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, 2014
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, $.01 par value, outstanding on November 3, 2014, was 50,093,690.
 

 

TABLE OF CONTENTS
 
PART I FINANCIAL INFORMATION
 
   
Page
ITEM 1 –
FINANCIAL STATEMENTS  
 
2
 
4
 
5
 
6
 
7
 
8-31
     
ITEM 2 –
32-49
     
ITEM 3 –
50-52
     
ITEM 4 –
52
     
     
PART II OTHER INFORMATION
 
     
ITEM 1 –
53
     
ITEM 1A –
53
     
ITEM 2 –
53
     
ITEM 3 –
53
     
ITEM 4 –
53
     
ITEM 5 –
53
     
ITEM 6 –
54
     
55
 
PART 1 - FINANCIAL INFORMATION
 
ITEM 1.  FINANCIAL STATEMENTS
 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended September 30,
 
 
 
   
 
 
 
2014
   
2013
 
 
 
(Unaudited)
 
 
 
(In thousands, except share data)
 
Revenues
 
   
 
Premiums earned
 
   
 
Gross
 
$
200,822
   
$
260,273
 
Ceded
   
(39,073
)
   
(79,217
)
Net earned premiums
   
161,749
     
181,056
 
Net commissions and fees
   
11,960
     
10,458
 
Net investment income
   
11,087
     
11,695
 
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
   
2,973
     
675
 
Net realized gains
   
2,973
     
675
 
Total revenues
   
187,769
     
203,884
 
                 
Expenses
               
Losses and loss adjustment expenses
   
141,753
     
197,314
 
Reinsurance recoveries
   
(35,095
)
   
(65,067
)
Net losses and loss adjustment expenses
   
106,658
     
132,247
 
Policy acquisition and other underwriting expenses
   
60,816
     
54,228
 
General, selling and administrative expenses
   
9,949
     
7,026
 
General corporate expenses
   
1,372
     
1,025
 
Amortization expense
   
1,011
     
1,037
 
Interest expense
   
3,506
     
3,581
 
Total expenses
   
183,312
     
199,144
 
Income before taxes and equity earnings
   
4,457
     
4,740
 
Federal and state income tax expense
   
445
     
356
 
Equity earnings of affiliates, net of tax
   
953
     
1,164
 
Equity earnings of unconsolidated subsidiaries, net of tax
   
2
     
(32
)
Net income
 
$
4,967
   
$
5,516
 
                 
Earnings Per Share
               
Basic
 
$
0.09
   
$
0.11
 
Diluted
 
$
0.09
   
$
0.11
 
                 
Weighted average number of common shares
               
Basic
   
50,092,755
     
49,887,200
 
Diluted
   
50,092,755
     
49,933,540
 
                 
Dividends paid per common share
 
$
0.02
   
$
0.02
 

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,

 
 
2014
   
2013
 
 
 
(Unaudited)
 
 
 
(In thousands, except share data)
 
Revenues
 
   
 
Premiums earned
 
   
 
Gross
 
$
630,275
   
$
789,468
 
Ceded
   
(141,864
)
   
(262,043
)
Net earned premiums
   
488,411
     
527,425
 
Net commissions and fees
   
33,349
     
28,631
 
Net investment income
   
33,557
     
34,603
 
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
   
9,252
     
3,860
 
Net realized gains
   
9,252
     
3,860
 
Total revenues
   
564,569
     
594,519
 
                 
Expenses
               
Losses and loss adjustment expenses
   
423,991
     
590,095
 
Reinsurance recoveries
   
(104,483
)
   
(190,661
)
Net losses and loss adjustment expenses
   
319,508
     
399,434
 
Policy acquisition and other underwriting expenses
   
179,373
     
163,283
 
General, selling and administrative expenses
   
25,196
     
18,950
 
General corporate expenses
   
4,420
     
3,301
 
Amortization expense
   
2,959
     
3,146
 
Goodwill impairment expense
   
-
     
115,397
 
Interest expense
   
10,440
     
9,431
 
Total expenses
   
541,896
     
712,942
 
Income (loss) before taxes and equity earnings
   
22,673
     
(118,423
)
Federal and state income tax expense (benefit)
   
4,474
     
(15,412
)
Equity earnings of affiliates, net of tax
   
2,870
     
2,547
 
Equity earnings of unconsolidated subsidiaries, net of tax
   
18
     
4
 
Net income (loss)
 
$
21,087
   
$
(100,460
)
                 
Earnings (Losses) Per Share
               
Basic
 
$
0.42
   
$
(2.01
)
Diluted
 
$
0.42
   
$
(2.01
)
                 
Weighted average number of common shares
               
Basic
   
50,054,031
     
49,866,326
 
Diluted
   
50,054,031
     
49,866,326
 
                 
Dividends paid per common share
 
$
0.06
   
$
0.06
 

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,
 
 
 
2014
   
2013
 
 
 
(Unaudited)
 
 
 
(In thousands)
 
Net income
 
$
4,967
   
$
5,516
 
Other comprehensive income, net of tax:
               
Unrealized (losses) gains  on securities
   
(932
)
   
3,243
 
Unrealized gains (losses) in affiliates and unconsolidated subsidiaries
   
41
     
(316
)
Increase on non-credit other-than-temporary impairments on securities
   
-
     
-
 
Net deferred derivative gains - hedging activity
   
232
     
140
 
Less reclassification adjustment for investment gains included in net income
   
(1,933
)
   
(457
)
Other comprehensive (losses) gains, net of tax
   
(2,592
)
   
2,610
 
Comprehensive income
 
$
2,375
   
$
8,126
 

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Nine Months Ended September 30,

 
 
2014
   
2013
 
 
 
(Unaudited)
 
 
 
(In thousands)
 
Net income (loss)
 
$
21,087
   
$
(100,460
)
Other comprehensive income  (loss), net of tax:
               
Unrealized gains (losses) on securities
   
22,819
     
(32,026
)
Unrealized gains (losses) in affiliates and unconsolidated subsidiaries
   
159
     
(254
)
Increase on non-credit other-than-temporary impairments on securities
   
-
     
-
 
Net deferred derivative (losses) gains - hedging activity
   
(973
)
   
3,178
 
Less reclassification adjustment for investment gains included in net income
   
(6,014
)
   
