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MIG > SEC Filings for MIG > Form 10-Q on 14-Aug-2013All Recent SEC Filings

Show all filings for MEADOWBROOK INSURANCE GROUP INC

Form 10-Q for MEADOWBROOK INSURANCE GROUP INC


14-Aug-2013

Quarterly Report


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

For the Periods ended June 30, 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 ability to secure a waiver from our lenders under our credit agreement in connection with the financial covenant non-compliance described under Note 4 - Debt; a failure of additional capital to be available or only available on unfavorable terms; 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 and the anticipated impact of the goodwill impairment charge recognized in the second quarter of 2013; efforts with regard to the review of strategic alternatives; actions taken by regulators, rating agencies or lenders, including the impact of the downgrade by
A.M. Best of the Company's Insurance Company Subsidiaries' financial strength 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; 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.


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For additional information with respect to certain of these and other factors, refer to the Item 1A of Part II Report on Form 10-Q for the first quarter ended June 30, 2013 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.

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 2.2% 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.

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 and six months ended June 30, 2013, there have been no material changes in regard to any of our critical accounting estimates.


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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:

                       Meadowbrook Insurance Group, Inc.

          Consolidated Statutory Surplus to GAAP Shareholders' Equity
                       For Six Months Ended June 30, 2013
                                 (In thousands)

Statutory Consolidated Surplus                                         $  498,393

Statutory to GAAP differences:
Deferred policy acquisition costs                           54,904
Unrealized gain (loss) on securities available for sale       (114 )
Non-admitted assets and other                               13,226

Total Statutory to GAAP differences                                        68,016

Total Non-Regulated Entities                                             (146,943 )
GAAP Consolidated Shareholders' Equity                                 $  419,466

Net Operating (Loss) Income and Net Operating (Loss) Income Per Share

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


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                                               For the Three Months Ended              For the Six Months Ended
                                                        June 30,                               June 30,
                                                2013                 2012              2013                2012
                                           (In thousands, except share and per      (In thousands, except share and
                                                       share data)                          per share data)
Net operating (loss) income                $      (115,090 )     $      (8,752 )   $    (108,213 )     $      (1,225 )
Net realized gains, net of tax                       2,032               1,020             2,237               1,597
Net (loss) income                          $      (113,058 )     $      (7,732 )   $    (105,976 )     $         372

Diluted earnings per common share:
Net operating (loss) income                $         (2.31 )     $       (0.17 )   $       (2.17 )     $       (0.02 )
Net (loss) income                          $         (2.27 )     $       (0.15 )   $       (2.13 )     $        0.01
Diluted weighted average common shares
outstanding                                     49,887,200          50,251,591        49,855,716          50,583,368

We use net operating (loss) income and net operating (loss) 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 (loss) 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 (loss) income and net operating (loss) income per share, along with net (loss) income and net
(loss) income per share, when reviewing and evaluating our performance.

Combined Ratio

The combined loss and expense ratio (or combined ratio), expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty insurance business. The combined ratio is a statutory (non-GAAP) accounting measurement, which represents the sum of (i) the ratio of losses and loss expenses to premiums earned (loss ratio), plus (ii) the ratio of underwriting expenses to premiums written (expense ratio). The combined ratios above have been modified to reflect GAAP accounting, as we evaluate the performance of our underwriting operations using the GAAP combined ratio. Specifically, the GAAP combined ratio is the sum of the loss ratio, plus the ratio of GAAP underwriting expenses (which include the change in deferred policy acquisition costs) to premiums earned (expense ratio). When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable.


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The accident year combined ratio is a non-GAAP measure that excludes changes in net ultimate loss estimates from prior accident year loss reserves. The accident year combined ratio provides us with an assessment of the specific policy year's profitability (which matches policy pricing with related losses) and assists us in our evaluation of product pricing levels and quality of business written. We use accident year combined ratio as one component to assess the Company's current year performance and as a measure to evaluate, and if necessary, adjust current year pricing and underwriting. The following is a reconciliation of the accident year combined ratio to the GAAP combined ratio:

                                              For the Three Months            For the Six Months
                                                 Ended June 30,                 Ended June 30,
                                              2013             2012           2013           2012
Accident year combined ratio                     100.9 %          97.8 %         99.9 %         97.1 %
Increase in net ultimate loss estimates
on prior year loss reserves                       15.1 %          13.3 %          8.7 %          9.5 %
GAAP Combined ratio                              116.0 %         111.1 %        108.6 %        106.6 %

We believe the accident year combined ratio 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 combined ratio and GAAP combined ratio separately when reviewing and evaluating our performance.

