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MIG > SEC Filings for MIG > Form 10-Q on 10-May-2013All Recent SEC Filings

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Form 10-Q for MEADOWBROOK INSURANCE GROUP INC


10-May-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For the Periods ended March 31, 2013 and 2012

Forward-Looking Statements

This quarterly report may provide information including certain statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These include statements regarding the intent, belief, or current expectations of management, including, but not limited to, those statements that use the words "believes," "expects," "anticipates," "estimates," or similar expressions. You are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks and uncertainties, and results could differ materially from those indicated by such forward-looking statements. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are: actual loss and loss adjustment expenses exceeding our reserve estimates; competitive pressures in our business; the failure of any of the loss limitation methods we employ; our geographic concentration and the business, economic, natural perils, man made perils, and regulatory conditions within our most concentrated region; our ability to appropriately price the risks we underwrite; goodwill impairment risk employed as part of our growth strategy; a decrease in our A.M. Best rating; increased risks or reduction in the level of our underwriting commitments due to market conditions; a failure of our reinsurers to pay losses in a timely fashion, or at all; interest rate changes; continued difficult conditions in the global capital markets and the economy generally; market and credit risks affecting our investment portfolio; liquidity requirements forcing us to sell our investments; a failure to introduce new products or services to keep pace with advances in technology; the new federal financial regulatory reform; our holding company structure and regulatory constraints restricting dividends or other distributions by our Insurance Company Subsidiaries; minimum capital and surplus requirements imposed on our Insurance Company Subsidiaries; a failure of additional capital to be available or only available on unfavorable terms; acquisitions and integration of acquired businesses resulting in operating difficulties, which may prevent us from achieving the expected benefits; our reliance upon producers, which subjects us to their credit risk; loss of one of our core selected producers; our dependence on the continued services and performance of our senior management and other key personnel; our reliance on our information technology and telecommunications systems; managing technology initiatives and obtaining the efficiencies anticipated with technology implementation; a failure in our internal controls; the cyclical nature of the property and casualty insurance industry; severe weather conditions and other catastrophes; the effects of litigation; state regulation; and assessments imposed upon our Insurance Company Subsidiaries to provide funds for failing insurance companies. For additional information with respect to certain of these and other factors, refer to the "Risk Factors" section contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2012 and subsequent filings made with the United States Securities and Exchange Commission. We are not under any obligation to (and expressly disclaim any obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise.


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Business Overview

We are a specialty niche focused commercial insurance underwriter and insurance administration services company. We market and underwrite specialty property and casualty insurance programs and products on both an admitted and non-admitted basis through a broad and diverse network of independent retail agents, wholesalers, program administrators and general agents, who value service, specialized knowledge, and focused expertise. Program business refers to an aggregation of individually underwritten risks that have some unique characteristic and are distributed through a select group of agents. We seek to combine profitable underwriting, income from our net commissions and fees, investment returns and efficient capital management to deliver consistent long-term growth in shareholder value.

Through our retail property and casualty agencies, we also generate commission revenue, which represents 2.4% of our total consolidated revenues. Our agencies are located in Michigan, California, Massachusetts, and Florida and produce commercial, personal lines, life and accident and health insurance that is placed primarily with unaffiliated insurance carriers. These agencies are a minimal source of business for our Insurance Company Subsidiaries.

We recognize revenue related to the services and coverages within the following categories: net earned premiums, management administrative fees, claims fees, commission revenue, net investment income, and net realized gains (losses).

We compete in the specialty insurance market. Our wide range of specialty niche insurance expertise allows us to accommodate a diverse distribution network ranging from specialized program agents to insurance brokers. In the specialty market, competition tends to place considerable focus on availability, service and other tailored coverages in addition to price. Moreover, our broad geographical footprint enables us to function with a local presence on both a regional and national basis. We also have the capacity to write specialty insurance in both the admitted and non-admitted markets. These unique aspects of our business model enable us to compete on factors other than price.

Recent Developments

On April 19, 2013, A.M. Best Company ("A.M. Best") announced it had removed the 'under review' status and affirmed the financial strength rating and issuer credit rating of our Insurance Company Subsidiaries and our issuer credit rating. A.M. Best had previously announced in October 2012 that they had put the financial strength rating and issuer credit rating of our Insurance Company Subsidiaries and our issuer credit rating under review with negative implications. Our Insurance Company Subsidiaries are rated "A-" (Excellent) by
A.M. Best.