(2,534
)
Other comprehensive  gains (losses), net of tax
   
15,991
     
(31,636
)
Comprehensive income (loss)
 
$
37,078
   
$
(132,096
)

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
4

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
 
 
 
September 30,
2014
   
December 31,
2013
 
 
 
(Unaudited)
   
 
 
 
(In thousands, except share data)
 
ASSETS
 
   
 
Investments
 
   
 
Debt securities available for sale, at fair value (amortized cost of $1,445,409 and $1,455,754 in 2014 and 2013, respectively)
 
$
1,480,162
   
$
1,463,046
 
Equity securities available for sale, at fair value (cost of $94,158 and $95,346 in 2014 and 2013, respectively)
   
106,870
     
109,982
 
Cash and cash equivalents
   
106,084
     
94,776
 
Accrued investment income
   
14,759
     
14,266
 
Premiums and agent balances receivable (net allowance of $5,410 and $5,094 in 2014 and 2013 respectively)
   
188,995
     
214,144
 
Reinsurance recoverable on:
               
Paid losses
   
8,358
     
14,453
 
Unpaid losses
   
537,879
     
505,431
 
Prepaid reinsurance premiums
   
34,620
     
63,908
 
Deferred policy acquisition costs
   
65,128
     
62,773
 
Deferred income taxes, net
   
28,520
     
41,435
 
Goodwill
   
6,857
     
5,644
 
Other intangible assets
   
22,911
     
24,509
 
Other assets
   
138,290
     
147,475
 
Total assets
 
$
2,739,433
   
$
2,761,842
 
 
               
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Liabilities
               
Losses and loss adjustment expenses
 
$
1,616,674
   
$
1,616,521
 
Unearned premiums
   
302,569
     
354,367
 
Debt
   
152,373
     
160,723
 
Debentures
   
80,930
     
80,930
 
Accounts payable and accrued expenses
   
42,246
     
29,712
 
Funds held and reinsurance balances payable
   
29,857
     
29,320
 
Payable to insurance companies
   
41,832
     
45,625
 
Other liabilities
   
24,848
     
31,231
 
Total liabilities
   
2,291,329
     
2,348,429
 
                 
Shareholders' Equity
               
Common stock, $0.01 par value; authorized 75,000,000 shares; 50,093,690 and 49,887,200 shares issued and outstanding
   
501
     
499
 
Additional paid-in capital
   
277,007
     
276,410
 
Retained earnings
   
138,976
     
120,894
 
Note receivable from officer
   
(690
)
   
(709
)
Accumulated other comprehensive income
   
32,310
     
16,319
 
Total shareholders' equity
   
448,104
     
413,413
 
Total liabilities and shareholders' equity
 
$
2,739,433
   
$
2,761,842
 
 
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, 2013
 
$
499
   
$
276,410
   
$
120,894
   
$
(709
)
 
$
16,319
   
$
413,413
 
Net income
   
-
     
-
     
21,087
     
-
     
-
     
21,087
 
Dividends declared
   
-
     
-
     
(3,005
)
   
-
     
-
     
(3,005
)
Change in unrealized gain or loss on available for sale securities, net of tax
   
-
     
-
     
-
     
-
     
16,600
     
16,600
 
Change in valuation allowance on deferred tax assets
   
-
     
-
     
-
     
-
     
205
     
205
 
Net deferred derivative loss - hedging activity
   
-
     
-
     
-
     
-
     
(973
)
   
(973
)
Stock award, net of tax
   
2
     
92
     
-
     
-
     
-
     
94
 
Long term incentive plan; stock award for 2013 and 2014 plan years
   
-
     
505
     
-
     
-
     
-
     
505
 
Change in investment of affiliates, net of tax
   
-
     
-
     
-
     
-
     
174
     
174
 
Change in investment of unconsolidated subsidiaries
   
-
     
-
     
-
     
-
     
(15
)
   
(15
)
Note receivable from officer
   
-
     
-
     
-
     
19
     
-
     
19
 
Balances September 30, 2014
 
$
501
   
$
277,007
   
$
138,976
   
$
(690
)
 
$
32,310
   
$
448,104
 

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,

 
 
2014
   
2013
 
 
 
(Unaudited)
 
 
 
(In thousands)
 
Cash Flows From Operating Activities
 
   
 
Net income (loss)
 
$
21,087
   
$
(100,460
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
               
Amortization of other intangible assets
   
2,959
     
3,146
 
Amortization of deferred debenture issuance costs
   
-
     
73
 
Impairment of goodwill
   
-
     
115,397
 
Depreciation of furniture, equipment, and building
   
3,217
     
3,479
 
Net amortization of discount and premiums on bonds
   
9,685
     
8,453
 
Accretion of issued debt/original issue discount
   
1,149
     
784
 
Amortization of capitalized convertible note fees
   
327
     
223
 
Gain on sale of investments
   
(9,159
)
   
(3,898
)
Gain on sale of fixed assets
   
(231
)
   
(66
)
Long-term incentive plan expense
   
538
     
324
 
Stock award
   
118
     
274
 
Equity earnings of affiliates, net of taxes
   
(2,870
)
   
(2,547
)
Equity earnings of unconsolidated subsidiaries, net of tax
   
(18
)
   
(4
)
Deferred income tax expense (benefit)
   
4,612
     
(7,870
)
Write-off of book of business
   
52
     
-
 
Changes in operating assets and liabilities:
               
(Increase) decrease in:
               
Premiums and agent balances receivable
   
25,208
     
(16,679
)
Reinsurance recoverable on paid and unpaid losses
   
(26,353
)
   
(108,321
)
Prepaid reinsurance premiums
   
29,288
     
50,493
 
Deferred policy acquisition costs
   
(2,355
)
   
(14,815
)
Other assets
   
8,406
     
(24,147
)
Increase (decrease) in:
               
Losses and loss adjustment expenses
   
153
     
123,411
 
Unearned premiums
   
(51,798
)
   
(30,690
)
Payable to insurance companies
   
(3,793
)
   
26,099
 
Funds held and reinsurance balances payable
   
537
     
(11,845
)
Other liabilities
   
(7,600
)
   
8,122
 
Total adjustments
   
(17,928
)
   
119,396
 
Net cash provided by operating activities
   
3,159
     
18,936
 
Cash Flows From Investing Activities
               
Purchase of debt securities available for sale
   
(63,765
)
   
