UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-K

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2013

OR

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-14094

MEADOWBROOK INSURANCE GROUP, INC.

(Exact name of Registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (248) 358-1100

Securities registered pursuant to Section 12(b) of the Act:

 

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes o No x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x   No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

Smaller reporting company o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

The aggregate market value of the voting and non-voting common stock held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of June 30, 2013 was $400,594,216.  As of February 21, 2014, there were 49,887,200 shares of the Company’s common stock ($.01 par value) outstanding.

Documents Incorporated by Reference

Certain portions of the Registrant’s Proxy Statement for the 2014 Annual Shareholders’ Meeting scheduled for May 16, 2014 are incorporated by reference into Part III of this report.

 

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MEADOWBROOK INSURANCE GROUP, INC.

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PART I

ITEM 1. BUSINESS

Legal Organization

Meadowbrook Insurance Group, Inc. (NYSE: MIG) is a holding company organized as a Michigan corporation in 1985. Our principal executive offices are located at 26255 American Drive, Southfield, Michigan 48034-6112 (telephone number: (248) 358-1100). Meadowbrook was initially founded in 1955 as “Meadowbrook Insurance Agency” and was subsequently incorporated in Michigan in 1965.

As used in this Form 10-K, references to the “Company”, “we”, “us”, or “our” refer to Meadowbrook Insurance Group, Inc. (“Meadowbrook”) and its subsidiaries: Star Insurance Company (“Star”), ProCentury Corporation (“ProCentury”), Meadowbrook Inc., and Crest Financial Corporation. References to Meadowbrook also include Star’s wholly-owned subsidiaries Ameritrust Insurance Corporation (“Ameritrust”), Savers Property and Casualty Insurance Company (“Savers”), and Williamsburg National Insurance Company (“Williamsburg”) and ProCentury’s wholly-owned subsidiaries Century Surety Company (“Century”), ProCentury Insurance Company (“PIC”), and ProCentury Risk Partners Insurance Company (“PROPIC”).

Star, Savers, Williamsburg, Ameritrust, Century, and PIC are collectively referred to as the “Insurance Company Subsidiaries.”

Recent Developments

Adverse Loss Development

In 2013, we experienced significant adverse loss development in prior accident years.  For the year ended December 31, 2103, we reported an increase in net ultimate loss estimates for accident years 2012 and prior of $68.4 million, $31.4 million of which was recorded in the fourth quarter of 2013.

A.M. Best Downgrades the Company’s Issuer Credit Rating

Following the release of our 2013 fourth quarter results, on February 21, 2014, A.M. Best Company (“A.M. Best”) downgraded the issuer credit rating for our Insurance Company Subsidiaries to “bbb” from “bbb+” while affirming their financial strength rating of B++ (Good).  A.M. Best also downgraded Meadowbrook’s issuer credit rating to “bb” from “bb+” and revised the outlook for the Insurance Company Subsidiaries to "negative" from "stable".  As a result of this recent development, we could experience a negative impact to our operations as described under "Risk Factors" below.

Business Overview

 

The Company’s objective is to create value by emphasizing a regional focus and diverse source of revenues between underwriting premiums, fee-for-service revenue and commissions:

Within our insurance company operations, we believe our approach balances an effective local touch with efficient national coordination and positions us to opportunistically pursue a wide range of business in response to changing market conditions.

 

Within our fee-for-service operations, we generate fee revenue by providing administrative and risk management services to self-insured groups, municipal pools and trusts.

Through our agency operations, we earn commission revenue through securing quality business and personal insurance products for our clients.

Our mission dictates our commitment to serving:

 

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MEADOWBROOK INSURANCE GROUP, INC.

Our strategy is to generate profitable results and to deliver consistent, long-term shareholder value. To achieve these results we seek to leverage the unique characteristics of our balanced business model to generate:

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consistent, profitable underwriting results;

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predictable investment income in a low-risk, high-quality, primarily fixed income portfolio;

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steady fee and commission income;

·

strong cash flow from our Insurance Company Subsidiaries and non-regulated fee-based services to leverage invested assets to equity and mange debt service;

·

steady growth through rate increases and select new business with proven track records;

We create a competitive advantage by investing in the talent and technology to efficiently service our clients; through strategically identified industry niches and individual account selectivity; and adequate pricing and focused claims handling.

We monitor our objectives and strategy within the context of the interest rate environment, insurance market cycle conditions, inflation and general economic conditions. Our enterprise risk management (“ERM”) and capital management strategies are designed to ensure our compliance with regulatory guidelines and that our industry reputation is in good-standing.  As we seek to maximize long-term shareholder value, our priorities and corresponding risk appetite may be influenced by these factors.

