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MIG > SEC Filings for MIG > Form 10-Q on 12-Nov-2013All Recent SEC Filings

Show all filings for MEADOWBROOK INSURANCE GROUP INC

Form 10-Q for MEADOWBROOK INSURANCE GROUP INC


12-Nov-2013

Quarterly Report


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

For the Periods ended September 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; 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, including the previously disclosed arbitration and class action litigation or any similar litigation which may be filed in the future; 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 Item 1A of Part II Report on Form 10-Q for the second 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.


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Through our retail property and casualty agencies, we also generate commission revenue, which represents 2.0% 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 nine months ended September 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 Nine Months Ended September 30, 2013
                                 (In thousands)

  Statutory Consolidated Surplus                                          $  505,598

  Statutory to GAAP differences:
  Deferred policy acquisition costs                            60,232
  Unrealized gain (loss) on securities available for sale       1,314
  Non-admitted assets and other                                 2,868

  Total Statutory to GAAP differences                                         64,414

  Debt at Holding Company
  Bank Debt                                                   (44,000 )
  Convertible Debt                                            (87,842 )
  Debentures                                                  (80,930 )

  Total Debt at Holding Company                                             (212,772 )

  Total Non-Regulated Entities                                                69,558
  GAAP Consolidated Shareholders' Equity                                  $  426,798

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

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


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                                              For the Three Months Ended           For the Nine Months Ended
                                                    September 30,                        September 30,
                                                2013               2012              2013               2012
                                             (In thousands, except share          (In thousands, except share
                                                 and per share data)                  and per share data)
Net operating income (loss)                $         5,077     $    (27,223 )   $      (103,136 )   $    (28,448 )
Net realized gains, net of tax                         439              613               2,676            2,210
Net income (loss)                          $         5,516     $    (26,610 )   $      (100,460 )   $    (26,238 )

Diluted earnings per common share:
Net operating income (loss)                $          0.10     $      (0.55 )   $         (2.07 )   $      (0.57 )
Net income (loss)                          $          0.11     $      (0.53 )   $         (2.01 )   $      (0.52 )
Diluted weighted average common shares
outstanding                                     49,933,540       49,776,011          49,866,326       50,312,285

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.

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 Nine Months
                                               Ended September 30,            Ended September 30,
                                              2013             2012           2013            2012
Accident year combined ratio                      99.2 %         107.9 %         99.7 %         100.9 %
Increase in net ultimate loss estimates
on prior year loss reserves                        3.8 %          19.2 %          7.0 %          13.0 %
GAAP Combined ratio                              103.0 %         127.1 %        106.7 %         113.9 %

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.


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Year-to-Date Developments

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 development, we could experience a negative impact to our operations.

Agreement to Provide "A" Rated Policy Insurance Solution

Effective July 1, 2013, certain of our Insurance Company Subsidiaries entered into quota share reinsurance agreement(s) with State National Insurance Company, National Specialty Insurance Company and United Specialty Insurance Company (collectively, "SNIC"), which will provide certain of our Insurance Company Subsidiaries the use of an "A" rated policy issuance carrier for a portion of the Company's business where an "A" rated policy issuer is required. For the three months ended September 30, 2013, we assumed $85.1 million in direct written premium from SNIC. The impact of the fee on the three and nine months ended September 30, 2013 expense ratios were 0.4% and 0.2%, respectively.

Termination of Quota Share Reinsurance Treaty

The quota share reinsurance treaty entered into December 31, 2012 was terminated in the third quarter for business effective October 1, 2013 and after. At September 30, 2013, we had ceded unearned premium of $40.0 million, which will be earned over the next twelve months, based on the premium effective date. The total pre-tax costs remaining, are $2.8 million (7% of the $40.0 million in ceded unearned premium), or $0.06 per share.

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

Executive Overview

Our results for the third quarter of 2013 were impacted by the increase in net ultimate loss estimates for 2012 and prior accident years, which added 3.8 percentage points to the GAAP combined ratio. The third quarter of 2013 results also reflect a 1.6 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 103.0% for the third quarter of 2013 compared to 127.1% for the comparable period in 2012. Our accident year combined ratio was 99.2% for the third quarter of 2013, compared to 107.9% in 2012. The third quarter of 2013 was also impacted by after-tax storm losses of $3.8 million, or $0.08 per diluted share, compared to $8.4 million, or $0.17 per diluted share, in the same quarter of 2012.

Net operating income (loss), a non-GAAP measure, increased $32.3 million, from a loss of $27.2 million, or ($0.55) per diluted share for the third quarter ended September 30, 2012, to net operating income of $5.1 million, or $0.10 per diluted share for the third quarter ended September 30, 2013. The third quarter 2013 results include an after-tax increase in net ultimate loss estimates for 2012 and prior accident years of $4.5 million, or $0.09 per diluted share. The third quarter of 2012 results include an after-tax increase in net ultimate loss estimates for 2011 and prior accident years of $27.9 million, or $0.56 per diluted share. In addition, the third quarter 2013 after-tax results were reduced by $1.5 million, or $0.03 per diluted share as a result of the quota share reinsurance treaty.

Gross written premium decreased $48.9 million, or 16.0%, to $257.0 million in 2013, compared to $305.9 million in 2012. This decrease primarily reflects the impact of business that was terminated during the fourth quarter of 2012 and planned premium reductions in specific underperforming programs. The decrease was partly offset by achieved rate increases and the maturation of existing programs.