(400,212
)
Proceeds from sales and maturities of debt securities available for sale
   
77,450
     
145,606
 
Purchase of equity securities available for sale
   
(27,619
)
   
(98,385
)
Proceeds from sales of equity securities available for sale
   
37,157
     
18,285
 
Capital expenditures
   
(1,316
)
   
(1,363
)
Other investing activities
   
6
     
(680
)
Net cash provided by (used in) investing activities
   
21,913
     
(336,749
)
Cash Flows From Financing Activities
               
Payments on term loan and revolving credit facility
   
(9,500
)
   
(4,500
)
Proceeds from convertible senior notes
   
-
     
96,324
 
Payments for convertible senior notes hedge
   
-
     
(12,942
)
Proceeds from issuance of warrants
   
-
     
3,023
 
Book overdrafts
   
(1,278
)
   
188
 
Dividends paid on common stock
   
(3,005
)
   
(2,993
)
Other financing activities
   
19
     
22
 
Net cash (used in) provided by financing activities
   
(13,764
)
   
79,122
 
Net increase (decrease) in cash and cash equivalents
   
11,308
     
(238,691
)
Cash and cash equivalents, beginning of period
   
94,776
     
342,124
 
Cash and cash equivalents, end of period
 
$
106,084
   
$
103,433
 
Supplemental Disclosure of Cash Flow Information:
               
Interest paid
 
$
5,077
   
$
8,092
 
Net income taxes (rececived) paid (1)
 
$
(5,136
)
 
$
1,165
 
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
               
Stock-based employee compensation
 
$
118
   
$
274
 

(1) Tax return refunds were received in first quarter of 2014 and 2013 for $8,886 and $3,067, respectively.

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, is a wholly owned subsidiary of ProCentury (Star, Savers, Williamsburg, Ameritrust, Century, and PIC are collectively referred to as “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, 2014 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 fiscal year ended December 31, 2013.

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.
 
8

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Effective July 1, 2013, the Insurance Company Subsidiaries entered into an agreement with State National Insurance Company, National Specialty Insurance Company and United Specialty Insurance Company (collectively, “SNIC”), whereby certain business from our Insurance Company Subsidiaries is written directly with SNIC and 100% assumed collectively by our Insurance Company Subsidiaries.  Our Insurance Company Subsidiaries pay SNIC a 5.5% policy issuance fee, which is reflected as assumed commission expense on the applicable Insurance Company Subsidiaries’ financial statements. For the three months and nine months ended September 30, 2014, our Insurance Company Subsidiaries collectively assumed $79.3 million and $214.4 million, respectively, in gross written premium from SNIC.  The impact of the SNIC policy issuance fee on the Company’s expense ratio was 2.3% and 2.2% for the three months and nine months ended September 30, 2014, respectively.

Fee income, which includes risk management consulting, loss control, and claims services, is recognized during the period that 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 unaffiliated insurance carriers are recognized when determinable, which is when such commissions are received.

Income Taxes

As of September 30, 2014 and December 31, 2013, the Company did not have any unrecognized tax benefits.  As of September 30, 2014 and December 31, 2013, the Company had no accrued interest or penalties related to uncertain tax positions.

Recent Accounting Pronouncements

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive

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 10 ~ Accumulated Other Comprehensive Income.
 
9

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, 2014 and December 31, 2013 were as follows (in thousands):
 
   
September 30, 2014
 
   
Cost or Amortized Cost
   
Gross Unrealized
   

Estimated
Fair Value
 
   

Gains
   

Losses
   
Non-Credit OTTI
 
Debt Securities:
 
   
   
   
   
 
U.S. Government and agencies
 
$
24,442
   
$
503
   
$
(118
)
 
$
-
   
$
24,827
 
Obligations of states and political subs
   
703,170
     
27,283
     
(3,838
)
   
-
     
726,615
 
Corporate securities
   
571,926
     
15,343
     
(4,367
)
   
-
     
582,902
 
Residential mortgage-backed securities
   
104,563
     
1,887
     
(2,384
)
   
-
     
104,066
 
Commercial mortgage-backed securities
   
21,592
     
318
     
(429
)
   
-
     
21,481
 
Other asset-backed securities
   
19,716
     
567
     
(12
)
   
-
     
20,271
 
Total debt securities available for sale
   
1,445,409
     
45,901
     
(11,148
)
   
-
     
1,480,162
 
Equity Securities:
                                       
Common stock
   
94,158
     
14,033
     
(1,321
)
   
-
     
106,870
 
Total equity securities available for sale
   
94,158
     
14,033
     
(1,321
)
   
-
     
106,870
 
Total securities available for sale
 
$
1,539,567
   
$
59,934
   
$
(12,469
)
 
$
-
   
$
1,587,032
 

   
December 31, 2013
 
   
Cost or Amortized Cost
   
Gross Unrealized
   

Estimated
Fair Value
 
   

Gains
   

Losses
   
Non-Credit OTTI
 
Debt Securities:
 
   
   
   
   
 
U.S. Government and agencies
 
$
24,985
   
$
572
   
$
(188
)
 
$
-
   
$
25,369
 
Obligations of states and political subs
   
730,004
     
25,509
     
(20,121
)
   
-
     
735,392
 
Corporate securities
   
534,913
     
15,529
     
(11,935
)
   
-
     
538,507
 
Residential mortgage-backed securities
   
118,930
     
2,191
     
(4,737
)
   
-
     
116,384
 
Commercial mortgage-backed securities
   
26,719
     
617
     
(868
)
   
-
     
26,468
 
Other asset-backed securities
   
20,203
     
763
     
(40
)
   
-
     
20,926
 
Total debt securities available for sale
   
1,455,754
     
45,181
     
(37,889
)
   
-
     
1,463,046
 
Equity Securities:
                                       
Perpetual preferred stock
   
71
     
147
     
-
     
-
     
218
 
Common stock
   
95,275
     
14,933
     
(444
)
   
-
     
109,764
 
Total equity securities available for sale
   
95,346
     
15,080
     
(444
)
   
-
     
109,982
 
Total securities available for sale
 
$
1,551,100
   
$
60,261
   
$
(38,333
)
 
$
-
   
$
1,573,028
 
 
10

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, 2014 and December 31, 2013 were as follows (in thousands):

