
  
$
(9,221
)

The accompanying notes are an integral part of the Consolidated Financial Statements.
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS

 
  
September 30,
    
December 31,
  
 
  
2013
    
2012
  
 
  
(Unaudited)
  
 
  
(In thousands, except share data)
  
ASSETS
  
   
 
Investments
  
   
 
Debt securities available for sale, at fair value (amortized cost of $1,460,190 and $1,211,794)
  
$
1,474,735
    
$
1,286,807
  
Equity securities available for sale, at fair value (cost of $102,981 and $20,389)
    
112,988
      
22,661
  
Cash and cash equivalents
    
103,433
      
342,124
  
Accrued investment income
    
15,118
      
11,167
  
Premiums and agent balances receivable, net
    
225,422
      
208,743
  
Reinsurance recoverable on:
                
Paid losses
    
17,047
      
13,612
  
Unpaid losses
    
486,791
      
381,905
  
Prepaid reinsurance premiums
    
92,687
      
143,180
  
Deferred policy acquisition costs
    
60,232
      
45,417
  
Deferred income taxes, net
    
35,374
      
10,929
  
Goodwill
    
5,644
      
121,041
  
Other intangible assets
    
25,118
      
28,264
  
Other assets
    
134,748
      
97,424
  
Total assets
  
$
2,789,337
    
$
2,713,274
  
 
                
LIABILITIES AND SHAREHOLDERS' EQUITY
                
Liabilities
                
Losses and loss adjustment expenses
  
$
1,579,391
    
$
1,455,980
  
Unearned premiums
    
408,728
      
439,418
  
Debt
    
161,842
      
78,500
  
Debentures
    
80,930
      
80,930
  
Accounts payable and accrued expenses
    
31,774
      
29,190
  
Funds held and reinsurance balances payable
    
37,777
      
49,622
  
Payable to insurance companies
    
31,740
      
5,641
  
Other liabilities
    
30,357
      
15,714
  
Total liabilities
    
2,362,539
      
2,154,995
  
 
                
Shareholders' Equity
                
Common stock, $0.01 par value; authorized 75,000,000 shares; 49,887,200 and 49,776,011 shares issued and outstanding
    
499
      
505
  
Additional paid-in capital
    
276,220
      
272,472
  
Retained earnings
    
133,742
      
237,351
  
Note receivable from officer
    
(715
)
    
(737
)
Accumulated other comprehensive income
    
17,052
      
48,688
  
Total shareholders' equity
    
426,798
      
558,279
  
Total liabilities and shareholders' equity
  
$
2,789,337
    
$
2,713,274
  

The accompanying notes are an integral part of the Consolidated Financial Statements.
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

 
  
Common
Stock
    
Additional
Paid-In
Capital
    
Retained
Earnings
    
Note
Receivable
from Officer
    
Accumulated
Other
Comprehensive
Income
    
Total
Shareholders'
Equity
  
 
  
(Unaudited, In thousands)
  
Balances December 31, 2012
  
$
505
    
$
272,472
    
$
237,351
    
$
(737
)
  
$
48,688
    
$
558,279
  
Net loss
    
-
      
-
      
(100,460
)
    
-
      
-
      
(100,460
)
Dividends declared
    
-
      
-
      
(2,993
)
    
-
      
-
      
(2,993
)
Change in unrealized gain or loss on available for sale securities, net of tax
    
-
      
-
      
-
      
-
      
(34,369
)
    
(34,369
)
Change in valuation allowance on deferred tax assets
    
-
      
-
      
-
      
-
      
(191
)
    
(191
)
Net deferred derivative gain - hedging activity
    
-
      
-
      
-
      
-
      
3,178
      
3,178
  
Stock award
    
1
      
274
      
-
      
-
      
-
      
275
  
Long term incentive plan; stock award for 2012 and 2013 plan years
    
-
      
324
      
-
      
-
      
-
      
324
  
Change in investment of affiliates, net of tax
    
-
      
-
      
-
      
-
      
(213
)
    
(213
)
Change in investment of unconsolidated subsidiaries
    
-
      
-
      
-
      
-
      
(41
)
    
(41
)
Stock warrant issuance
    
-
      
3,023
      
-
      
-
      
-
      
3,023
  
Other reclass
    
(7
)
    
127
      
(156
)
    
-
      
-
      
(36
)
Note receivable from officer
    
-
      
-
      
-
      
22
      
-
      
22
  
Balances September 30, 2013
  
$
499
    
$
276,220
    
$
133,742
    
$
(715
)
  
$
17,052
    
$
426,798
  

The accompanying notes are an integral part of the Consolidated Financial Statements.
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30,

 
  
2013
    
2012
  
 
  
(Unaudited)
  
 
  
(In thousands)
  
Cash Flows From Operating Activities
  
   
 
Net loss
  
$
(100,460
)
  
$
(26,238
)
Adjustments to reconcile net loss to net cash provided by operating activities:
                
Amortization of other intangible assets
    
3,146
      
4,095
  
Amortization of deferred debenture issuance costs
    
73
      
94
  
Impairment of goodwill
    
115,397
      
-
  
Depreciation of furniture, equipment, and building
    
3,479
      
3,916
  
Net amortization of discount and premiums on bonds
    
8,453
      
4,680
  
Accretion of issued debt/original issue discount
    
784
      
-
  
Amortization of capitalized convertible note fees
    
223
      
-
  
Gain on sale of investments
    
(3,898
)
    
(3,236
)
Gain on sale of fixed assets
    
(66
)
    
