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MIG > SEC Filings for MIG > Form 10-Q on 9-May-2014All Recent SEC Filings

Show all filings for MEADOWBROOK INSURANCE GROUP INC

Form 10-Q for MEADOWBROOK INSURANCE GROUP INC


9-May-2014

Quarterly Report


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

For the Periods ended March 31, 2014 and 2013

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; 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, the lowering of the outlook of this ratings from "stable" to "negative", A.M. Best's downgrade of our issuer credit rating and any other future action by A.M. Best with respect to such ratings; 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.


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For additional information with respect to certain of these and other factors, refer to the Item 1A of Part I to our Annual Report on Form 10-K for the year ended December 31, 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, which also owns and operates insurance agencies and an insurance administration services company. 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 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 homogeneous risks that have similar characteristics 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 agency operations, we also generate commission revenue, which represents 2.8% 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 which are placed primarily with unaffiliated insurance carriers. Although our agencies are a minimal source of business for our Insurance Company Subsidiaries, the agency operations remain a core strategy enabling us to balance our sources of revenue and better understand the needs of independent agents within our own insurance carrier operations.

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.


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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 5, 2014, are those that we consider to be our critical accounting estimates. For the three months ended March 31, 2014, 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:

                       Meadowbrook Insurance Group, Inc.
          Consolidated Statutory Surplus to GAAP Shareholders' Equity
                         For Period Ending: March 2014

           Statutory Consolidated Surplus                           496,683

           Statutory to GAAP differences:
           Deferred policy acquisition costs          66,435
           Other                                      (1,398 )

           Total Statutory to GAAP differences                       65,037

           Total Non-Regulated Entities                            (129,926 )

           GAAP Consolidated Shareholders' Equity                   431,794

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:


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                                                        For the Three Months Ended March 31,
                                                        2014                            2013
                                                   (In thousands, except share and per share data)
Net operating income                           $                 8,390         $                 6,877
Net realized gains, net of tax                                   1,966                             205
Net income                                     $                10,356         $                 7,082

Diluted earnings per common share:
Net operating income                           $                  0.17         $                  0.14
Net income                                     $                  0.21         $                  0.14
Diluted weighted average common shares
outstanding                                                 49,984,743                      49,845,023

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.

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
                                                           Ended March 31,
                                                        2014             2013
      Accident year combined ratio                         100.3 %          99.0 %
      (Decrease) increase in net ultimate loss
      estimates on prior year loss reserves                 -0.4 %           2.1 %
      GAAP combined ratio                                   99.9 %         101.1 %

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.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2014 AND 2013

Executive Overview

Our GAAP combined ratio improved by 1.2 percentage points to 99.9% in the first quarter 2014 from 101.1% for the comparable quarter in 2013. This improvement reflects continued stabilization of reserves, improved current accident year loss experience and earned rate increases in excess of loss ratio trends. These improvements were somewhat offset by the cost of using an unaffiliated insurance company for policy issuance, non-recurring severance costs and the deleveraging impact of the anticipated reduction in earned premium associated with the Company's efforts to terminate unprofitable business.

Net operating income, a non-GAAP measure the Company defines as net income excluding after-tax realized gains and losses, increased $1.5 million, from $6.9 million, or $0.14 per diluted share for the first quarter ended March 31, 2013, to $8.4 million, or $0.17 per diluted share for the first quarter ended March 31, 2014.

The first quarter 2014 results include a pre-tax decrease in net ultimate loss estimates for accident years 2013 and prior of a favorable $0.7 million, or 0.4 percentage points of the loss and LAE ratio. The first quarter 2013 results include a pre-tax increase in net ultimate loss estimates for accident years 2012 and prior of an unfavorable $3.6 million, or 2.1 percentage points of the loss and LAE ratio. Our accident year loss and LAE ratio, a non-GAAP measure that excludes changes in net ultimate loss estimates from prior year loss reserves, was 63.9% for the first quarter of 2014 compared to 69.3% for the comparable quarter in 2013, an improvement of 5.4 percentage points.