   
September 30, 2014
   
December 31, 2013
 
Unrealized gains
 
$
59,934
   
$
60,261
 
Unrealized losses
   
(12,469
)
   
(38,333
)
Non-credit OTTI
   
-
     
-
 
Net unrealized gains
   
47,465
     
21,928
 
Deferred federal income tax expense
   
(16,612
)
   
(7,675
)
Net unrealized gains on investments, net of deferred federal income taxes
 
$
30,853
   
$
14,253
 
 
Net realized gains (losses including OTTI) on securities, for the three months and nine months ended September 30, 2014 and 2013 were as follows (in thousands):

   
For the Three Months Ended September 30,
   
For the Nine Months
Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Realized gains (losses):
               
Debt securities:
               
Gross realized gains
 
$
857
   
$
87
   
$
1,193
   
$
1,617
 
Gross realized losses
   
(383
)
   
(40
)
   
(383
)
   
(211
)
Total debt securities
   
474
     
47
     
810
     
1,406
 
Equity securities:
                               
Gross realized gains
   
2,328
     
656
     
8,357
     
2,502
 
Gross realized losses
   
(4
)
   
-
     
(8
)
   
(10
)
Total equity securities
   
2,324
     
656
     
8,349
     
2,492
 
Net realized gains
 
$
2,798
   
$
703
   
$
9,159
   
$
3,898
 
                                 
OTTI included in realized losses on securities above
 
$
-
   
$
-
   
$
-
   
$
-
 

Proceeds from the sales of debt and equity securities available for sale were $31.8 million and $12.8 million for the three months ended September 30, 2014 and 2013, respectively.  Proceeds from the sales of debt and equity securities available for sale were $62.9 million and $88.9 million for the nine months ended September 30, 2014 and 2013, respectively.
 
11

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
At September 30, 2014, 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
 
$
41,384
   
$
41,962
 
Due after one year through five years
   
535,460
     
558,383
 
Due after five years through ten years
   
601,630
     
611,530
 
Due after ten years
   
121,064
     
122,469
 
Mortgage-backed securities, collateralized obligations and asset-backed securities
   
145,871
     
145,818
 
   
$
1,445,409
   
$
1,480,162
 
 
Net investment income for the three months and nine months ended September 30, 2014 and 2013 was as follows (in thousands):

   
For the Three Months
Ended September 30,
   
For the Nine Months
Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Net Investment Income Earned From:
 
   
   
   
 
Debt securities
 
$
10,515
   
$
10,888
   
$
31,746
   
$
32,593
 
Equity securities
   
811
     
1,043
     
2,658
     
2,593
 
Cash and cash equivalents
   
171
     
165
     
400
     
558
 
Total gross investment income
   
11,497
     
12,096
     
34,804
     
35,744
 
Less investment expenses
   
410
     
401
     
1,247
     
1,141
 
Net investment income
 
$
11,087
   
$
11,695
   
$
33,557
   
$
34,603
 

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.
 
12

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

The Company reviewed its investment portfolio in relation to its OTTI policy and determined the Company did not need to record a credit related OTTI loss, nor recognize a non-credit related OTTI loss in other comprehensive income for the three months and nine months ended September 30, 2014 or 2013.
 
13

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, 2014
 
   
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
   
-
   
$
-
   
$
-
     
3
   
$
3,399
   
$
(118
)
   
3
   
$
3,399
   
$
(118
)
Obligations of states and political subs
   
29
     
96,714
     
(1,407
)
   
40
     
132,304
     
(2,431
)
   
69
     
229,018
     
(3,838
)
Corporate securities
   
93
     
197,177
     
(2,592
)
   
23
     
60,425
     
(1,775
)
   
116
     
257,602
     
(4,367
)
Residential mortgage-backed securities
   
4
     
28,700
     
(814
)
   
9
     
46,060
     
(1,570
)
   
13
     
74,760
     
(2,384
)
Commercial mortgage-backed securities
   
3
     
5,064
     
(159
)
   
2
     
7,792
     
(270
)
   
5
     
12,856
     
(429
)
Other asset-backed securities
   
3
     
4,435
     
(12
)
   
-
     
-
     
-
     
3
     
4,435
     
(12
)
Total debt securities
   
132
     
332,090
     
(4,984
)
   
77
     
249,980
     
(6,164
)
   
209
     
582,070
     
(11,148
)
Equity Securities:
                                                                       
Common stock
   
22
     
19,027
     
(1,223
)
   
3
     
1,390
     
(98
)
   
25
     
20,417
     
(1,321
)
Total equity securities
   
22
     
19,027
     
(1,223
)
   
3
     
1,390
     
(98
)
   
25
     
20,417
     
(1,321
)
Total securities
   
154
   
$
351,117
   
$
(6,207
)
   
80
   
$
251,370
   
$
(6,262
)
   
234
   
$
602,487
   
$
(12,469
)

   
December 31, 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
   
5
   
$
6,181
   
$
(91
)
   
1
   
$
903
   
$
(97
)
   
6
   
$
7,084
   
$
(188
)
Obligations of states and political subs
   
103
     
285,264
     
(16,218
)
   
16
     
43,811
     
(3,903
)
   
119
     
329,075
     
(20,121
)
Corporate securities
   
121
     
259,581
     
(10,663
)
   
8
     
16,734
     
(1,272
)
   
129
     
276,315
     
(11,935
)
Residential mortgage-backed securities
   
13
     
72,458
     
(3,879
)
   
1
     
8,095
     
(858
)
   
14
     
80,553
     
(4,737
)
Commercial mortgage-backed securities
   
5
     
12,451
     
(868
)
   
-
     
-
     
-
     
5
     
12,451
     
(868
)
Other asset-backed securities
   
4
     
8,522
     
(40
)
   
-
     
-
     
-
     
4
     
8,522
     
(40
)
Total debt securities
   
251
     
644,457
     
(31,759
)
   
26
     
69,543
     
(6,130
)
   
277
     
714,000
     
(37,889
)
Equity Securities:
                                                                       
Perpetual preferred stock
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Common stock
   
15
     
12,112
     
(444
)
   
-
                     
15
     
12,112
     
(444
)
Total equity securities
   
15
     
12,112
     
(444
)
   
-
     
-
     
-
     
15
     
12,112
     
(444
)
Total securities
   
266
   
$
656,569
   
$
(32,203
)
   
26
   
$
69,543
   
$
(6,130
)
   
292
   
$
726,112
   
$
(38,333
)

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”).
 