(66
)
Long-term incentive plan expense
    
324
      
159
  
Stock award
    
274
      
279
  
Equity earnings of affiliates, net of taxes
    
(2,547
)
    
(2,041
)
Equity (earnings) losses of unconsolidated subsidiaries, net of tax
    
(4
)
    
28
  
Deferred income tax expense (benefit)
    
(7,870
)
    
(3,437
)
Goodwill adjustment
    
-
      
(249
)
Write-off of book of business
    
-
      
123
  
Changes in operating assets and liabilities:
                
(Increase) decrease in:
                
Premiums and agent balances receivable
    
(16,679
)
    
(42,783
)
Reinsurance recoverable on paid and unpaid losses
    
(108,321
)
    
(55,495
)
Prepaid reinsurance premiums
    
50,493
      
(19,002
)
Deferred policy acquisition costs
    
(14,815
)
    
(9,905
)
Other assets
    
(24,147
)
    
(3,773
)
Increase (decrease) in:
                
Losses and loss adjustment expenses
    
123,411
      
214,445
  
Unearned premiums
    
(30,690
)
    
78,326
  
Payable to insurance companies
    
26,099
      
(466
)
Funds held and reinsurance balances payable
    
(11,845
)
    
17,113
  
Other liabilities
    
8,122
      
(28,676
)
Total adjustments
    
119,396
      
154,129
  
Net cash (used in) provided by operating activities
    
18,936
      
127,891
  
Cash Flows From Investing Activities
                
Purchase of debt securities available for sale
    
(400,212
)
    
(242,172
)
Proceeds from sales and maturities of debt securities available for sale
    
145,606
      
103,529
  
Purchase of equity securities available for sale
    
(98,385
)
    
-
  
Proceeds from sales of equity securities available for sale
    
18,285
      
3,090
  
Capital expenditures
    
(1,363
)
    
(2,183
)
Other investing activities
    
(680
)
    
(4,008
)
Net cash used in investing activities
    
(336,749
)
    
(141,744
)
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
    
(4,500
)
    
(23,875
)
Payments on line of credit
    
-
      
(14,500
)
Proceeds from convertible senior notes
    
96,324
      
-
  
Payments for convertible senior notes hedge
    
(12,942
)
    
-
  
Proceeds from issuance of warrants
    
3,023
      
-
  
Book overdrafts
    
188
      
656
  
Dividends paid on common stock
    
(2,993
)
    
(7,546
)
Share repurchases
    
-
      
(11,517
)
Other financing activities
    
22
      
22
  
Net cash provided by financing activities
    
79,122
      
23,240
  
Net (decrease) increase in cash and cash equivalents
    
(238,691
)
    
9,387
  
Cash and cash equivalents, beginning of period
    
342,124
      
101,757
  
Cash and cash equivalents, end of period
  
$
103,433
    
$
111,144
  
Supplemental Disclosure of Cash Flow Information:
                
Interest paid
  
$
8,092
    
$
5,951
  
Net income taxes paid (1)
  
$
1,165
    
$
3,510
  
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
                
Stock-based employee compensation
  
$
274
    
$
279
  

(1)
Tax return refunds were received in first quarter of 2013 and 2012 for $3,067 and $475, respectively.

The accompanying notes are an integral part of the Consolidated Financial Statements.
 MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 1 – Summary of Significant Accounting Policies

Basis of Presentation and Management Representation

The consolidated financial statements include accounts, after elimination of intercompany accounts and transactions, of Meadowbrook Insurance Group, Inc. (the “Company” or “Meadowbrook”), its wholly owned subsidiary Star Insurance Company (“Star”), and Star’s wholly owned subsidiaries, Savers Property and Casualty Insurance Company (“Savers”), Williamsburg National Insurance Company (“Williamsburg”), and Ameritrust Insurance Corporation (“Ameritrust”). The consolidated financial statements also include Meadowbrook, Inc., Crest Financial Corporation, and their respective subsidiaries. In addition, the consolidated financial statements 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, 2013 are not necessarily indicative of the results expected for the full year. In addition, certain amounts in the 2012 financial statements have been reclassified to conform to the 2013 presentation as a result of adopting the new Accumulated Other Comprehensive guidance noted below and to reflect the reclassification adjustment net of taxes.

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 fiscal year ended December 31, 2012.

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.

Effective July 1, 2013, we entered into a 100% quota share reinsurance agreement(s) with State National Insurance Company, National Specialty Insurance Company and United Specialty Insurance Company  (collectively, “SNIC”), wherein certain of our business is written direct with SNIC and 100% assumed by certain of our insurance companies. The SNIC business has a 5.5% fee, which is reflected as assumed commission on the applicable Company’s insurance company’s books.  As of third quarter 2013, the insurance companies have assumed $85.1 million in gross written premium from SNIC.  The impact of the SNIC fee on the Company’s expense ratio was 0.4% and 0.2% for the three months and nine months ended September 30, 2013, respectively.

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.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Income Taxes

As of September 30, 2013 and December 31, 2012, the Company did not have any unrecognized tax benefits and had no accrued interest or penalties related to uncertain tax positions.

Recent Accounting Pronouncements

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income

In February 2013, the FASB issued guidance to improve the reporting of reclassifications out of accumulated other comprehensive income. The guidance requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. The guidance is to be applied prospectively for reporting periods beginning after December 15, 2012. The Company adopted this new guidance on January 1, 2013 and included the required disclosures in Note 11 ~ Accumulated Other Comprehensive Income.