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Excluding the impact of the previously terminated multi line quota share reinsurance treaty with Swiss Re America Corporation ("Swiss Re Treaty"), the accident year loss and LAE ratio improved 3.3 percentage points to 62.7% for 2014, from 66.0% in 2013. This improvement reflects a 4.8 percentage point improvement relating to earned rate increases of 10.7% which are approximately 9.0 percentage points in excess of loss ratio trends; approximately 1.0 percentage point improvement from underwriting actions; and a 2.4 percentage point improvement from the cessation of earned premium from the run-off of terminated business. These cumulative implied improvements were tempered by a more conservative loss ratio selection for the 2014 accident year. This selection was within standard actuarial methods and based on the inherent risks associated with a less mature accident year.

As planned, gross written premium decreased $66.0 million, or 24.7%, to $201.7 million in 2014, compared to $267.7 million in the same period in 2013. The decline in premium is attributed to the termination of, or reduction in premium from certain programs for which pricing and underwriting did not meet the Company's standards and was offset by an overall 6.8% written rate increase.

Results of Operations

Net income for the three months ended March 31, 2014, was $10.4 million, or $0.21 per dilutive share, compared to net income of $7.1 million, or $0.14 per dilutive share, for the comparable period of 2013. Net operating income, a non-GAAP measure, increased to $8.4 million, or $0.17 per dilutive share, compared to net operating income of $6.9 million, or $0.14 per dilutive share for the comparable period in 2013. Total diluted weighted average shares outstanding for the three months ended March 31, 2014 was 49,984,743 compared to 49,845,023 for the comparable period in 2013. This increase reflects the impact of shares issued under our Long Term Incentive Plan. Refer to Note 8 ~ Earnings Per Share of the Notes to the Consolidated Financial Statements, for additional information specific to the impact of our Long Term Incentive Plan.

Revenues

Revenues for the three months ended March 31, 2014 decreased $2.8 million, or
1.5%, to $188.9 million, from $191.7 million for the comparable period in 2013.
This decrease primarily reflects the reduction within our net earned premiums,
partially offset by an increase in net commissions and fees and net realized
gains.

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

                                                 For the Three Months
                                                    Ended March 31,
                                                  2014           2013
              Revenue:
              Net earned premiums              $   162,539     $ 170,588
              Management administrative fees         5,139         3,369
              Claims fees                            1,667         1,743
              Commission revenue                     5,241         4,522
              Net investment income                 11,261        11,140
              Net realized gains                     3,025           316
              Total revenue                    $   188,872     $ 191,678

Net earned premiums decreased $8.1 million, or 4.7%, to $162.5 million for the three months ended March 31, 2014, from $170.6 million in the comparable period in 2013. This expected decrease was primarily the result of the termination of, or reduction in, certain programs in which pricing and underwriting did not meet our underwriting standards and was offset by an overall 10.7% earned rate increase, which exceeded our estimated loss trend of 1.7%.


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Net commission and fee revenue increased $2.4 million, or 25.0%, to $12.0 million for the three months ended March 31, 2014, from $9.6 million for the comparable period in 2013. This increase was driven primarily by commission revenue generated from our subsidiary US Specialty Underwriters ("USSU") that is no longer considered intercompany (and therefore not eliminated in consolidation) as the applicable polices are now written by SNIC and reinsured by our Insurance Company Subsidiaries. This increase did not impact our consolidated financial results as there is a corresponding increase in the expenses from net commission and fee operations.

Net realized gains increased $2.7 million, to $3.0 million for the three months ended March 31, 2014, from $0.3 million for the comparable period in 2013.

Expenses

Expenses decreased $6.2 million from $183.2 million for the three months ended
March 31, 2013 to $177.0 million for the three months ended March 31, 2014.