 

The Meadowbrook Approach

We have built our business in a manner that is designed to adapt to changing market conditions and deliver more predictable results. The following highlights key aspects of our model that contribute to our balanced approach:

Diverse Revenue Sources: We generate the vast majority of our revenues from net earned premiums. To help generate our premiums, we have developed specialty niche expertise relative to a wide range of underwriting risks. Consequently, our premium base is broadly diversified by line of business, customer, type of distribution and geography. We also generate fee-for-service revenues from risk management services and commission revenue from our agencies that are not related to our insurance underwriting operations. Our range of capabilities provides flexibility for our long-term business development efforts as we seek to generate profitable growth. We also believe revenue diversification reduces our risk profile and enhances the sustainability of our business model.

Positioned to Manage Insurance Cycles: We serve markets that operate on different cycles and believe our mix of admitted and non-admitted capabilities enhances our balanced business model. Our admitted market capabilities generally provide a consistent source of revenues as this market generally has less pronounced cycles, higher renewal retentions, and more stable pricing than the non-admitted markets. Our non-admitted capabilities enable us to respond opportunistically to otherwise unavailable insurance and volatile pricing environments.

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MEADOWBROOK INSURANCE GROUP, INC.

Conservative Investment Philosophy: We seek to generate consistent investment income through a low-risk, high-quality investment portfolio.  We manage overall credit, interest rate, and liquidity risks when making investment decisions. We invest in highly-rated, investment grade securities. The duration of our high quality investment portfolio is well matched to our loss reserves and our investment approach reinforces our focus on underwriting profitability.

Ability to Attract and Retain Talented Insurance Professionals throughout United States: We have assembled a team of talented insurance professionals and are committed to providing career development opportunities and building a culture focused on delivering superior customer service. Our associates possess a wide range of expertise across all functions and lines of business. Moreover, our regional structure enables our associates to deliver strong and responsive local service to our clients. We believe this is a unique aspect of our business model that enables us to better serve our agency network.

Culture of Disciplined Underwriting, Claims Handling & Reserving: We have built a control environment that emphasizes a commitment to disciplined underwriting, claims handling and reserving. New business opportunities undergo a rigorous due diligence process with input provided from key functional areas and existing business is actively managed as discussed below.

Our underwriters are focused on achieving pricing adequacy and appropriate risk selection through adherence to program or insurance product underwriting guidelines. Underwriting trends are closely monitored, which enables us to proactively manage our business as we seek to deliver more predictable results. Our specialty lines products rely on dedicated underwriter leadership whereby the product is managed to meet a defined type of insured and we retain full underwriting and pricing authority.  Our main street excess and surplus lines business includes binding authority and brokerage production sources. Our non-admitted program business employs dedicated underwriting specialists in the particular class of business being considered. These professionals review policy files for completeness and compliance with our terms, conduct on-site audits, and, when necessary, send and enforce underwriting notifications on files found to be out of compliance.  With regard to property coverages, we limit exposures from catastrophe prone areas and purchase excess of loss and catastrophe reinsurance.

Additionally, our actuarial associates support underwriting with pricing and loss analysis. Corporate loss reserves are determined for each line of business, as Meadowbrook regularly performs a complete and detailed reserve analysis. Meadowbrook’s actuaries utilize both standard and proprietary systems to accurately and efficiently analyze reserves. We also engage an outside actuarial firm to review our reserve estimates.

Finally, we have built a strong claims handling function internally that plays a substantial role in claims management and handling activities. Meadowbrook employs approximately 252 claims personnel who operate from 14 regional offices, located throughout the United States. We also operate a centralized support call center and manage a network of independent adjusters. Claims monitoring is conducted through self and corporate audits, internal controls and executive oversight reports.

Description of Programs, Products, and Services

We market and underwrite specialty property and casualty insurance programs and products on both an admitted and non-admitted basis. We categorize our products into the following four categories:

Admitted Programs and Standard Market Products: The admitted programs that we write are characterized by risks that are homogeneous or similar within specialty line, class and niche segments of business but have a diverse geographic profile. We also write a range of standard market products that are distributed through specialty agents.  Generally, the average account premium for our admitted programs and standard market products is approximately $6,500.  Due to the specialized nature of the program and distribution style, our admitted programs tend to have higher premium retention levels. This helps create stability in our business amid the cyclicality of the insurance industry.  Examples of admitted programs we underwrite include coverages for the food service industry, educators, physicians, agricultural businesses and public entities. The largest line of business for our standard market products is workers’ compensation.