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, 2013 and December 31, 2012 were as follows (in thousands):

 
  
September 30, 2013
  
 
  
Cost or
    
Gross Unrealized
    
 
 
  
Amortized
    
   
   
Non-Credit
    
Estimated
  
 
  
Cost
    
Gains
    
Losses
    
OTTI
    
Fair Value
  
Debt Securities:
  
   
   
   
   
 
U.S. Government and agencies
  
$
25,701
    
$
651
    
$
(146
)
  
$
-
    
$
26,206
  
Obligations of states and political subs
    
743,216
      
27,265
      
(18,357
)
    
-
      
752,124
  
Corporate securities
    
515,684
      
16,325
      
(11,403
)
    
-
      
520,606
  
Redeemable preferred stocks
    
854
      
354
      
-
      
-
      
1,208
  
Residential mortgage-backed securities
    
123,730
      
2,439
      
(3,278
)
    
-
      
122,891
  
Commercial mortgage-backed securities
    
30,474
      
823
      
(818
)
    
-
      
30,479
  
Other asset-backed securities
    
20,531
      
705
      
(15
)
    
-
      
21,221
  
Total debt securities available for sale
    
1,460,190
      
48,562
      
(34,017
)
    
-
      
1,474,735
  
Equity Securities:
                                        
Perpetual preferred stock
    
6,007
      
1,224
      
-
      
-
      
7,231
  
Common stock
    
96,974
      
10,120
      
(1,337
)
    
-
      
105,757
  
Total equity securities available for sale
    
102,981
      
11,344
      
(1,337
)
    
-
      
112,988
  
Total securities available for sale
$
1,563,171
$
59,906
$
(35,354
 )
$
-
$
1,587,723

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
 
  
December 31, 2012
  
 
  
Cost or
    
Gross Unrealized
    
 
 
  
Amortized
    
   
   
Non-Credit
    
Estimated
  
 
  
Cost
    
Gains
    
Losses
    
OTTI
    
Fair Value
  
Debt Securities:
  
   
   
   
   
 
U.S. Government and agencies
  
$
26,788
    
$
918
    
$
(22
)
  
$
-
    
$
27,684
  
Obligations of states and political subs
    
587,276
      
43,124
      
(1,427
)
    
-
      
628,973
  
Corporate securities
    
482,290
      
25,569
      
(858
)
    
-
      
507,001
  
Redeemable preferred stocks
    
1,743
      
436
      
-
      
-
      
2,179
  
Residential mortgage-backed securities
    
73,530
      
4,393
      
(41
)
    
-
      
77,882
  
Commercial mortgage-backed securities
    
33,732
      
1,800
      
-
      
-
      
35,532
  
Other asset-backed securities
    
6,435
      
1,125
      
(4
)
    
-
      
7,556
  
Total debt securities available for sale
    
1,211,794
      
77,365
      
(2,352
)
    
-
      
1,286,807
  
Equity Securities:
                                        
Perpetual preferred stock
    
6,930
      
1,578
      
-
      
-
      
8,508
  
Common stock
    
13,459
      
901
      
(207
)
    
-
      
14,153
  
Total equity securities available for sale
    
20,389
      
2,479
      
(207
)
    
-
      
22,661
  
Total securities available for sale
$
1,232,183
$
79,844
$
(2,559
)
$
-
$
1,309,468

Gross unrealized gains, losses, and non-credit OTTI on available for sale securities as of September 30, 2013 and December 31, 2012 were as follows (in thousands):

 
  
September 30,
2013
    
December 31,
2012
  
Unrealized gains
  
$
59,906
    
$
79,844
  
Unrealized losses
    
(35,354
)
    
(2,559
)
Non-credit OTTI
    
-
      
-
  
Net unrealized gains
    
24,552
      
77,285
  
Deferred federal income tax expense
    
(8,593
)
    
(26,957
)
Net unrealized gains on investments, net of deferred federal income taxes
  
$
15,959
    
$
50,328
  

Net realized gains (losses including OTTI) on securities, for the three months and nine months ended September 30, 2013 and 2012 were as follows (in thousands):

 
  
For the Three Months
Ended September 30,
    
For the Nine Months
Ended September 30,
  
 
  
2013
    
2012
    
2013
    
2012
  
Realized gains (losses):
  
   
   
   
 
Debt securities:
  
   
   
   
 
Gross realized gains
  
$
87
    
$
818
    
$
1,617
    
$
2,812
  
Gross realized losses
    
(40
)
    
(16
)
    
(211
)
    
(49
)
Total debt securities
    
47
      
802
      
1,406
      
2,763
  
Equity securities:
                                
Gross realized gains
    
656
      
78
      
2,502
      
473
  
Gross realized losses
    
-
      
-
      
(10
)
    
-
  
Total equity securities
    
656
      
78
      
2,492
      
473
  
Net realized gains
  
$
703
    
$
880
    
$
3,898
    
$
3,236
  
 
                                
OTTI included in realized losses on securities above
  
$
-
    
$
-
    
$
-
    
$
-
  
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Proceeds from the sales of debt and equity securities available for sale were $12.8 million and $6.6 million for the three months ended September 30, 2013 and 2012, respectively. Proceeds from the sales of debt and equity securities available for sale were $88.9 million and $27.0 million for the nine months ended September 30, 2013 and 2012, respectively.