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Critical Accounting Policies

In certain circumstances, we are required to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions periodically on an on-going basis based on a variety of factors. There can be no assurance, however, that actual results will not be materially different than our estimates and assumptions, and that reported results of operation will not be affected by accounting adjustments needed to reflect changes in these estimates and assumptions. The accounting estimates and related risks described in our Annual Report on Form 10-K, as filed with the United States Securities and Exchange Commission on March 8, 2013, are those that we consider to be our critical accounting estimates. For the three months ended March 31, 2013, there have been no material changes in regard to any of our critical accounting estimates.

Non-GAAP Financial Measures

Statutory Surplus

Statutory surplus is a non-GAAP measure with the most directly comparable financial GAAP measure being shareholders' equity. The following is a reconciliation of statutory surplus to shareholders' equity:

          Consolidated Statutory Surplus to GAAP Shareholders' Equity
                        For Period Ending March 31, 2013
                                 (In thousands)

Statutory Consolidated Surplus                                  $ 501,166

Statutory to GAAP differences:
Deferred policy acquisition costs                    51,967
Unrealized gain on securities available for sale     57,749
Non-admitted assets and other                        (4,354 )

Total Statutory to GAAP differences                               105,362

Total Non-Regulated Entities                                      (41,065 )
GAAP Consolidated Shareholders' Equity                          $ 565,463


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Net Operating Income and Net Operating Income Per Share

Net operating income and net operating income per share are non-GAAP measures that represent net income excluding net realized gains or loss, net of tax. The most directly comparable financial GAAP measures to net operating income and net operating income per share are net income and net income per share, respectively. Net operating income and net operating income per share are intended as supplemental information and are not meant to replace net income or net income per share. Net operating income and net operating income per share should be read in conjunction with the GAAP financial results. The following is a reconciliation of net operating income to net income, as well as net operating income per share to net income per share:

                                                        For the Three Months Ended March 31,
                                                        2013                            2012
                                                   (In thousands, except share and per share data)
Net operating income                           $                 6,877         $                 7,527
Net realized gains, net of tax                                     205                             577
Net income                                     $                 7,082         $                 8,104

Diluted earnings per common share:
Net operating income                           $                  0.14         $                  0.15
Net income                                     $                  0.14         $                  0.16
Diluted weighted average common shares
outstanding                                                 49,845,023                      50,921,465

We use net operating income and net operating income per share as components to assess our performance and as measures to evaluate the results of our business. We believe these measures provide investors with valuable information relating to our ongoing performance that may be obscured by the net effect of realized gains and losses as a result of our market risk sensitive instruments, which primarily relate to fixed income securities that are available for sale and not held for trading purposes. Realized gains and losses may vary significantly between periods and are generally driven by external economic developments, such as capital market conditions. Accordingly, net operating income excludes the effect of items that tend to be highly variable from period to period and highlights the results from our ongoing business operations and the underlying loss or profitability of our business. We believe that it is useful for investors to evaluate net operating income and net operating income per share, along with net income and net income per share, when reviewing and evaluating our performance.


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Accident Year Loss Ratio

The accident year loss and LAE ratio is a non-GAAP measure and represents our net loss and LAE ratio excluding the impact of any changes in net ultimate loss estimates on prior year loss and LAE reserves. The most directly comparable financial GAAP measure to the accident year loss and LAE ratio is the net loss and LAE ratio. The accident year loss and LAE ratio is intended as supplemental information and is not meant to replace the net loss and LAE ratio. The accident year loss and LAE ratio should be read in conjunction with the GAAP financial results. The following is a reconciliation of the accident year loss and LAE ratio to the net loss and LAE ratio:

                                                 For the Three Months Ended March 31,
                                                     2013                     2012
Accident year loss and LAE ratio                           69.3 %                   63.5 %
Increase in net ultimate loss estimates on
prior year loss reserves                                    2.1 %                    5.3 %
Net loss & LAE ratio                                       71.4 %                   68.8 %

We use the accident year loss and LAE ratio as one component to assess our current year performance and as a measure to evaluate and, if necessary, adjust our pricing and underwriting. Our net loss and LAE ratio is based on calendar year information. Adjusting this ratio to an accident year loss and LAE ratio allows us to evaluate information based on the current accident year activity. We believe this measure provides investors with valuable information for comparison to historical trends and current industry estimates. We also believe that it is useful for investors to evaluate the accident year loss ratio and LAE and net loss and LAE ratio separately when reviewing and evaluating our performance.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012

Executive Overview

Our results for the first quarter of 2013 were impacted by the increase in net ultimate loss estimates for 2012 and prior accident years, which added 2.1 percentage points to the GAAP combined ratio. The first quarter of 2013 results also reflect a 1.8 combined ratio percentage points impact from the quota share reinsurance treaty that was entered into during the fourth quarter of 2012. Our GAAP combined ratio was 101.1% for the first quarter of 2013 compared to 101.5% for the comparable quarter in 2012. Our accident year combined ratio was 99.0% for the first quarter of 2013, compared to 96.2% in 2012.