Main Street Excess and Surplus Lines: The excess and surplus lines business we write include broad classes of “Main Street” commercial risks that are generally ineligible for coverage by the standard market.  Generally, the average account premium for our excess and surplus lines risks is approximately $2,250.  The excess and surplus lines regulatory environment allows rate and form freedom, which gives us the flexibility to design tailored coverage forms that are often more restrictive than those available in the admitted market. The high degree of flexibility contributes to heightened competition during soft markets and creates the potential for rapid expansion during hard markets. Examples of our excess and surplus lines business we underwrite include coverages for restaurants, bars/taverns, apartments, hotels/motels, and contractors’ liability.  These examples and sub-classes can change as underwriting circumstances dictate.

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MEADOWBROOK INSURANCE GROUP, INC.

Non-Admitted Programs: The non-admitted programs we write have characteristics that are similar to our admitted programs; however, the commercial risks we provide coverage for are generally ineligible for coverage by the standard or admitted market. With this focus on non-admitted program underwriting, we are able to provide coverage for start-up organizations and relatively low volume programs that other markets are unable or unwilling to serve. Examples of non-admitted programs we offer include coverages for pet-sitters, oil and gas contractors, and professional liability.

Specialty Market Products: We also offer specialty market products, where specific and unique underwriting expertise is required.  We develop product solutions designed for specific specialty lines and market segments that may leverage either our admitted market or non-admitted market product capabilities, or both, depending on the market need. The specific and unique underwriting expertise that is required to write business in the segments we serve creates barriers to entry for new competitors. Examples of specialty markets we serve are the excess workers’ compensation, environmental, and marine markets.

As part of delivering our insurance programs and products, we are actively involved in a range of activities as described below:

Program and Product Design. Before implementing a new program on behalf of a client, we generally review: (1) financial projections for the contemplated program, (2) historical loss and actuarial experience, (3) actuarial studies of the underlying risks, (4) the credit worthiness of the potential agent or client, and (5) the availability of reinsurance. Our senior management team and associates representing each of the risk-management disciplines work together to design, market, and implement new programs. Our due diligence process is structured to provide an underwriting risk assessment of the program and how the program fits within our client’s entity wide business plan and our overall risk profile.

Underwriting Risk Selection and Policy Issuance. Our underwriting personnel help develop the proper criteria for selecting risks, while actuarial and reinsurance personnel evaluate and recommend the appropriate levels of rate and risk retention. The program is then tailored according to the requirements and qualifications of each client. With managed programs, we may also perform underwriting services based upon the profile of the specific program for a fee.

Claims Administration and Handling.  We provide substantially all claims management and handling services for workers’ compensation and most other lines, such as property, automobile liability, professional liability, and general liability. Our claims handling is managed by our field offices. Our corporate claims department monitors the results through self-audits, corporate claim audits, internal controls, and other executive oversight reports. With the exception of Midwest Financial Holdings, LLC (“MFH”), where we have direct access to their paid and case reserve loss data and perform corporate claims audits, we handle substantially all claims functions for the majority of the programs we underwrite. Our involvement in claims administration and handling provides benchmarks and valuable feedback to program managers in assessing the client’s risk environment and the overall structure of the program.

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MEADOWBROOK INSURANCE GROUP, INC.

Agency.  We earn commission revenue through the operation of our independent retail insurance agencies, located in Michigan, California, Massachusetts and Florida. These agencies produce commercial, personal lines, life and accident and health insurance that is placed primarily with unaffiliated insurance carriers.

We market our specialty property and casualty insurance 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 (referred to as, “agents” or “producers”). On a limited basis, some of our producers provide certain policy issuance functions on our behalf.

Unlike traditional standard market companies that sell a full menu of insurance products through their distribution network, we selectively determine distribution and target agents that meet the specific product focus and needs for each of our targeted programs for our admitted business. We seek program agents with a primary focus and established niche expertise and where our relationship is a significant if not a majority source of their revenues.

Our largest producer in 2013 was Midwest General Insurance Agency, LLC (“Midwest General”), which, in combination with its affiliates, accounted for 14.5% of our gross written premium. We have a 28.5% equity interest in Midwest General Agency’s parent, MWFH. No other producer was responsible for more than 10% of our gross written premium.