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

                                                               For the Three Months Ended
                                                                        March 31,
                                                                  2014             2013
Expense:
Net losses and loss adjustment expenses                        $  103,190       $  121,816
Policy acquisition and other underwriting expenses                 59,198           50,605
General selling & administrative expenses                           8,495            6,023
General corporate expenses                                          1,633            1,516
Amortization expense                                                  987            1,071
Interest expense                                                    3,462            2,197
Total expenses                                                 $  176,965       $  183,228

Net loss and loss adjustment expenses ("LAE") decreased $18.6 million, to $103.2 million for the three months ended March 31, 2014, from $121.8 million for the same period in 2013. Our loss and LAE ratio was 63.5% for the three months ended March 31, 2014 and 71.4% for the three months ended March 31, 2013; an improvement of 7.9 percentage points. The loss and LAE ratio for the first quarter of 2014 includes a 0.4 percentage point decrease from net ultimate loss estimates for accident years 2013 and prior. The accident year loss and LAE ratio was 63.9% for the three months ended March 31, 2014 down from 69.3% in the comparable period in 2013; an improvement of 5.4 percentage points. Additional discussion of our quarterly reserve activity is described below within the Other Items ~ Reserves section.


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Policy acquisition and other underwriting expenses increased $8.6 million, to $59.2 million for the three months ended March 31, 2014 from $50.6 million for the same period in 2013. Our expense ratio increased 6.7% to 36.4% for the first quarter 2014 from 29.7% for the first quarter 2013. Excluding the impact of the Swiss Re Treaty, the expense ratio increased 5.3 percentage points to 36.9% for the three months ended March 31, 2014, from 31.6% for the same period in 2013. The increase in the expense ratio, excluding the Swiss Re Treaty, reflects the impact of non-recurring severance costs of 1.0 percentage point, the cost associated with the use of an unaffiliated "A" rated insurance company for policy issuance of 1.8 percentage points, deleveraging fixed costs in relation to the decrease in earned premium of approximately 2.0 percentage points, and the remaining 0.5 percentage point increase reflects shifts in the mix of business.

Federal income tax expense for the three months ended March 31, 2014 was $2.7 million, or 23.2% of income before taxes, compared to $1.7 million, or 20.6% of income before taxes, for the same period in 2013. Income tax expense on capital gains and the change in our valuation allowance on deferred tax assets was $1.1 million and $0.1 million for the periods ended March 31, 2014 and 2013, 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.

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 $0.6 million, or $0.01 per dilutive share, for the three months ended March 31, 2014, compared to $0.3 million, or less than $0.01 per dilutive share, for the comparable period of 2013. We received dividends from MFH in the three months ended March 31, 2014 and 2013, for $1.5 million and $0.4 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, 2014, approximately $6.4 million of the commitment had been satisfied with $3.6 million of unfunded commitment remaining. Our ownership interest is approximately 1.3% of the fund, which we are accounting for under the equity method of accounting. Century Surety Company will recognize 1.3% 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 $0.7 million, or $0.01 per dilutive share and $0.2 million, or less than $0.01 per dilutive share, for the three months ended March 31, 2014 and 2013, respectively.


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Reserves

The modest favorable development in the first quarter was a function of the cumulative effect of the underwriting and pricing improvements that we have implemented to date as well as our efforts to continue to stabilize key segments of the Company's loss reserves. Workers' compensation reserves developed favorably in the quarter, led by the California-dominated business segments, for which substantial rate and underwriting improvements have been enacted over the last few years. The 2013 accident year reserves for all lines showed favorable signs as the accident year continues to mature. The favorable reserve indications reflect the effectiveness of rate changes, underwriting improvements and termination of underperforming blocks of business since 2012. The 2014 accident year reserve indications reflect additional improvement beyond the 2013 accident year. Reserves on terminated business remained stable in the quarter.

At March 31, 2014, 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 $970.0 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):

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