Net operating income, a non-GAAP measure, decreased $0.6 million, from $7.5 million, or $0.15 per diluted share for the first quarter ended March 31, 2012, to $6.9 million, or $0.14 per diluted share for the first quarter ended March 31, 2013. The first quarter 2013 results include an after-tax increase in net ultimate loss estimates for 2012 and prior accident years of $2.3 million, or $0.05 per diluted share. By contrast, the first quarter of 2012 results include an after-tax decrease in net ultimate loss estimates for 2011 and prior accident years of $6.6 million, or $0.13 per diluted share. In addition, the first quarter 2013 after-tax results were reduced by $2.2 million, or $0.04 per diluted share as a result of the quota share reinsurance treaty.

Gross written premium increased $9.7 million, or 3.8%, to $267.7 million in 2013, compared to $258.0 million in 2012. This growth primarily reflects the accelerating pace of rate increases that have been achieved in combination with the maturation of existing programs where we are achieving adequate pricing levels. This growth was partially offset by the termination of, or reductions in, certain programs where pricing and underwriting did not meet our targets.


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Results of Operations

Net income for the three months ended March 31, 2013, was $7.1 million, or $0.14 per dilutive share, compared to net income of $8.1 million, or $0.16 per dilutive share, for the comparable period of 2012. Net operating income, a non-GAAP measure, decreased to $6.9 million, or $0.14 per dilutive share, compared to net operating income of $7.5 million, or $0.16 per dilutive share for the comparable period in 2012. Total diluted weighted average shares outstanding for the three months ended March 31, 2013 was 49,845,023 compared to 50,921,465 for the comparable period in 2012. This decrease reflects the impact of our Share Repurchase Plan.

Revenues

Revenues for the three months ended March 31, 2013 decreased $24.6 million, or
11.4%, to $191.7 million, from $216.2 million for the comparable period in
2012. This decrease primarily reflects the reduction within our net earned
premiums.

The following table sets forth the components of revenues (in thousands):

                                   For the Three Months Ended March 31,
                                       2013                    2012
Revenue:
Net earned premiums              $         170,588       $         192,815
Management administrative fees               3,369                   2,927
Claims fees                                  1,743                   1,662
Commission revenue                           4,522                   4,376
Net investment income                       11,140                  13,732
Net realized gains                             316                     732
Total revenue                    $         191,678       $         216,244

Net earned premiums decreased $22.2 million, or 11.5%, to $170.6 million for the three months ended March 31, 2013, from $192.8 million in the comparable period in 2012. This decrease was primarily the result of the quota share reinsurance treaty as well as termination of, or reductions in, certain programs where pricing and underwriting did not meet our targets.

Net investment income decreased by $2.6 million, or 18.9%, to $11.1 million for the three months ended March 31, 2013, from $13.7 million in the comparable period in 2012. The decrease reflects the impact from the fourth quarter 2012 sale of a portion of our bond portfolio in order to generate realized gains. We reinvested the proceeds during the first quarter of 2013, with the replacement of those bonds at lower interest rates.


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Expenses

Expenses decreased $23.8 million from $207.0 million for the three months ended
March 31, 2012 to $183.2 million for the three months ended March 31, 2013.

The following table sets forth the components of expenses (in thousands):

                                                                 For the Three Months Ended March 31,
                                                                     2013                    2012
Expense:
Net losses and loss adjustment expenses                        $         121,816       $         132,747
Policy acquisition and other underwriting expenses                        50,605                  63,113
General selling & administrative expenses                                  6,023                   6,339
General corporate expenses                                                 1,516                   1,373
Amortization expense                                                       1,071                   1,416
Interest expense                                                           2,197                   1,977
Total expenses                                                 $         183,228       $         206,965

Net loss and loss adjustment expenses ("LAE") decreased $10.9 million, to $121.8 million for the three months ended March 31, 2013, from $132.7 million for the same period in 2012. Our loss and LAE ratio was 71.4% for the three months ended March 31, 2013 and 68.8% for the three months ended March 31, 2012. The loss and LAE ratio for the first quarter of 2013 includes a 2.1 percentage point increase from net ultimate loss estimates for accident years 2012 and prior, whereas the 2012 results included a 5.3 percentage point increase from net ultimate loss estimates for accident years 2011 and prior. The accident year loss and LAE ratio was 69.3% for the three months ended March 31, 2013 up from 63.5% in the comparable period in 2012. In addition, the 2013 accident year loss and LAE ratio reflects the cumulative effect of an increase in our 2013 accident year forecasted loss and LAE ratio based upon the increase in net ultimate loss estimates for the 2009, 2010, and 2011 accident years previously recognized in the second and third quarters of 2012, and was partially offset by earned rate increases and other underwriting actions. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section.