We seek to offer incentives to our distribution network in a manner that aligns our distributors’ financial interests with our balanced business model. We believe that risk-sharing motivates participants to focus on underwriting selection, loss prevention, risk control measures and adherence to stricter underwriting guidelines. Risk sharing structures are designed based on the particular risk management goals of our clients, market conditions and our assessment of the opportunity for generating operating profit. We categorize risk sharing into two categories: profit sharing and quota sharing.

Profit-Sharing: In addition to the initial commission allowed to the program agent, we at times offer various program dependent, profit-sharing commission contracts. These are tailored to the specific product and its attributes.

Quota Sharing: A second way we offer incentives to our producers is through quota-share reinsurance structures. In these scenarios, producers of the business determine which risks to submit to us for underwriting. For risks submitted, Meadowbrook underwrites individual primary insurance policies for members of a group or association, or a specific industry. We share in the operating results with the producer through a quota share reinsurance agreement with an insurance company (owned, or affiliated with the producer) or a captive or rent-a-captive.

We believe our selective approach to distribution also serves to align the agents’ financial interests with our balanced business model. Our selective approach reduces channel conflict and allows our agencies to generate franchise value. This is a mutually beneficial approach to enhancing the value of our distribution relationships.

Technology

We seek to leverage our business technology platform in order to achieve a high level of customer service and enhance operating efficiencies. We provide a select set of internet-based business processing systems to our producers to automate their capability to rate, quote, bind and service insurance policies in a timely and efficient manner. Advantage is a processing system for quoting and binding workers’ compensation insurance policies. Century On-Line (“COL”) is a processing system for quoting, binding, and issuing policies for general liability, property and garage insurance policies underwritten by our excess and surplus lines company, Century. Further, we provide additional systems on a network-accessible basis for processing select package and commercial automobile programs. In addition to reducing our internal administrative processing costs, these systems enhance underwriting practices by automating risk selection criteria.

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MEADOWBROOK INSURANCE GROUP, INC.

Competition and Pricing

We are part of a highly competitive industry that is cyclical and historically characterized by periods of high premium rates and shortages of underwriting capacity followed by periods of intense competition and excess underwriting capacity resulting in lower pricing and relaxed eligibility standards including broadening of coverages. We compete with other providers of specialty insurance programs, products, and risk management services, as well as with traditional providers of commercial insurance. Some of our competitors may have greater financial resources than we do.

Pricing is a primary means of competition in the commercial insurance market. Competition is also based on the availability and quality of products, quality and speed of service (including claims service), financial strength, ratings, distribution systems and technical expertise. In addition to the factors noted above, the insurance industry also competes on commission rates.

Principal competitive factors for providing risk management services include the costs of self-insuring relative to the cost of purchasing insurance from an insurance carrier, the availability and pricing of excess reinsurance coverage, cash flow needs, and the expected quality and consistency of the services to be provided.

We believe that we are able to compete based on our experience, the combined quality of our products and services, the high level of our employees’ professional expertise, our processing technology platforms, and our program-oriented approach. However, our ability to successfully compete is dependent upon a number of factors, including market and competitive conditions, many of which are outside of our control.

Significant Mergers, Acquisitions, and Strategic Investments

We review merger, acquisition, divestitures, and investments on a strategic basis, while considering our capital strategy and business needs. We consider a range of factors (in relation to organic growth capabilities and plans) when looking at transactions including:

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probability of revenue increases, service and cost synergies such as the ability to leverage our diverse revenue platform, expansion of current distribution network, enhancement of servicing capabilities, and complimentary product lines and classes;

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opportunity to expand an existing specialty into new markets and/or expand into new specialty areas;

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ability to attract and retain talented insurance professionals that blend with our culture; and

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opportunity to create “win-win” situations by mitigating our downside risk and providing sellers with the opportunity to obtain fair value through deal structure, including adjustments to the purchase price based upon actual results

Geographic Diversity and Mix of Business

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MEADOWBROOK INSURANCE GROUP, INC.

The following table summarizes our gross written premium distribution by state for the years ended December 31, 2013, 2012, and 2011 (in thousands). We include only states that were top ten gross written premium production states in 2013:

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MEADOWBROOK INSURANCE GROUP, INC.

The following table summarizes gross written premiums, net earned premiums, and net written premiums by line of business for the years ended December 31, 2013, 2012, and 2011 (in thousands):

Meadowbrook Insurance Group, Inc.