Recent Developments

Adverse Reinsurance Arbitration Award

On July 23, 2013, we were notified of an adverse interim final award in a reinsurance arbitration against us on ceded losses that date back to a reinsurance treaty in place for the 1999 to 2001 policy periods, a provision for these ceded losses was recorded as a $5.2 million allowance for ceded recoverables. With an accrual for other items of approximately $2.9 million, the total pre-tax impact was $8.2 million and the after-tax impact was $5.3 million, or $0.11 per diluted share. This subsequent event was recorded in the second quarter 2013 financial statements. Refer to Note 9 ~ Commitments and Contingencies, for additional information specific to the arbitration award.

A.M. Best Downgrades the Company's Financial Strength Rating

On August 2, 2013, A.M. Best Company ("A.M. Best") lowered Meadowbrook's issuer credit rating, as well its financial strength ratings and downgraded the Company's Insurance Company Subsidiaries' financial strength rating from "A-" (Excellent) with a "negative" outlook to "B++" (Good) with a "stable" outlook. As a result of this recent development we could experience a negative impact to our operations as described in our updated risk factors section below.


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Agreement to Provide "A" Rated Policy Insurance Solution

On August 4, 2013, our Insurance Company Subsidiaries entered into agreements with State National Insurance Company and its affiliates, which will provide our Insurance Company Subsidiaries the use of an "A" rated policy insurance company for a portion of its business where an "A" rated policy issuer is required.

Goodwill Impairment

The company recorded a non-cash impairment of goodwill of $115.4 million in the three months ended June 30, 2013, as described in Note 11 ~ Subsequent Events.

Financial Covenants

As of June 30, 2013, we were not in compliance with some of our financial covenants applicable to the Credit Facilities as a result of the goodwill impairment recorded in the second quarter of 2013. While we remain in discussions with the lending group to amend the loan agreements that may include obtaining a waiver and revision of the financial covenants. We have not obtained, and there can be no assurance that we will obtain such an amendment. Refer to Note 4 ~ Debt, for additional information specific to our financial covenants.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2013 AND 2012

Executive Overview

Our results for the second quarter of 2013 were impacted by a $115.4 million, or $2.31 per diluted share, goodwill impairment charge that we recorded as described under "Recent Developments". In addition our results for the second quarter of 2013 were impacted by an evaluation of the impact of an adverse interim final reinsurance arbitration award, which added 3.8 percentage points to the GAAP combined ratio, above average storm losses, which added 2.7 percentage points to the GAAP combined ratio, and the increase in net ultimate loss estimates for 2012 and prior accident years, which added 15.1 percentage points to the GAAP combined ratio. The second quarter of 2013 results also reflect a 4.5 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 116.0% for the second quarter of 2013, compared to a GAAP combined ratio of 111.1% for the comparable quarter in 2012. Our accident year combined ratio was 100.9% for the second quarter of 2013, compared to 97.8% in 2012.

Net operating loss, a non-GAAP measure, was ($115.1 million), or ($2.31) per diluted share for the second quarter ended June 30, 2013. Excluding the impact of the goodwill impairment charge, net operating loss was ($13.6 million), or ($0.27) per diluted share for the second quarter ended June 30, 2013, compared to net operating loss of ($8.8 million), or ($0.17) per diluted share for the second quarter ended June 30, 2012. The second quarter 2013 results include an after-tax increase in net ultimate loss estimates for 2012 and prior accident years of $17.2 million, or $0.35 per diluted share. By contrast, the second quarter of 2012 results include an after-tax increase in net ultimate loss estimates for 2011 and prior accident years of $18.3 million, or $0.37 per diluted share. The second quarter 2013 after-tax results were impacted by $5.3 million, or $0.11 per diluted share, as a result of the adverse reinsurance arbitration award and $3.8 million, or $0.08 per diluted share, as a result of above average storm losses. In addition, the second quarter 2013 after-tax results were impacted by $2.0 million, or $0.04 per diluted share as a result of the quota share reinsurance treaty.


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Gross written premium decreased to $234.1 million in the second quarter ended June 30, 2013, compared to $256.1 million in the comparable period of 2012. This anticipated decrease primarily reflects the impact of business that was discontinued in 2012. This decrease was largely offset by the accelerating pace of rate increases that have been achieved in combination with the maturation of existing programs.