Policy acquisition and other underwriting expenses decreased $12.5 million, to $50.6 million for the three months ended March 31, 2013 from $63.1 million for the same period in 2012. Our expense ratio decreased 3.0 percentage points to 29.7% for the three months ended March 31, 2013, from 32.7% for the same period in 2012. This improvement reflects the impact of the quota share reinsurance treaty and our ability to leverage fixed costs and execute on expense management initiatives.

Federal income tax expense for the three months ended March 31, 2013 was $1.7 million, or 20.6% of income before taxes, compared to $1.7 million, or 18.6% of income before taxes, for the same period in 2012. Income tax expense on capital gains and the change in our valuation allowance on deferred tax assets, was $111,000 and $155,000 for the three months ended March 31, 2013 and 2012, respectively. The higher rate reflects a lower proportion of taxable income derived from net investment income, which includes a portion of tax exempt income, as opposed to fee based or underwriting income.


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Other Items

Equity earnings of affiliated, net of tax

In July 2009, our subsidiary, Star, purchased a 28.5% ownership interest in an affiliate, Midwest Financial Holdings, LLC ("MFH"), for $14.8 million in cash. We are not required to consolidate this investment because we are not the primary beneficiary of the business, nor do we control the entity's operations. Our ownership interest is significant, but is less than a majority ownership and, therefore, we are accounting for this investment under the equity method of accounting. Star recognizes 28.5% of the profits and losses as a result of this equity interest ownership. We recognized equity earnings, net of tax, from MFH of $0.3 million, or less than $0.01 per dilutive share, for the three months ended March 31, 2013, compared to $0.7 million, or $0.01 per dilutive share, for the comparable period of 2012. We received dividends from MFH in the three months ended March 31, 2013 and 2012, for $0.4 million and $1.0 million, respectively.

In November 2012, our subsidiary, Century Surety Company, committed to a $10 million strategic equity investment in Aquiline Financial Services Fund II L.P. As of March 31, 2013, approximately $3.8 million of the commitment had been satisfied with $6.2 million of unfunded commitment remaining. Our ownership interest is approximately 1.34% of the fund, which we are accounting for under the equity method of accounting. Century Surety Company will recognize 1.34% of the Fund's profits and losses as a result of this equity interest ownership. We recognized equity earnings, net of tax, from the Aquiline Financial Services Fund II L.P. of $0.2 million, or less than $0.01 per dilutive share, for the three months ended March 31, 2013.


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Reserves

At March 31, 2013, our best estimate for the ultimate liability for loss and LAE
reserves, net of reinsurance recoverables, was $1.1 billion. We established a
reasonable range of reserves of approximately $951.0 million to $1.2 billion.
This range was established primarily by considering the various indications
derived from standard actuarial techniques and other appropriate reserve
considerations. The following table sets forth this range by line of business
(in thousands):

                                                 Minimum        Maximum
                                                 Reserve        Reserve        Selected
Line of Business                                  Range          Range         Reserves

Workers' Compensation                           $ 402,201     $   471,241     $   450,547
Residual Markets                                   19,190          21,254          20,637
Commercial Multiple Peril / General Liability     381,214         493,206         434,468
Commercial Automobile                             118,445         139,270         130,193
Other                                              29,993          34,532          32,196
Total Net Reserves                              $ 951,043     $ 1,159,503     $ 1,068,041

Reserves are reviewed and established by our internal actuaries for adequacy and peer reviewed by our third-party actuaries. When reviewing reserves, we analyze historical data and estimate the impact of numerous factors such as (1) per claim information; (2) industry and our historical loss experience; (3) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (4) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple factors.

The key assumptions used in our selection of ultimate reserves included the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the three months ended March 31, 2013, and the year ended December 31, 2012.


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For the three months ended March 31, 2013, we reported an increase in net ultimate loss estimates for accident years 2012 and prior of $3.6 million, or 0.3% of $1.1 billion of beginning net loss and LAE reserves at December 31, 2012. The change in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2013 that differed from the projected activity. The major components of this change in ultimates are as follows (in thousands):

                                                   Incurred Losses                             Paid Losses
                       Reserves at                                                                                          Reserves at
                       December 31,       Current       Prior         Total        Current        Prior         Total        March 31,
Line of Business           2012            Year         Years       Incurred        Year          Years         Paid            2013

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