Summary of GWP, NEP, and NWP

As noted above, gross written premium decreased in 2013 due primarily to business that was targeted to be terminated during the fourth quarter of 2012 and planned premium reductions in specific underperforming areas. The decrease was partially offset by achieved rate increases and the maturation of existing programs. During 2013, we achieved overall average written rate increases of approximately 12%. The average written rate increases for our workers’ compensation line of business in 2013 was approximately 16%.

Reserves

The following table shows the development of reserves for unpaid losses and loss adjustment expenses (“LAE”) from 2004 through 2013 for our Insurance Company Subsidiaries

Development of the ProCentury acquired reserves is not included for the years prior to 2008, because our merger with ProCentury (the “ProCentury Merger”) was not effective until August 1, 2008. The lower portion of the table reflects the impact of reinsurance for the years 2004 through 2013 reconciling the net reserves shown in the upper portion of the table to gross reserves.

Additional information relating to our reserves is included within the Losses and Loss Adjustment Expenses and Reinsurance Recoverables section of Note 1 ~ Summary of Significant Accounting Policies and Note 4 ~ Liability for Losses and Loss Adjustment Expenses of the Notes to the Consolidated Financial Statements, as well as to the Critical Accounting Policies section and the Reserves section of Item 7, Management’s Discussion and Analysis.

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MEADOWBROOK INSURANCE GROUP, INC.

Analysis of Loss and Loss Adjustment Expense Development

 

	Years Ended December 31,
	2004	2005	2006	2007	2008	2009	2010	2011	2012	2013
	(in thousands)
Reserves for losses and LAE at end of period	$226,996	$271,423	$302,655	$341,541	$625,331	$682,376	$784,202	$879,093	$1,074,075	$1,111,090
Adjusted reserves for losses and LAE at end of period	$226,996	$271,423	$302,655	$341,541	$625,331	$682,376	$784,202	$879,093	$1,074,075	$1,111,090
Cumulative paid as of
1 year later	79,056	83,271	81,779	95,393	173,525	187,818	269,913	331,440	396,480
2 years later	124,685	133,809	140,308	155,745	279,221	338,925	458,376	560,826
3 years later	153,780	170,226	180,197	197,558	369,313	441,938	598,254
4 years later	171,946	195,242	204,802	233,421	425,223	520,024
5 years later	186,454	210,993	228,284	255,627	469,293
6 years later	195,691	226,048	241,737	279,743
7 years later	204,939	235,193	258,360
8 years later	211,149	245,528
9 years later	220,105
Reserves re-estimated as of end of year:
1 year later	231,880	268,704	295,563	330,416	596,661	651,373	791,514	964,608	1,142,475
2 years later	227,462	263,069	286,647	327,862	566,878	654,641	844,001	1,014,009
3 years later	226,437	261,319	292,516	331,034	568,751	684,621	874,804
4 years later	226,492	265,448	293,897	339,931	580,023	704,163
5 years later	232,314	268,007	303,948	346,790	598,137
6 years later	233,560	276,374	305,504	360,406
7 years later	238,547	276,130	316,316
8 years later	238,446	285,106
9 years later	245,533
Net cumulative redundancy (deficiency):
Dollars	($18,538)	($13,683)	($13,661)	($18,866)	$27,193	($21,787)	($90,602)	($134,917)	($68,400)
Percentage	-8.2%	-5.0%	-4.5%	-5.5%	4.3%	-3.2%	-11.6%	-15.3%	-6.4%
Net reserves	226,996	271,423	302,655	341,541	625,331	682,376	784,202	879,093	1,074,075	1,111,090
Ceded reserves	151,161	187,254	198,422	198,461	260,366	266,801	280,854	315,884	381,905	505,431
Gross reserves	378,157	458,677	501,077	540,002	885,697	949,177	1,065,056	1,194,977	1,455,980	1,616,521
Net re-estimated	245,533	285,106	316,316	360,406	598,137	704,163	874,804	1,014,009	1,142,475
Ceded re-estimated	206,798	208,635	207,365	206,353	250,422	267,263	301,587	333,319	394,647
Gross re-estimated	452,331	493,741	523,680	566,759	848,559	971,427	1,176,392	1,347,328	1,537,122
Gross cumulative redundancy (deficiency)	($74,174)	($35,064)	($22,604)	($26,757)	$37,137	($22,250)	($111,335)	($152,351)	($81,142)

 

The following table sets forth the difference between GAAP reserves for loss and loss adjustment expenses and statutory reserves for loss and loss adjustment expenses at December 31, (in thousands):

* 100% Quota Share reinsurance agreement related to a worker’s compensation novation policy, with reinsurance provisions recognized as retroactive reinsurance on a GAAP basis in accordance with ASC 944- Financial Services- Insurance and recognized as prospective reinsurance on a statutory basis in accordance with SSAP 62R- Property and Casualty Reinsurance.