14

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 the amounts provided represent fair values.  The Company’s control process includes, but is not limited to, an 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 6.7% 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 93.1% 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.
 
15

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 15 securities totaling $3.2 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 determine the fair value all 15 of these securities, the third party investment manager used benchmarking techniques based upon industry sector, rating and other factors.

Also included in Level 3 valuation is the conversion feature within the Notes (as defined in Note 5 ~ Derivative Instruments) and the Notes Hedges.  The estimated fair values of both the conversion feature and the 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, 2014 (in thousands):

   
   
Fair Value Measurements Using
 
   
September 30, 2014
   
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
 
$
24,827
   
$
-
   
$
24,827
   
$
-
 
Obligations of states and political subs
   
726,615
     
-
     
726,615
     
-
 
Corporate securities
   
582,902
     
-
     
581,822
     
1,080
 
Residential mortgage-backed securities
   
104,066
     
-
     
104,066
     
-
 
Commercial mortgage-backed securities
   
21,481
     
-
     
21,481
     
-
 
Other asset-backed securities
   
20,271
     
-
     
18,126
     
2,145
 
Total debt securities available for sale
   
1,480,162
     
-
     
1,476,937
     
3,225
 
Equity Securities:
                               
Common stock
   
106,870
     
106,870
     
-
     
-
 
Total equity securities available for sale
   
106,870
     
106,870
     
-
     
-
 
Total securities available for sale
   
1,587,032
     
106,870
     
1,476,937
     
3,225
 
Derivatives:
                               
Derivatives - interest rate swaps
   
56
     
-
     
56
     
-
 
Cash conversion feature of cash  convertible notes
   
(11,266
)
   
-
     
-
     
(11,266
)
Purchased cash convertible note hedge
   
11,266
     
-
     
-
     
11,266
 
Total derivatives
   
56
     
-
     
56
     
-
 
                                 
Total securities available for sale and derivatives
 
$
1,587,088
   
$
106,870
   
$
1,476,993
   
$
3,225
 
 
16

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, 2014 (in thousands):
 
   
Commercial
mortgage-backed
and Other asset-
backed securities
   
Corporate securities
   
Total
 
Balance as of December 31, 2013
 
$
2,608
   
$
889
   
$
3,497
 
                         
Total gains or losses (realized/unrealized):
                       
Included in earnings
   
367
     
24
     
391
 
Included in other comprehensive income
   
(194
)
   
168
     
(26
)
                         
Purchases
                   
-
 
Issuances
                   
-
 
Settlements
   
(637
)
   
-
     
(637
)
                         
Transfers in and out of Level 3
   
-
     
-
     
-
 
Balance as of September 30, 2014
 
$
2,145
   
$
1,080
   
$
3,225
 

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 each reporting period.  There were no transfers between Levels 1, 2 and 3 for the three months and nine months ended September 30, 2014 and 2013, respectively.
 
17

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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.

As of September 30, 2014, the outstanding balance on the Company’s term loan facility was $18.0 million. Pursuant to the Second Amendment to Credit Agreement and Waiver, dated September 19, 2013 (the “Amendment”), the available borrowing under the revolving credit facility was reduced from $100.0 million to $30.0 million with further periodic reductions to $21.0 million as of March 31, 2016, less any optional reductions to the revolving commitments. The Amendment also established an amortization schedule for the revolving credit facility beginning on September 30, 2014. The Company has $15.0 million outstanding under its revolving credit facility and $0.1 million in letters of credit as of September 30, 2014. The undrawn portion of the revolving credit facility, which was $9.1 million as of September 30, 2014, 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 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%, and (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 the 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 the 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, 2014, the interest rate on the Company’s term loan was 2.75%, which consisted of a variable rate of 0.25%, plus an applicable margin of 2.50%. At September 30, 2014, the interest rate on the Company’s revolving credit facility was approximately 0.23%, plus a 2.50% margin.

Additionally, under the Amendment, the financial covenants applicable to the Credit Facilities were modified to consist of: (1) minimum consolidated net worth of the Company and its subsidiaries of $365,697,000 as of the effective date of the Amendment, with quarterly increases thereafter equal to 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 (as defined in the Amendment) for all material Insurance Company Subsidiaries of 1.75 times Company Action Level (as defined in the Amendment), (3) a maximum permitted consolidated leverage ratio of 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++” for all Insurance Company Subsidiaries. As of September 30, 2014, the Company was in compliance with these debt covenants.
 
18

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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, 2014 and 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 $36.3 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, 2014 (1)
   
Principal Amount
 
 
 
 
 
 
 
   
 
2003
Junior subordinated debentures
2008
2033
Three-month LIBOR, plus 4.05%
   
4.28
%
 
$
10,310
 
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.00%
   
4.23
%
   
13,000
 
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.20%
   
4.43
%
   
12,000
 
2005
Junior subordinated debentures
2010
2035
Three-month LIBOR, plus 3.58%
   
3.81
%
   
20,620
 
 
Junior subordinated debentures (2)
2007
2032
Three-month LIBOR, plus 4.00%
4.23
%
15,000
 
Junior subordinated debentures (2)
2008
2033
Three-month LIBOR, plus 4.10%
4.33
%
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 our merger with ProCentury (the “ProCentury Merger”) on July 31, 2008.

Excluding the junior subordinated debentures acquired in conjunction with the ProCentury Merger, the Company received a total of $53.3 million in net proceeds from the issuances of the above long-term debt, of which $26.2 million was contributed to the surplus of its Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes.
 
19

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 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 was 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 a fundamental change, 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 which 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%.
 
20

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The following table shows the amounts recorded for the debt component of the Notes as of September 30, 2014 and December 31, 2013 (in thousands):

   
September 30,
2014
   
December 31,
2013
 
Outstanding principal
 
$
100,000
   
$
100,000
 
Unamortized OID
   
(10,627
)
   
(11,777
)
Total debt component
 
$
89,373
   
$
88,223
 
                 
Deferred issuance costs of $3.7 million will also be amortized into interest expense over the term of the Notes. Interest expense on the Notes, including amortization of deferred issuance costs, was $1.8 million and $1.7 million for the three months ended September 30, 2014 and 2013, respectively. Interest expense on the Notes, including amortization of deferred issuance costs, was $5.2 million and $3.7 million for the nine months ended September 30, 2014 and 2013, respectively.