At September 30, 2013, the amortized cost and estimated fair value of available for sale debt securities by contractual maturity are shown below. Expected maturities may differ from contractual maturities, because certain borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands):

 
  
Available for Sale
  
 
  
Amortized
Cost
    
Estimated
Fair Value
  
Due in one year or less
  
$
34,436
    
$
34,879
  
Due after one year through five years
    
414,302
      
429,113
  
Due after five years through ten years
    
667,466
      
672,615
  
Due after ten years
    
169,251
      
163,537
  
Mortgage-backed securities, collateralized obligations and asset-backed securities
    
174,735
      
174,591
  
 
  
$
1,460,190
    
$
1,474,735
  

Net investment income for the three months and nine months ended September 30, 2013 and 2012 was as follows (in thousands):

 
  
For the Three Months
Ended September 30,
    
For the Nine Months
Ended September 30,
  
 
  
2013
    
2012
    
2013
    
2012
  
Net Investment Income Earned From:
  
   
   
   
 
Debt securities
  
$
10,888
    
$
13,544
    
$
32,593
    
$
40,348
  
Equity securities
    
1,043
      
421
      
2,593
      
1,297
  
Cash and cash equivalents
    
165
      
197
      
558
      
610
  
Total gross investment income
    
12,096
      
14,162
      
35,744
      
42,255
  
Less investment expenses
    
401
      
347
      
1,141
      
1,025
  
Net investment income
  
$
11,695
    
$
13,815
    
$
34,603
    
$
41,230
  

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

Available for sale securities are reviewed for declines in fair value, excluding other-than-temporary declines. 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 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.

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 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.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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/or
· 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 of the cost of the security 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 of the cost of the security, the Company considers, among other things, the severity and duration of the decline in fair value of the equity security, as well as the cause of decline, a fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer.

During the quarter, the Company reviewed its investment portfolio in conjunction with its OTTI policy and determined the Company was not required to record a credit related OTTI loss or recognize a non-credit related OTTI loss in other comprehensive income for the three months and nine months ended September 30, 2013 and 2012.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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, 2013  
 
  
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
    
7
    
$
7,334
    
$
(146
)
    
-
    
$
-
    
$
-
      
7
    
$
7,334
    
$
(146
)
Obligations of states and political subs
    
112
      
324,676
      
(18,357
)
    
-
      
-
       -      
112
      
324,676
      
(18,357
)
Corporate securities  
    
126
      
265,822
      
(11,403
)
    
-
      
-
       -      
126
      
265,822
      
(11,403
)
Redeemable preferred stocks
    
-
      
-
      
-
      
-
      
-
       -      
-
      
-
      
-
  
Residential mortgage-backed securities
    
11
      
82,127
      
(3,278
)
    
-
      
-
       -      
11
      
82,127
      
(3,278
)
Commercial mortgage-backed securities
    
6
      
13,023
      
(818
)
    
-
      
-
       -      
6
      
13,023
      
(818
)
Other asset-backed securities
    
2
      
8,789
      
(15
)
    
-
      
-
       -      
2
      
8,789
      
(15
)
Total debt securities
    
264
      
701,771
      
(34,017
)
    
-
      
-
       -    
264
      
701,771
      
(34,017
)
Equity Securities:
                                                                        
Perpetual preferred stock
    
-
      
-
      
-
      
-
      
-
       -      
-
      
-
      
-
  
Common stock  
    
19
      
18,985
      
(956
)
    
2
      
4,499
       (381 )    
21
      
23,484
      
(1,337
)
Total equity securities
    
19
      
18,985
      
(956
)
    
2
      
4,499
       (381 )    
21
      
23,484
      
(1,337
)
Total securities
283
$
720,756
$
(34,973
)
2
$
4,499
$
(381
)
285
$
725,255
$
(35,354
)
 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
  
December 31, 2012
  
 
  
Less than 12 months
    
Greater than 12 months
    
Total
  
 
  
Number
of Issues
    
Fair Value of Investments
with
Unrealized
Losses
    
Gross
Unrealized
Losses and
Non-Credit
OTTI
    
Number
of Issues
    
Fair Value of Investments
with
Unrealized
Losses
    
Gross
Unrealized
Losses and Non-
Credit
OTTI
    
Number
of Issues
    
Fair Value of Investments
with
Unrealized
Losses
    
Gross
Unrealized
Losses and
Non-Credit
OTTI
  
Debt Securities:
  
   
   
   
   
   
   
   
   
 
U.S. Government and agencies
    
5
    
$
7,063
    
$
(22
)
    
-
    
$
-
    
$
-
      
5
    
$
7,063
    
$
(22
)
Obligations of states and political subs
    
23
      
69,016
      
(1,427
)
    
-
      
-
      
-
      
23
      
69,016
      
(1,427
)
Corporate securities                                                
    
50
      
113,348
      
(858
)
    
-
      
-
      
-
      
50
      
113,348
      
(858
)
Redeemable preferred stocks
    
-
      
-
      
-
      
-
      
-
      
-
      
-
      
-
      
-
  
Residential mortgage-backed securities
    
1
      
10,219
      
(40
)
    
1
      
24
      
(1
)
    
2
      
10,243
      
(41
)
Commercial mortgage-backed securities
    
-
      
-
      
-
      
-
      
-
      
-
      
-
      
-
      
-
  
Other asset-backed securities
    
2
      
463
      
(4
)
    
-
      
-
      
-
      
2
      
463
      
(4
)
Total debt securities
    
81
      
200,109
      
(2,351
)
    
1
      
24
      
(1
)
    
82
      
200,133
      
(2,352
)
Equity Securities:
                                                                        