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MEADOWBROOK INSURANCE GROUP, INC.

For the year ended December 31, 2013, we reported an increase of $81.1 million in gross ultimate loss estimates for accident years 2012 and prior, or 5.6% of $1,456.0 million of gross loss and LAE reserves at January 1, 2013.  We reported a $68.4 million increase in net ultimate loss and LAE estimates for accident years 2012 and prior, or 6.4% of $1,074.1 million of net loss & LAE reserves at January 1, 2013.

For the year ended December 31, 2012, we reported an increase of $96.1 million in gross ultimate loss estimates for accident years 2011 and prior, or 8.0% of $1,195.0 million of gross loss and LAE reserves at January 1, 2012.  We reported an $85.5 million increase in net ultimate loss and LAE estimates for accident years 2011 and prior, or 9.7% of $879.1 million of net loss & LAE reserves at January 1, 2012.

Reinsurance

Information relating to our reinsurance structure and treaty information is included within Note 6 ~ Reinsurance of the Notes to the Consolidated Financial Statements.

Investments

Information relating to our investment portfolio is included within Note 3 ~ Investments of the Notes to the Consolidated Financial Statements and the Investments section of Item 7, Management’s Discussion and Analysis, as well as Item 7A Quantitative and Qualitative Disclosures about Market Risk.

Regulation

Insurance Company Regulation

Our Insurance Company Subsidiaries are subject to regulation in the states where they conduct business. State insurance regulations generally are designed to protect the interests of policyholders, state insurance consumers or claimants rather than shareholders or other investors. The nature and extent of such state regulation varies by jurisdiction, but generally involves:

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prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company;

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regulation of certain transactions entered into by an insurance company with any of its affiliates;

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approval of premium rates, forms and policies used for many lines of insurance;

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standards of solvency and minimum amounts of capital and surplus that must be maintained;

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establishment of reserves required to be maintained for unearned premium, loss and loss adjustment expense, or for other purposes;

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limitations on types and amounts of investments;

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underwriting and claims settlement practices;

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restrictions on the size of risks that may be insured by a single company;

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licensing of insurers and agents;

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deposits of securities for the benefit of policyholders; and

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the filing of periodic reports with respect to financial condition and other matters.

In addition, state regulatory examiners perform periodic examinations of insurance companies. The results of these examinations can give rise to regulatory orders requiring remedial, injunctive or other corrective action.

Insurance Holding Company Regulation

We operate as an insurance holding company system and are subject to regulation in the jurisdictions in which we conduct business. These regulations require that each insurance company in the system register with the insurance department of its state of domicile and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system which are domiciled in that state. The insurance laws similarly provide that all transactions among members of a holding company system must be fair and reasonable. Certain types of transactions between insurance subsidiaries and their parents and affiliates generally must be disclosed to the state regulators, and prior approval of the applicable state insurance regulator generally is required for any material or extraordinary transaction. In addition, a change of control of a domestic insurer or of any controlling person requires the prior approval of the state insurance regulator.

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MEADOWBROOK INSURANCE GROUP, INC.

Various State and Federal Regulation

Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. In addition, for some classes of insureds individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, if permitted by applicable regulations, these adverse effects on profitability can be minimized through repricing of coverages or limitations or cessation of the affected business.

Reinsurance Intermediary

Our reinsurance intermediaries are also subject to regulation. Under applicable regulations, an intermediary is responsible, as a fiduciary, for funds received on account of the parties to the reinsurance transaction. The intermediaries are required to hold such funds in appropriate bank accounts subject to restrictions on withdrawals and prohibitions on commingling.

 

Licensing and Agency Contracts

 

We, or certain of our designated employees, must be licensed to act as agents by state regulatory authorities in the states in which we conduct business. Regulations and licensing laws vary in individual states and are often complex.

 

Insurance licenses are issued by state insurance regulators upon application and may be of perpetual duration or may require periodic renewal. We must apply for and obtain appropriate new licenses before we can expand into a new state on an admitted basis or offer new lines of insurance that require separate or additional licensing. 

Insurers operating on an admitted basis must file premium rate schedules and policy or coverage forms for review and approval by the insurance regulators. In many states, rates and policy forms must be approved prior to use, and insurance regulators have broad discretion in judging whether an insurer’s rates are adequate, not excessive and not unfairly discriminatory.