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Results of Operations

Net income for the three months ended September 30, 2013, was $5.5 million, or $0.11 per dilutive share compared to net loss of ($26.6 million), or ($0.53) per dilutive share, for the comparable period of 2012. Net operating income, a non-GAAP measure, for the three months ended September 30, 2013 was $5.1 million or $0.10 per dilutive share, compared to net operating loss of ($27.2 million), or ($0.55) per dilutive share for the comparable period in 2012. Total diluted weighted average shares outstanding for the three months ended September 30, 2013 was 49,933,540 compared to 49,776,011 for the comparable period in 2012.
This increase was caused by the issuance of certain stock awards.

Revenues

Revenues for the three months ended September 30, 2013 decreased $41.7 million,
or 17.0%, to $203.9 million, from $245.5 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 September 30,
                                                  2013           2012
              Revenue:
              Net earned premiums              $   181,056     $ 223,407
              Management administrative fees         5,270         2,705
              Claims fees                            1,736         1,596
              Commission revenue                     3,452         3,109
              Net investment income                 11,695        13,815
              Net realized gains                       675           902
              Total revenue                    $   203,884     $ 245,534

Net earned premiums decreased $42.4 million, or 19.0%, to $181.1 million for the three months ended September 30, 2013, compared to $223.4 million for the same 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 $2.1 million, or 15.3%, to $11.7 million for the three months ended September 30, 2013, compared to $13.8 million for the same 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 from the sale during the first quarter of 2013, at lower interest rates.

Management administrative fees increased by $2.6 million, or 95%, from $2.7 million in the third quarter 2012 to $5.3 million in third quarter of 2013. In the third quarter of 2013, a portion of our management administrative fee revenue that was previously eliminated as an intercompany transaction is now included with the SNIC policy issuance relationship. As such, that portion of the fee is no longer eliminated as it is considered third party revenue.


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Expenses

Expenses decreased $95.1 million from $294.3 million for the three months ended
September 30, 2012 compared to $199.1 million for the three months ended
September 30, 2013. This decrease was primarily driven by an $80.5 million
decrease in net losses and loss adjustment expenses.

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

                                                           For the Three Months
                                                            Ended September 30,
                                                            2013           2012
    Expense:
    Net losses and loss adjustment expenses              $   132,247     $ 212,698
    Policy acquisition and other underwriting expenses        54,228        71,373
    General selling & administrative expenses                  7,026         5,745
    General corporate expenses                                 1,025           717
    Amortization expense                                       1,037         1,372
    Interest expense                                           3,581         2,372
    Total expenses                                       $   199,144     $ 294,277

Net loss and loss adjustment expenses ("LAE") decreased $80.5 million, to $132.2 million for the three months ended September 30, 2013, compared to $212.7 million for the same period in 2012. Our calendar year loss and LAE ratio was 73.0% for the three months ended September 30, 2013 compared to 95.2% for the three months ended September 30, 2012. The loss and LAE ratio for the third quarter of 2013 includes a 3.8 percentage point increase from net ultimate loss estimates for accident years 2012 and prior, whereas the 2012 results included a 19.2 percentage point increase from net ultimate loss estimates for accident years 2011 and prior. The accident year loss and LAE ratio was 69.2% for the three months ended September 30, 2013 compared to 76.0% for the three months ended September 30, 2012. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section.

Policy acquisition and other underwriting expenses decreased $17.1 million, to $54.2 million for the three months ended September 30, 2013 compared to $71.4 million for the same period in 2012. Our expense ratio decreased 1.9 percentage points to 30.0% for the three months ended September 30, 2013, compared to 31.9% for the same period in 2012. The decrease in the expense ratio reflects the benefit of the ceding commission from the quota share reinsurance treaty of $17.4 million in the third quarter of 2013 that did not exist in third quarter 2012, partially offset by an increase in corporate overhead costs related to a reallocation of overhead costs from the Company's fee-for service operations to the Insurance Company Subsidiaries' operations. The reallocation added 1.4 percentage points to the expense ratio and reflected a shift of corporate resources used to support capital and operating enhancements focused on strengthening statutory surplus and returning the insurance companies to an underwriting profit. This reallocation had no net income effect as there was a corresponding decrease to general selling & administrative costs.

Interest expense for the three months ended September 30, 2013 increased $1.2 million, to $3.6 million, compared to $2.4 million for the same 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 September 30, 2013 and 2012 was 6.9% and 43.9% respectively. These rates include adjustments to an annual operating effective tax rate. The expected annual operating tax rate primarily excludes discrete charges related to the arbitration allowance and the goodwill impairment charge taken during the second quarter of 2013. Excluding these discrete items, the annual operating effective tax rate for 2013 is expected to be approximately (8.8%). Income tax expense on capital gains and the change in our valuation allowance on deferred tax assets was $0.2 million and $0.3 million for the three months ended September 30, 2013 and 2012, respectively. The lower 2013 quarterly operating federal effective tax rate reflects a higher concentration of tax-advantaged investment income compared to 2012.


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RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2013 AND 2012

Executive Overview

Our results for the nine months ended September 30, 2013 were impacted by a $115.4 million, or $2.31 per diluted share, goodwill impairment charge that we recorded during the second quarter of 2013, as described in Note 9 - Goodwill of the Notes to the Consolidated Financial Statements. In addition, our results for the nine months ended September 30, 2013 were impacted by an evaluation of the impact of an adverse interim final award from a reinsurance arbitration, which added 1.3 percentage points to the GAAP combined ratio before the impact of the quota share reinsurance treaty, and the increase in net ultimate loss estimates for 2012 and prior accident years, which added 7.0 percentage points to the GAAP combined ratio. The nine months ended September 30, 2013 results also reflect a 2.6 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 106.7% for the nine months ended September 30, 2013, compared . . .

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