Perpetual preferred stock
    
-
      
-
      
-
      
-
      
-
      
-
      
-
      
-
      
-
  
Common stock                                                
    
-
      
-
      
-
      
2
      
4,583
      
(207
)
    
2
      
4,583
      
(207
)
Total equity securities
    
0
      
-
      
-
      
2
      
4,583
      
(207
)
    
2
      
4,583
      
(207
)
Total securities
81
$
200,109
$
(2,351
)
3
$
4,607
$
(208
)
84
$
204,716
$
(2,559
)
 
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, 2012
  
$
(156
)
Additional credit impairments on:
        
Previously impaired securities
    
-
  
Securities for which an impairment was not previously recognized
    
-
  
Reductions
    
156
  
Balance as of September 30, 2013
  
$
-
  

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”).
MEADOWBROOK INSURANCE GROUP, INC.

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

Level 1 – Valuations that are based on unadjusted quoted prices in active markets for identical securities. The fair value of exchange-traded preferred and common equities, and mutual funds included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The fair value measurements that were based on Level 1 inputs comprise 7.2% 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 92.6% 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 0.2% 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.

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.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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 17 securities totaling $3.5 million or 0.2% 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 benchmarking techniques based upon industry sector, rating and other factors.

Also included in Level 3 valuation are the conversion feature within the Notes (as defined in Note 4 ~Debt) and the convertible senior notes hedge. The estimated fair values of both the conversion feature and the convertible senior notes hedge are obtained from the third party financial institution counterparties valued using non-binding broker quotations and significant unobservable inputs.

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, 2013 (in thousands):

 
  
   
Fair Value Measurements Using
  
 
  
September 30,
2013
    
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
  
$
26,206
    
$
-
    
$
26,206
    
$
-
  
Obligations of states and political subs
    
752,124
      
-
      
752,124
      
-
  
Corporate securities
    
520,606
      
-
      
519,668
      
938
  
Redeemable preferred stocks
    
1,208
      
1,208
      
-
      
-
  
Residential mortgage-backed securities
    
122,891
      
-
      
122,891
      
-
  
Commercial mortgage-backed securities
    
30,479
      
-
      
30,307
      
172
  
Other asset-backed securities
    
21,221
      
-
      
18,781
      
2,440
  
Total debt securities available for sale
    
1,474,735
      
1,208
      
1,469,977
 
    
3,550
  
Equity Securities:
                                
Perpetual preferred stock
    
7,231
      
7,013
      
218
      
-
  
Common stock
    
105,757
      
105,757
      
-
      
-
  
Total equity securities available for sale
    
112,988
      
112,770
      
218
      
-
  
Total securities available for sale
  
$
1,587,723
    
$
113,978
    
$
1,470,195
    
$
3,550
  
Derivatives:
                                
Derivatives - interest rate swaps
  
$
360
    
$
-
    
$
360
    
$
-
  
Cash conversion feature of cash convertible notes
    
(15,144
)
    
-
      
-
      
(15,144
)
Purchased cash convertible note hedge
    
15,144
      
-
      
-
      
15,144
  
Total derivatives
  
$
360
    
$
-
    
$
360
    
$
-
  
 
                                
Total securities available for sale and derivatives
  
$
1,588,083
    
$
113,978
    
$
1,470,555
    
$
3,550
  

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The following table presents changes in Level 3 available for sale investments and derivatives measured at fair value on a recurring basis as of September 30, 2013 (in thousands):

 
  
Fair Value
Measurement
Using Significant
Unobservable
Inputs - Level 3
  
Balance as of December 31, 2012
  
$
5,444
  
 
        
Total gains or losses (realized/unrealized):
        
Included in earnings
    
748
  
Included in other comprehensive income
    
(520
)
 
        
Purchases
    
12,942
  
Issuances
    
(12,942
)
Settlements
    
(2,122
)
 
        
Transfers in and out of Level 3
    
-
  
Balance as of September 30, 2013
  
$
3,550
  

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

The Company’s policy on recognizing transfers between hierarchy levels is applied at the end of a reporting period. During the three months and nine months ended September 30, 2013, no transfers into or out of Levels 1, 2 and 3 were required.

NOTE 4 – Debt

Credit Facilities

On August 29, 2012, the Company executed $130.0 million in senior credit facilities (the “Credit Facilities”). The Credit Facilities included a $30.0 million term loan facility and a $100.0 million revolving credit facility.  On September 19, 2013, the Company amended the Credit Facilities pursuant to a Second Amendment to Credit Agreement and Waiver (the “Amendment”).

Under the Amendment, the term loan facility continues to have a four year term, along with no changes to the amortization period. As of September 30, 2013, the outstanding balance on the Company’s term loan facility was $24.0 million. The Amendment reduced available borrowing under the revolving credit facility from $100.0 million to $30.0 million with further periodic reductions to $21.0 million as of March 31, 2016.  The Amendment also established an amortization schedule for the revolving credit facility beginning on September 30, 2014.  The Company has $20.0 million outstanding under its revolving credit facility as of September 30, 2013, and $0.5 million in letters of credit have been issued as of September 30, 2013. The undrawn portion of the revolving credit facility, which was $9.5 million as of September 30, 2013, is available to finance working capital and for other general corporate purposes, including but not limited to, surplus contributions to its Insurance Company Subsidiaries to support premium growth or strategic acquisitions.