 

The applicable licensing laws and regulations in all states are subject to amendment or reinterpretation by state regulatory authorities, and such authorities are vested in most cases with relatively broad discretion as to the granting, revocation, suspension and renewal of licenses. We, or our employees, could be excluded, or temporarily suspended, from continuing with some or all of our activities in, or otherwise subjected to penalties by, a particular state.

 

Insurance Regulation Concerning Change or Acquisition of Control

Star, Williamsburg, Ameritrust, and PIC are domestic property and casualty insurance companies organized under the insurance laws (the “Insurance Codes”) of Michigan, while Savers, Century and PROPIC are organized under the Insurance Codes of Missouri, Ohio, and Washington D.C., respectively. The Insurance Codes provide that acquisition or change of control of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the relevant insurance regulatory authority. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company must generally file with the relevant insurance regulatory authority an application for change of control (commonly known as a “Form A”) containing information required by statute and published regulations and provide a copy of such Form A to the domestic insurer. Control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing ten percent or more of the voting securities of the company.

In addition, many state insurance regulatory laws contain provisions that require pre-notification to state agencies of a change in control of a non-domestic admitted insurance company in that state. While such pre-notification statutes do not authorize the state agency to disapprove the change of control, such statutes do authorize issuance of a cease and desist order with respect to the non-domestic admitted insurer if certain conditions exist, such as undue market concentration.

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MEADOWBROOK INSURANCE GROUP, INC.

Any future transactions that would constitute a change in control would also generally require prior approval by the Insurance Departments of Michigan, Missouri, Ohio, and Washington D.C. and would require pre-acquisition notification in those states that have adopted pre-acquisition notification provisions and in which the insurers are admitted. Such requirements may deter, delay or prevent certain transactions that could be advantageous to our shareholders.

Membership in Insolvency Funds and Associations and Mandatory Pools

Most states require admitted property and casualty insurers to become members of insolvency funds or associations, which generally protect policyholders against the insolvency of insurers. Members of the fund or association must contribute to the payment of certain claims made against insolvent insurers. Maximum contributions required by law in any one year vary between 1% and 2% of the annual premium written by a member in that state. For 2013, 2012, and 2011, assessments from insolvency funds were $7.0 million, $6.8 million, and $8.6 million, respectively. Most of these payments are recoverable through future policy surcharges and premium tax reductions.

Our Insurance Company Subsidiaries are also required to participate in various mandatory insurance facilities or in funding mandatory pools, which are generally designed to provide insurance coverage for consumers who are unable to obtain insurance in the voluntary insurance market. Among the pools participated in are those established in certain states to provide windstorm and other similar types of property coverage. These pools typically require all companies writing applicable lines of insurance in the state for which the pool has been established to fund deficiencies experienced by the pool based upon each company’s relative premium writings in that state, with any excess funding typically distributed to the participating companies on the same basis. To the extent that reinsurance treaties do not cover these assessments, they may have an adverse effect on the Company. For 2013, 2012, and 2011, total assessments paid to all such facilities were $4.2 million, $4.9 million, and $5.0 million, respectively.

Restrictions on Dividends and Risk-Based Capital

For information on Restrictions on Dividends and Risk-based Capital that affect us please refer to Note 8 ~ Regulatory Matters and Rating Issues of the Notes to the Consolidated Financial Statements and the Regulatory and Rating Issues section within Item 7, Management’s Discussion and Analysis.

NAIC-IRIS Ratios

The National Association of Insurance Commissioners’ (“NAIC”) Insurance Regulatory Information System (“IRIS”) was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more ratios generally leads to inquiries or possible further review from individual state insurance commissioners. Refer to the Regulatory and Rating Issues section within Item 7, Management’s Discussion and Analysis.