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 of the Notes, 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, 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 Accounting Standards Codification (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, 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.
 
21

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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, with gross unrealized gains reported as other assets and gross unrealized losses reported as other liabilities. The effective portion of the changes in fair value is accounted for within other comprehensive income. The interest differential to be paid or received is accrued and recognized as an adjustment to interest expense.
 
The following table summarizes the rates and amounts associated with the Company’s interest rate swaps (in thousands):
 
Effective Date
Expiration Date
Debt Instrument
Counterparty Interest Rate Terms
 
Fixed Rate
   
Fixed Amount at September 30, 2014
 
 
 
 
 
 
   
 
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
 
9/28/2012
8/30/2016
Term loan (1)
Three-month LIBOR
   
0.714
%
   
18,000
 
4/29/2013
4/29/2023
Senior debentures
Three-month LIBOR, plus 4.00%
   
6.250
%
   
13,000
 
6/30/2013
6/30/2023
Junior subordinated debentures
Three-month LIBOR, plus 4.05%
   
6.340
%
   
10,000
 
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
 
 
 
 
    
 
Total
   
$
98,000
 
 
(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.

In relation to the above interest rate swaps, the net interest expense incurred was approximately $0.5 million for each of the three months ended September 30, 2014 and 2013. The net interest expense incurred for the nine months ended September 30, 2014 and 2013 was approximately $1.3 million and $1.8 million, respectively.

As of September 30, 2014, the total fair value of the interest rate swaps was $56,000, which reflects a gross unrealized gain position of $0.9 million and a gross unrealized loss position of ($0.8 million). As of December 31, 2013, the total fair value of the interest rate swaps was $1.6 million, which reflects a gross unrealized gain position of $2.9 million and a gross unrealized loss position of ($1.3 million). At September 30, 2014 and December 31, 2013, accumulated other comprehensive income included accumulated loss on the cash flow hedge, net of taxes, of approximately ($36,000) and accumulated gain on the cash flow hedge, net of taxes, of approximately $1.0 million, respectively. The Company does not net the unrealized gains and losses in the financial statements.
 
22

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Cash Convertible Senior Notes and Note Hedges

In order to offset the risk associated with the cash conversion feature of the Notes, the Company entered into the Note Hedges. Both the cash conversion feature of the Notes and the Note Hedges are measured at fair value with gains and losses recorded in the Company’s Consolidated Statements of Income.
 
At September 30, 2014, the cash conversion feature of the Notes had a fair market value of ($11.3 million) and the Note Hedges had a fair market value of $11.3 million.  At December 31, 2013, cash conversion feature of cash convertible notes had a fair market value of ($16.8 million) and the Note Hedges had a fair market value of $16.8 million.

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 named executive officers and other members of management of the Company, out of its 2002 Amended and Restated Stock Option Plan (the “Plan”). No restricted stock awards were issued in 2012, 2013 or 2014. 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 his or her employment without “Good Reason”; as provided for in the employee’s respective employment agreements. The Company recorded approximately $14,000 and $83,000 of restricted stock awards compensation expense for the three months ended September 30, 2014 and 2013, respectively.   The Company recorded approximately $82,000 and $247,000 of restricted stock awards compensation expense for the nine months ended September 30, 2014 and 2013, respectively.

On February 13, 2014, and February 13, 2013, the Company issued an award of 2,400 shares of non-restricted stock to each outside member of the Board of Directors, which vested immediately. On May 16, 2014 and August 12, 2014, the Company issued an award of 2,400 shares of non-restricted stock and an award of 2,000 shares of non-restricted stock, in each case to a then newly elected member of the Board of Directors, respectively.  These stock awards vested immediately.  The Company recorded approximately $12,000 and $0 of non-restricted stock awards compensation expense for the three months ended September 30, 2014 and 2013, respectively.  The Company recorded approximately $148,000 and $137,000 of non-restricted stock awards compensation expense for the nine months ended September 30, 2014 and 2013, respectively.
 
23

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 7 – Shareholders’ Equity

At September 30, 2014, shareholders’ equity was $448.1 million, or a book value of $8.94 per common share, compared to $413.4 million, or a book value of $8.29 per common share, at December 31, 2013.

The Company’s Share Repurchase Plan expired on October 28, 2013. For the three months and nine months ended September 30, 2014, there were no share repurchases.
 
When evaluating the declaration of a dividend, the Company’s Board of Directors considers a variety of factors including, but not limited to, cash flow, liquidity needs, results of operations, industry conditions, and our overall financial condition.  As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from its Insurance Company Subsidiaries.  Additionally, pursuant to the Amendment (Note 4 ~ Debt) the Company cannot pay quarterly dividends in excess of the lesser of $0.02 per share or $1.25 million in the aggregate without the bank’s prior approval.

The Company paid dividends to its common shareholders of $3.0 million for each of the nine months ended September 30, 2014 and 2013.

On October 31, 2014, the Company’s Board of Directors declared a quarterly dividend of $0.02 per common share.  The dividend is payable on December 3, 2014, to shareholders of record as of November 20, 2014.

NOTE 8 – Earnings Per Share

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

24

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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, 2014 and 2013 (in thousands, except per share amounts):

 
 
For the Three Months
Ended September 30,
   
For the Nine Months
Ended September 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
Net income (loss)
 
$
4,967
   
$
5,516
   
$
21,087
   
$
(100,460
)
 
                               
Common shares:
                               
Basic
                               
Weighted average shares outstanding
   
50,092,755
     
49,887,200
     
50,054,031
     
49,866,326
 
 
                               
Diluted
                               
Weighted average shares outstanding
   
50,092,755
     
49,887,200
     
50,054,031
     
49,866,326
 
Dilutive effect of:
                               
Share awards under long term incentive plan
   
-
     
46,340
     
-
         
Total
   
50,092,755
     
49,933,540
     
50,054,031
     
49,866,326
 
 
                               
Net income (loss) per common share
                               
Basic
 
$
0.09
   
$
0.11
   
$
0.42
   
$
(2.01
)
Diluted
 
$
0.09
   
$
0.11
   
$
0.42
   
$
(2.01
)
 
NOTE 9 – Goodwill

The Company evaluates existing goodwill for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset might be impaired.  Goodwill impairment is performed at the reporting unit level.