The Credit Facilities replaced the Company’s former term loan of $65.0 million and revolving credit agreement of $35.0 million, entered into on July 31, 2008, which were terminated upon the closing of the Credit Facilities on August 29, 2012. At December 31, 2012, the Company had an outstanding balance of $28.5 million on its term loan and a $20.0 million outstanding balance on its revolving credit facility. There was $0.5 million in letters of credit that had been issued as of December 31, 2012.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The principal amount outstanding under the Credit Facilities provides for interest at either the Alternative Base Rate (“ABR”) or the London interbank offered rate (“LIBOR”). ABR borrowings under the Credit Facilities will bear interest at the greatest of (a) the Administrative Agent’s prime rate, (b) the federal funds effective rate plus 0.5%, or (c) the adjusted LIBOR for a one-month period plus 1.0%, in each case, plus a margin that is adjusted on the basis of Company’s consolidated leverage ratio. Eurodollar borrowings under the Credit Facilities will bear interest at the adjusted LIBOR for the interest period in effect plus a margin that is adjusted on the basis of Company’s consolidated leverage ratio. In addition, the Credit Facilities provide for an unused facility fee ranging between twenty-five basis points and thirty-seven and a half basis points, based on the Company’s consolidated leverage ratio as defined by the Credit Facilities. At September 30, 2013, the interest rate on the Company’s term loan was 3.21%, which consisted of a weighted fixed rate of 0.71%, plus an applicable margin of 2.50%, as described in Note 5 ~ Derivative Instruments. At September 30, 2013, the interest rate on the Company’s revolving credit facility was 0.31%, plus a 2.50% margin.

Additionally, the Amendment revised the financial covenants applicable to the Credit Facilities that consist of: (1) minimum consolidated net worth of $365,697,000 as of the effective date of the Amendment, with quarterly increases thereafter of the sum of (a) seventy-five percent of positive net income and (b) seventy-five percent of increases in shareholders’ equity by reason of the issuance and sale of equity interests, if any, (2) minimum Risk Based Capital Ratio for all material insurance company subsidiaries of 1.75 times Company Action Level, (3) maximum permitted consolidated leverage ratio of (i) 0.375 to 1.00 at any time prior to September 30, 2014, or (ii) 0.35 to 1.00 at any time on or after September 30, 2014, (4) minimum consolidated fixed charge coverage ratio of 1.25 to 1.00, and (5) minimum A.M. Best rating of “B++.” As of September 30, 2013, the Company was in compliance with these debt covenants.

FHLBI

During 2011, certain of the Insurance Company Subsidiaries (Star, Williamsburg and Ameritrust) became members of the Federal Home Loan Bank of Indianapolis (“FHLBI”). As a member of the FHLBI, these subsidiaries have the ability to borrow on a collateralized basis at relatively low borrowing rates providing a source of liquidity. As of September 30, 2013, the Company had borrowed $30.0 million from the FHLBI after pledging as collateral residential mortgage-backed securities (“RMBS”) having a carrying value of $40.1 million, and making a FHLBI common stock investment of approximately $1.6 million. The Company has the ability to increase its borrowing capacity through purchasing additional investments in FHLBI and pledging additional securities. The Company retains all the rights regarding the collateralized RMBS.

Debentures

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

Year of
Issuance
Description
Year
Callable
Year Due
Interest Rate Terms
  
Interest Rate
at September
30, 2013 (1)
    
Principal Amount
  
 
 
 
 
 
  
   
 
2003
Junior subordinated debentures
2008
2033
Three-month LIBOR, plus 4.05%
    
4.30
%
  
$
10,310
  
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.00%
    
4.26
%
    
13,000
  
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.20%
    
4.46
%
    
12,000
  
2005
Junior subordinated debentures
2010
2035
Three-month LIBOR, plus 3.58%
    
3.83
%
    
20,620
  
Junior subordinated debentures (2)
2007
2032
Three-month LIBOR, plus 4.00%
    
4.26
%
    
15,000
  
Junior subordinated debentures (2)
2008
2033
Three-month LIBOR, plus 4.10%
    
4.36
%
    
10,000
  
 
 
 
 
         
  
Total
    
$
80,930
  

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

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

Excluding the junior subordinated debentures acquired in conjunction with the ProCentury Merger, the Company received a total of $53.3 million in net proceeds from the issuances of the above long-term debt, of which $26.2 million was contributed to the surplus of its Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes. Associated with the issuance of the above long-term debt, the Company incurred approximately $1.7 million in issuance costs for commissions paid to the placement agents in the transactions.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The junior subordinated debentures issued in 2003 and 2005 were issued in conjunction with the issuance of $10.0 million and $20.0 million in mandatory redeemable trust preferred securities to a trust formed by an institutional investor from the Company’s unconsolidated subsidiary trusts, Meadowbrook Capital Trust I and Meadowbrook Capital Trust II, respectively.

The junior subordinated debentures acquired in the ProCentury Merger were issued in conjunction with the issuance of $15.0 million and $10.0 million in floating rate trust preferred securities to a trust formed from the Company’s unconsolidated trust, ProFinance Statutory Trust I and ProFinance Statutory Trust II. The Company also acquired the remaining unamortized portion of the capitalized issuance costs associated with these debentures. The remaining unamortized portion of the issuance costs acquired was $625,000. These issuance costs are included in other assets on the balance sheet. The remaining balance is being amortized over a five year period beginning August 1, 2008, as a component of interest expense.  As of September 30, 2013, these issuance costs were fully amortized.

The junior subordinated debentures are unsecured obligations of the Company and are junior to the right of payment to all senior indebtedness of the Company. The Company has guaranteed that the payments made to the four trusts mentioned above will be distributed to the holders of the respective trust preferred securities.