Results of Operations

Net loss for the three months ended June 30, 2013, was ($113.1 million), or ($2.27) per dilutive share. Excluding the impact of the goodwill impairment charge, net loss for the three months ended June 30, 2013, was ($11.5 million), or ($0.23) per dilutive share, compared to net loss of ($7.7 million), or ($0.15) per dilutive share, for the comparable period of 2012. Net operating loss, a non-GAAP measure, for the three months ended June 30, 2013 was ($115.1 million) or ($2.31) per dilutive share. Excluding the impact of the goodwill impairment charge, net operation loss for the three months ended June 30, 2013 was ($13.6 million), or ($0.27) per dilutive share, compared to net operating loss of ($8.8 million), or ($0.17) per dilutive share for the comparable period in 2012. Total diluted weighted average shares outstanding for the three months ended June 30, 2013 was 49,887,200 compared to 50,251,591 for the comparable period in 2012. This decrease reflects the impact of our Share Repurchase Plan.

Revenues

Revenues for the three months ended June 30, 2013 decreased $36.1 million, or
15.4%, to $199.0 million, from $235.1 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 June 30,
                                    2013           2012
Revenue:
Net earned premiums              $   175,781     $ 211,303
Management administrative fees         2,791         2,823
Claims fees                            1,674         1.599
Commission revenue                     4,074         4,130
Net investment income                 11,768        13,683
Net realized gains                     2,869         1,567
Total revenue                    $   198,957     $ 235,105

Net earned premiums decreased $35.5 million, or 16.8%, to $175.8 million for the three months ended June 30, 2013, from $211.3 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.


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Net investment income decreased by $1.9 million, or 14.0%, to $11.8 million for the three months ended June 30, 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.

Net realized gains increased by $1.3 million, or 83.1%, to $2.9 million for the three months ended June 30, 2013, from $1.6 million in the comparable period in 2012. The increase in realized gains during 2013 relates to higher volume of sales primarily from repositioning our common equity portfolio.

Expenses

Expenses increased $85.4 million from $245.2 million for the three months ended
June 30, 2012 to $330.6 million for the three months ended June 30, 2013. This
increase primarily reflects the $115.4 million goodwill impairment as discussed
under "Recent Developments".

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

                                                       For the Three Months
                                                          Ended June 30,
                                                        2013           2012
Expense:
Net losses and loss adjustment expenses              $   145,371     $ 165,758
Policy acquisition and other underwriting expenses        58,450        68,993
General selling & administrative expenses                  5,901         6,327
General corporate expenses                                   760           758
Amortization expense                                       1,038         1,307
Goodwill impairment expense                              115,397             -
Interest expense                                           3,653         2,033
Total expenses                                       $   330,570     $ 245,176

Net loss and loss adjustment expenses ("LAE") decreased $20.4 million, to $145.4 million for the three months ended June 30, 2013, from $165.8 million for the same period in 2012. Our calendar year loss and LAE ratio was 82.7% for the three months ended June 30, 2013 and 78.4% for the three months ended June 30, 2012. The loss and LAE ratio for the second quarter of 2013 includes a 15.1 percentage point increase from net ultimate loss estimates for accident years 2012 and prior, whereas the 2012 results included a 13.4 percentage point increase from net ultimate loss estimates for accident years 2011 and prior. The accident year loss and LAE ratio was 67.6% for the three months ended June 30, 2013 and 65.1% for the three months ended June 30, 2012. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section.


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Policy acquisition and other underwriting expenses decreased $10.5 million, to $58.5 million for the three months ended June 30, 2013 from $69.0 million for the same period in 2012. Our expense ratio increased 0.6 percentage points to 33.3% for the three months ended June 30, 2013, from 32.7% for the same period in 2012. The increase in the expense ratio reflects the adverse reinsurance arbitration result which was partly offset by our ability to leverage fixed costs and growth in business where we receive a ceding commission for providing insurance services to a workers' compensation placement facility.

Interest expense for the three months ended June 30, 2013 increased $1.6 million, to $3.6 million, from $2.0 million for the comparable period in 2012. The increase in interest expense is primarily attributed to the Notes we issued in the first quarter of 2013.

The GAAP effective tax rate for the three months ended June 30, 2013 and 2012 was 13.5% and 18.2% respectively. These rates include adjustments to an annual operating effective tax rate. The annual operating effective tax rate for 2013 is expected to be approximately 4.8%. Income tax expense (benefit) on capital gains and the change in our valuation allowance on deferred tax assets was $0.8 million and $0.5 million for the three months ended June 30, 2013 and 2012, respectively. Excluding the impact of the goodwill impairment, the GAAP effective tax rate for the three months ended Jun 30, 2013 would have been 23.7%. The higher GAAP effective tax rate reflects a larger adjustment to the annual operating effective tax rate in 2013 compared to 2012.

RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2013 AND 2012

Executive Overview

Our results for the six months ended June 30, 2013 were impacted by a $115.4 million, or $2.31 per diluted share, goodwill impairment charge that we recorded . . .

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