In accordance with accounting guidance, the Company concluded its reporting units to be specialty insurance operations and agency operations. The nature of the business and economic characteristics of all agency operations and all specialty insurance operations are similar based upon, but not limited to, the following; (1) management alignment within each reporting unit, (2) the Company’s Insurance Company Subsidiaries operating under a reinsurance pooling arrangement, and (3) the ability of the Company to leverage its expertise and fixed costs within each reporting unit.
 
Pursuant to ASC 350 Goodwill and Other Intangible Assets, goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year or more frequently if management believes indicators of impairment exist. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The performance of the test involves a two-step process.  Step One of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. If the carrying amount of a reporting unit exceeds the reporting unit's fair value, the Company performs Step Two to determine the amount of impairment loss. The Step Two analysis involves determining the potential impairment of goodwill as the difference between the carried goodwill and the hypothetical fair value of the enterprise less the fair value of the tangible net assets and less the estimation of identifiable intangible assets, such as agent relationships, licenses, trademarks and other intangibles that are not carried on the books at fair value.
 
25

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Estimating the fair value of reporting units is a subjective process involving the use of estimates and judgments, particularly related to future cash flows, discount rates (including market risk premiums) and market multiples. The fair values of the reporting units were determined using a blend of two commonly used valuation techniques, the market approach and the income approach. The Company gives consideration to two valuation techniques, as either technique can be an indicator of value. For the market approach, valuations of reporting units were based on an analysis of price multiples of net income, net book value and net tangible book value. The peer group price multiples used in the analysis were selected based on management’s judgment. For the income approach, the Company estimated future cash flows using a discounted cash flow model (“DCF model”). A DCF model was selected to be comparable to what would be used by market participants to estimate fair value. The DCF model incorporated expected future growth rates, terminal value amounts, and the applicable weighted-average cost of capital to discount estimated cash flows. The projections used in the estimate of fair value are consistent with the Company’s forecast and long-range plans.
 
     On August 2, 2013, A.M. Best (insurance industry rating agency) downgraded Meadowbrook's issuer credit rating, as well its financial strength ratings and the issuer credit ratings of its subsidiaries after the Company reported weaker-than-anticipated second-quarter results.  Subsequent to the announcement, the Company’s stock price decreased by 10%.  These events represented a triggering event for potential goodwill impairment.  The Company completed an interim goodwill impairment evaluation as of June 30, 2013, as required under ASC 350, and determined that a goodwill impairment existed in the Specialty Insurance Operations (SIO) reporting unit, as the carrying value of the unit exceeded its fair value.  After further analysis, the Company recorded a provisional impairment adjustment of $115.4 million at June 30, 2013.  This provisional adjustment represented a full impairment of SIO’s reporting unit’s goodwill.
 
     The carrying amount of the goodwill was $6.9 million and $5.6 million at September 30, 2014 and December 31, 2013, respectively and represented goodwill attributable to the Company’s Agency Operations reporting unit.  There were no triggering events in 2014 related to such goodwill.

     The following summarizes the goodwill activity and beginning and ending balances for the nine months ended September 30, 2014 and the year ended December 31, 2013 (in thousands):

   
Agency Operations
   
Specialty Insurance Operations
   
Total
 
   
   
   
 
Balance as of January 1, 2013
 
$
5,644
   
$
115,397
   
$
121,041
 
Goodwill Impairment
   
-
     
(115,397
)
   
(115,397
)
Balance at December 31, 2013
   
5,644
     
-
     
5,644
 
Goodwill Addition
   
1,213
     
-
     
1,213
 
Balance at September 30, 2014
 
$
6,857
   
$
-
   
$
6,857
 
 
26

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 10 – Commitments and Contingencies

The Company and its subsidiaries are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, the Company vigorously defends such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by the policy of insurance at issue. We account for such activity through the establishment of unpaid loss and loss expense reserves. We also maintain errors and omissions insurance and extra-contractual coverage under reinsurance treaties related to the policy of insurance at issue or other appropriate insurance. In terms of any retentions or deductibles associated with such insurance, the Company has established accruals for such retentions or deductibles, when necessary, based upon current available information. In accordance with accounting guidance, if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is reasonably estimable; then an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets. Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income. Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, the Company does not believe that there is a reasonable possibility that, other than with regard to the arbitration described below, any material loss exceeding amounts already accrued, if any, will result from any of the claims, lawsuits and proceedings to which the Company is subject to, either individually, or in the aggregate.
 
Arbitration

The Company purchased a three year underlying per occurrence excess of loss reinsurance agreement (the “Retention Buy Down Treaty”) from a reinsurer (the “Reinsurer”), which reinsured the Company’s statutory workers’ compensation business for the period of January 1, 1999 through January 1, 2002. Under the Retention Buy Down Treaty, the Company ceded losses to the Reinsurer of approximately $42.6 million. The Company was also a party to an unrelated excess of loss treaty with another reinsurer for its workers’ compensation business covering the same periods (the “Excess of Loss Treaty”). Under the Excess of Loss Treaty, the Company’s retention was $250,000 per occurrence. The Company purchased the Retention Buy Down Treaty to reduce its $250,000 existing per occurrence retention to $100,000. In approximately 2008, a dispute arose between the Company and the Reinsurer as to how the Retention Buy Down Treaty applied to certain losses. When the Company and the Reinsurer could not come to a mutual understanding, the Company initiated arbitration proceedings requesting payment of its outstanding balance. On July 23, 2013, the arbitration panel issued an interim final award finding the Retention Buy Down Treaty did not include certain losses that the Company believed were subject to the Retention Buy Down Treaty.
 