The Company estimates that the fair value of the above mentioned junior subordinated debentures and senior debentures issued approximate the gross proceeds of cash received at the time of issuance.

Cash Convertible Senior Notes

On March 18, 2013, the Company issued $100.0 million of 5.0% cash convertible senior notes (the “Notes”), which mature on March 15, 2020. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing September 15, 2013. Until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their Notes solely into cash at any time on or after September 15, 2019 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. The notes are not convertible into Meadowbrook common stock or any other securities under any circumstances. The initial conversion rate is 108.8732 shares of common stock per $1,000 principal amount of the Notes (equivalent to an initial conversion price of approximately $9.18 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of certain fundamental changes with respect to the Company, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal, plus any accrued and unpaid interest. The proceeds from the issuance of the Notes were bifurcated into a debt component and an embedded conversion option component.

Due to the bifurcation, the debt component reflects an original issue discount (“OID”) of $12.9 million. The OID and deferred issuance costs of $3.7 million will be amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the OID, the Notes’ effective interest rate is 7.4%. Interest expense, including amortization of deferred issuance costs, recognized on the Notes was $1.7 million and $3.7 million for the three and nine months ended September 30, 2013, respectively.

The following table shows the amounts recorded for the debt component of the Notes as of September 30, 2013 (in thousands):

Outstanding principal
  
$
100,000
  
Unamortized OID
    
(12,158
)
Total debt component
  
$
87,842
  

MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
As the conversion feature is structured under the cash settlement method, the embedded conversion option is reported as a derivative liability.

In connection with the offering of the Notes, the Company also entered into cash convertible senior notes hedge transactions (the “Note Hedges”) and warrant transactions (the “Warrants”) with respect to its common stock with certain counter-parties. Upon conversion, the Note Hedges are intended to offset potential cash payments in excess of the principal of the Notes. The Note Hedges and Warrants are separate transactions, which were entered into by the Company with certain counter-parties and are not part of the terms of the Notes.

The Company paid $12.9 million for the Note Hedges, which are exercisable upon conversion of the Notes. The Note Hedges are structured under the cash settlement method and are accounted for as a derivative asset.

The Company received $3.0 million for the warrants sold to certain counter-parties. The warrants have a strike price of $11.69 and will be net share settled; meaning the Company will issue a number of shares per warrant corresponding to the difference between its share price on each warrant exercise date and the exercise price. The warrants meet the definition of derivatives under the guidance in ASC 815; however, because these instruments have been determined to be indexed to the Company’s own stock and meet the criteria for equity classification under ASC 815-40, the warrants have been accounted for as an adjustment to the Company’s paid-in-capital.

If the market value per share of the Company’s common stock exceeds the strike price of the warrants, the warrants will have a dilutive effect on the Company’s net income per share and the Company will use the “treasury stock” method in calculating the dilutive effect on earnings per share.

NOTE 5 – Derivative Instruments

The Company has entered into interest rate swap transactions to mitigate its interest rate risk on its existing debt obligations. These interest rate swap transactions have been designated as cash flow hedges and are deemed highly effective hedges. These interest rate swap transactions are recorded at fair value on the balance sheet and the effective portion of the changes in fair value are accounted for within other comprehensive income. The interest differential to be paid or received is accrued and recognized as an adjustment to interest expense.

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

Effective
Date
Expiration
Date
Debt Instrument
Counter-party Interest Rate Terms
  
Fixed Rate
    
Fixed Amount
at September
30, 2013
  
 
 
 
 
  
   
 
6/30/2013
6/30/2023
Junior subordinated debentures
Three-month LIBOR, plus 4.05%
    
6.340
%
  
$
10,000
  
4/29/2013
4/29/2023
Senior debentures
Three-month LIBOR, plus 4.00%
    
6.250
%
    
13,000
  
9/28/2012
8/30/2016
Term loan (1)
Three-month LIBOR
    
0.714
%
    
24,000
  
8/15/2013
8/15/2023
Junior subordinated debentures (2)
Three-month LIBOR
    
2.180
%
    
10,000
  
9/4/2013
9/4/2023
Junior subordinated debentures (2)
Three-month LIBOR
    
2.270
%
    
15,000
  
9/8/2010
5/24/2016
Senior debentures
Three-month LIBOR, plus 4.20%
    
6.248
%
    
5,000
  
9/16/2010
9/15/2015
Junior subordinated debentures
Three-month LIBOR, plus 3.58%
    
6.160
%
    
10,000
  
9/16/2010
9/15/2015
Junior subordinated debentures
Three-month LIBOR, plus 3.58%
    
6.190
%
    
10,000
  
5/24/2011
5/24/2016
Senior debentures
Three-month LIBOR, plus 4.20%
    
6.472
%
    
7,000
  
 
 
 
       
  
Total
    
$
104,000
  

(1) The Company is required to make fixed rate interest payments on the current balance of the term loan, amortizing in accordance with the term loan amortization schedule. The Company fixed only the variable interest portion of the loan. The actual interest payments associated with the term loan also include an additional rate of 2.50% in accordance with the Credit Facilities.

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

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
In relation to the above interest rate swaps, the net interest expense incurred for the three months ended September 30, 2013 and 2012 was approximately $0.5 million and $1.0 million, respectively. The net interest expense incurred for the nine months ended September 30, 2013 and 2012 was approximately $1.8 million and $2.5 million, respectively.

As of September 30, 2013 and December 31, 2012, the total fair value of the interest rate swaps were unrealized gains (losses) of $0.4 million and ($4.5 million), respectively. At September 30, 2013 and December 31, 2012, accumulated other comprehensive income included accumulated gain (loss) on the cash flow hedge, net of taxes, of approximately $0.2 million and ($2.9 million), respectively.

In March 2012, the Company replaced its existing $5.6 million convertible note and $664,000 demand note receivables with an unaffiliated insurance agency into new debt instruments with a related limited liability company. The new instruments were effective January 1, 2012 and consist of a $2 million convertible note and a $4.2 million term loan. The interest rate on the convertible note is 3% and is due on January 1, 2022. This note is convertible at the option of the Company based upon a pre-determined formula. The interest rate on the term loan is 5.5% and is due on April 30, 2016. As security for the note and term loan, the borrower granted the Company a first lien on all of its accounts receivable, cash, general intangibles, and other assets. As additional collateral for the note and term loan, the Company obtained guaranties of payment and performance from certain affiliated companies of the borrower, as well as related individuals, which guaranties are secured by additional collateral.

Cash Convertible Senior Notes and Note Hedges

As discussed in Note 4 ~ Debt, the Company issued the Notes. Holders may convert their cash convertible notes subject to certain conversion provisions. In order to offset the risk associated with the cash conversion feature, the Company entered into convertible note hedges with certain counterparties. Both the cash conversion feature and the purchased convertible note hedges are measured at fair value with gains and losses recorded in the Company’s Consolidated Statements of Income.

NOTE 6 – Restricted and Non-Restricted Stock Awards

On February 23, 2011 and 2010, the Company issued 28,500 and 202,500 restricted stock awards, respectively, to executives of the Company, out of its 2002 Amended and Restated Stock Option Plan (the “Plan”). No restricted stock awards were issued in 2012 or 2013. The restricted stock awards vest over a four year period, with the first twenty percent vesting immediately on the date issued (i.e., February 23) and the remaining eighty percent vesting annually on a straight line basis over the requisite four year service period. The unvested restricted stock awards are subject to forfeiture in the event the employee is terminated for “Good Cause” or voluntarily resigns their employment without “Good Reason” as provided for in the employee’s respective employment agreements. The Company recorded approximately $83,000 of restricted stock awards compensation expense for both the three months ended September 30, 2013 and 2012, respectively. The Company recorded approximately $247,000 and $211,000 of restricted stock awards compensation expense for the nine months ended September 30, 2013 and 2012, respectively.

On February 13, 2013, and February 23, 2012 the Company issued 2,400 and 1,500 non-restricted stock awards, respectively, to each member of the Board of Directors, which vested immediately. The Company recorded zero non-restricted stock awards compensation expense for the three months ended September 30, 2013 and 2012, respectively. The Company recorded approximately $137,000 and $149,000 of non-restricted stock awards compensation expense for the nine months ended September 30, 2013 and 2012, respectively.
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 7 – Shareholders’ Equity

At September 30, 2013, shareholders’ equity was $426.8 million, or a book value of $8.56 per common share, compared to $558.3 million, or a book value of $11.22 per common share, at December 31, 2012. The decrease in shareholders’ equity from year end primarily relates to the goodwill impairment expense that was recorded in the three months ended June 30, 2013.

On October 28, 2011, the Company’s Board of Directors approved a Share Repurchase Plan authorizing management to purchase up to 5.0 million shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months. For the three months and nine months ended September 30, 2013, there were no share repurchases. For the three months ended September 30, 2012, there were no share repurchases.  For the nine months ended September 30, 2012, the Company purchased and retired approximately 1.3 million shares of common stock for a total cost of approximately $11.5 million.  The Share Repurchase Plan expired on October 28, 2013.

For the nine months ended September 30, 2013, the Company paid dividends to its common shareholders of $3.0 million. For the nine months ended September 30, 2012, cash dividends paid to common shareholders totaled $7.5 million.

On October 29, 2013, the Company’s Board of Directors declared a quarterly dividend of $0.02 per common share. The dividend is payable on December 3, 2013, to shareholders of record as of November 18, 2013.

When evaluating the declaration of a dividend, the Company’s Board of Directors considers a variety of factors, including but not limited to, cash flow, liquidity needs, results of operations, industry conditions, regulatory constraints related to the Insurance Company Subsidiaries, and our overall financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from its Insurance Company Subsidiaries.

NOTE 8 – Earnings Per Share

Basic earnings per share are based on the weighted average number of common shares outstanding during the year, while diluted earnings per share include the weighted average number of common shares and potential dilution from shares issuable pursuant to stock awards using the treasury stock method.

The following table is a reconciliation of the income and share data used in the basic and diluted earnings per share computations for the three months and nine months ended September 30, 2013 and 2012 (in thousands, except per share amounts):

 
  
For the Three Months
Ended September 30,
    
For the Nine Months
Ended September 30,
  
 
  
2013
    
2012
    
2013
    
2012
  
Net income (loss)
$
5,516
$
(26,610
)
$
(100,460
)
$
(26,238
)
 
                            
Common shares:
                                
Basic
                                
Weighted average shares outstanding
    
49,887,200
      
49,776,011
      
49,866,326
      
50,312,285
  
 
                                
Diluted
                                
Weighted average shares outstanding
    
49,887,200
      
49,776,011
      
49,866,326
      
50,312,285
  
Dilutive effect of:
                                
Share awards under long term incentive plan