27

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
During the arbitration, the Reinsurer sought from the Company an award of $1.6 million. This amount reflected the difference between what the Company claimed was due from the Reinsurer ($2.9 million) and what the Reinsurer claimed it was due back from the Company ($4.5 million). The panel awarded the Reinsurer $1.6 million, and $2.0 million in interest, plus attorney’s fees. Based upon the panel’s interpretation of the Retention Buy Down Treaty, the Company was required to reverse certain of its ceded incurred losses due from the Reinsurer. The Company recorded this change in ceded incurred losses during the second quarter of 2013. Notwithstanding the panel’s netting of the outstanding balances, the panel requested the Company submit additional documentation listing all programs covered by the Retention Buy Down Treaty and the Company's retained limit for each program. The Reinsurer was allowed to respond and submit its bill for attorney’s fees. The Company paid the $1.6 million and $2.0 million in interest, as required by the interim final award. On August 6, 2013, the Company submitted the above-mentioned additional documentation.

On August 9, 2013 the Reinsurer argued the Company’s submission was non-compliant. On August 12, 2013 and August 13, 2013, the panel (by majority) issued two orders: (1) the first order determined the Company’s submission of August 6, 2013 was non-compliant; and (2) the second order modified the terms of the interim final award and limited the submissions to documents previously produced in the arbitration.
 
The Company filed a complaint in state court to vacate and/or modify the interim final award.
 
On August 21, 2013, the Company brought a Motion to Stay Proceedings before the panel, because it had discovered evidence of what it believed were improper ex parte contacts between the Reinsurer’s lawyer and the arbitrator appointed by the Reinsurer. On August 29, 2013, the panel (by majority) denied the Company’s Motion to Stay Proceedings.

Subsequently, the Company filed a Motion to Stay the Arbitration in the state court requesting discovery to investigate what the Company believed was a “tainted” arbitration panel. The Reinsurer removed the case to the United States District Court for the Eastern District of Michigan.

MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
On September 4, 2013, the Reinsurer filed a response to the Company’s submission before the panel seeking an additional $25 million in damages from the Company. On September 10, 2013, the Company filed a motion seeking a preliminary injunction from the federal court requesting the court enjoin the panel from issuing any further decisions.

On September 12, 2013, the federal court granted the Company’s preliminary injunction enjoining the panel from issuing any further decisions, finding the Company would likely succeed on its underlying complaint seeking to vacate the interim final award due to the strong evidence of: (1) improper ex parte communications between the arbitrator appointed by the Reinsurer and its lawyer; (2) a breach of the arbitration provision within the Retention Buy Down Treaty, because the Reinsurer’s arbitrator and the neutral arbitrator issued two substantive orders without the knowledge or input from the Company’s arbitrator; and (3) failing to disclose to the Company certain relationships between the Reinsurer and its arbitrator.

The Reinsurer appealed the preliminary injunction. On April 9, 2014, the Sixth Circuit Court of Appeals issued an opinion and order finding the trial court did not have jurisdiction to issue its preliminary injunction enjoining the panel.  The appellate court found that the Company could challenge the fairness of the proceedings and partiality of the arbitrators after a final award was issued.

On July 25, 2014, the panel issued its final award.  The panel (by majority) awarded the reinsurer approximately $10.9 million, plus interest. The Company immediately filed a complaint in federal district court to vacate and/or modify the arbitration award(s) for the same reasons the court previously granted the Company’s request for a preliminary injunction : (1) improper ex parte communications  between the arbitrator appointed by the Reinsurer and its lawyer; (2) breach of the Retention Buy Down Treaty’s arbitration provision because the Reinsurer’s arbitrator and the neutral arbitrator issued two substantive orders without input from the Company’s arbitrator; and (3) failure to disclose to the Company certain relationships between the Reinsurer and its arbitrator.   In addition, the following additional grounds were included in the complaint: (1) financial conflict of interest on the part of the Reinsurer’s arbitrator; (2) breach of the Retention Buy Down Treaty’s arbitration provision because the Reinsurer’s arbitrator was not a “disinterested” arbitrator and was “under the control of” the Reinsurer; (3) evident partiality of the neutral arbitrator; (4) failure to consider material evidence, in accordance with Michigan law; (5) improper interpretation and re-writing of the treaty; and (6) improper award of interest and attorney fees contrary to Michigan law.  The Reinsurer has filed a motion to confirm the panel’s majority interim and final awards. The Company has filed a motion to vacate and/or modify the awards.
 
The Company intends to vigorously pursue its complaint to vacate the arbitration award(s). While the Company believes it will succeed upon the merits, given the inherent uncertainty surrounding the conclusion of this proceeding, an adverse outcome in this matter could have a material impact on our results of operations or cash flows on a particular quarter or annual period. If this matter is resolved against the Company, we currently estimate the Company would suffer a loss of approximately $10.9 million, plus approximately $5.0 million of interest, attorney fees and costs.
 
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Securities Class Actions

In August and October 2013, two putative class action complaints were filed in the United States District Court for the Southern District of New York against the Company, Robert Cubbin and Karen Spaun.  The cases were subsequently consolidated and on April 25, 2014, the plaintiffs filed a Consolidated Amended Class Action Complaint naming the same defendants, on behalf of a putative class consisting of all persons who purchased the Company’s stock between February 17, 2009 and February 21, 2014 (the “Class Period”).  The Consolidated Amended Complaint alleges that during the purported Class Period, the defendants made materially false and misleading statements relating to the Company’s reserves and reported goodwill.  On July 7, 2014, the defendants filed a motion to dismiss the Consolidated Amended Class Action Complaint.  The Plaintiffs filed a Second Amended Complaint in response to our motion to dismiss. On November 5, 2014, the Company filed another motion to dismiss seeking a dismissal of Plaintiffs Second Amended Complaint.  The Company intends to vigorously defend against these claims. The Company has not accrued any amounts for the securities class actions as the Company does not believe that a loss relating to these matters is probable, or that an estimate of a range of potential loss relating to these matters, can reasonably be made.

NOTE 11 – Accumulated Other Comprehensive Income

The Company’s comprehensive income includes net earnings plus unrealized gain or loss on available-for-sale investment securities, net of tax. In reporting comprehensive earnings on a net basis in the income statement, we used a 35 percent tax rate. The following table illustrates the amounts reclassified from accumulated other comprehensive income:
 
MEADOWBROOK INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Reclassifications out of accumulated other comprehensive income: Three Months Ended September 30, 2014 (in thousands)
 
Details about accumulated other
comprehensive income components
 
Amount reclassified from accumulated other
comprehensive income
 
Affected line item in the statement where
net income is presented
 
 
 
   
Unrealized gain or loss on available for sale securities
 
 
  
 
 
$