Effect of Federal Legislation

The Terrorism Risk Insurance Act, or TRIA, was enacted in November 2002, renewed December 31, 2005 and most recently on December 31, 2007.  Congress’s extension of TRIA, now referred to as TRIPRA (Terrorism Risk Insurance Program Reauthorization and Extension Act of 2007) is set to expire December 31, 2014, unless renewed.  The law extends the federal Terrorism Insurance Program which requires insurance companies to offer terrorism coverage and provides compensation for insured losses resulting from acts of certified terrorism, subject to a program event trigger of $100.0 million, after the insurer retains loss equal to 20% of its direct earned premium as permitted by the Act.    Insurers covered by TRIPRA are also responsible for a 15% coinsurance of loss in excess of their stated retention.   There is no assurance that TRIPRA will be extended beyond December 31, 2014.  The Company currently purchases $164.0 million of terrorism protection under its workers’ compensation treaties to satisfy these obligations; however, there is no assurance that in the future the Company will be able to obtain coverage at a reasonable cost.  The Company is evaluating alternative strategies to address its exposure which is specifically related to employee concentrations in certain large hospitals where the company provides statutory workers’ compensation limits, in the event TRIPRA is not extended beyond December 31, 2014.  The Company may (a) secure additional reinsurance protection to cover acts of terrorism thereby potentially increasing its cost of insurance; (b) impose aggregate limits on workers’ compensation policies where previously statutory limits were extended where permitted; and/or (c) non-renew certain specific risks where other alternatives are not commercially feasible.  The Company is actively engaged in evaluating these alternatives and monitoring its aggregation exposures to terrorism on a regular basis, we will implement a strategy that conservatively addresses the uncertainty around the possible non-renewal of TRIPRA at December 31, 2014.

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MEADOWBROOK INSURANCE GROUP, INC.

Employees

At February 21, 2014, we employed 954 associates to service our clients and provide management services to our Insurance Company Subsidiaries as described below. We believe we have good relationships with our associates.

Available Information

Our Internet address is www.meadowbrook.com. There we make available, free of charge, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Statements of Beneficial Ownership (Forms 3, 4, and 5), and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish to, the SEC. You may read and copy materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington D.C., 20549. You may obtain information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  In addition, the SEC maintains an Internet site that contains reports, proxy statements, and other information that we file at www.sec.gov.  Our SEC reports can also be accessed through the investor relations section of our website. The information found on our website is not part of this or any other report we file with, or furnish to the SEC. The Charters of the Governance and Nominating Committee, the Compensation Committee, the Audit Committee and the Capital Strategy and Investment Committee, as well as the Board of Directors Governance Guidelines are also available on our website, or available in print to any shareholder who requests this information.  In addition, our Compliance Code of Conduct and Business Ethics policy is available on our website, or in print to any shareholder who requests this information.

Glossary of Selected Insurance Terms

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MEADOWBROOK INSURANCE GROUP, INC.

ITEM 1A. RISK FACTORS

In addition to the other information set forth in this report, including the information regarding forward-looking statements set forth in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, you should carefully consider the following risk factors, categorized by “Risks Related to Our Business”, “Risks Related to Our Industry” and “Risks Related to Our Common Stock”, which could materially affect our business, financial condition or results of operations in future periods.

Actual loss and loss adjustment expenses may exceed our reserve estimates, which would negatively impact our profitability and financial position.

In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of the loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and the related loss adjustment expenses. Loss reserves are an estimate of what we anticipate the ultimate costs to be and therefore do not represent an exact calculation of liabilities. Estimating loss reserves is a difficult and complex process involving many variables and subjective judgments. As part of the reserving process, we review historical data and consider the impact of various factors such as:

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MEADOWBROOK INSURANCE GROUP, INC.

This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future results. It also assumes that adequate historical or other data exists upon which to make these judgments. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves and actual results are likely to differ from original estimates.

In 2013, we experienced material reserve strengthening because of significant adverse loss development, and for the year ended December 31, 2013, we reported an increase in net ultimate loss estimates for accident years 2012 and prior of $68.4 million, or $63.1 million excluding an adverse arbitration award.   The adverse development did impact our financial strength ratings of our Insurance Company Subsidiaries as discussed under “A decrease in our A.M. Best rating could negatively affect our business” below.

 

Additional unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the future.  These additional losses could arise from changes in the legal environment, laws and regulations, climate change, catastrophic events, increases in loss severity or frequency, or other causes.  Such future losses could be substantial.  Inflationary scenarios may cause the cost of claims, especially medical claims, to rise, impacting reserve adequacy and our results of operations.  There can be no assurance that we will not in the future experience significant adverse loss developments that could result in reserve strengthening and additional material charges to earnings.

Additional information relating to our reserves is included within the Losses and Loss Adjustment Expenses and Reinsurance Recoverables section of Note 1 ~ Summary of Significant Accounting Policies and Note 4 ~ Liability for Losses and Loss Adjustment Expenses of the Notes to the Consolidated Financial Statements, as well as to the Critical Accounting Policies section and the Reserves section of Item 7, Management’s Discussion and Analysis.

A decrease in our A.M. Best rating could negatively affect our business.

Financial ratings are an important factor influencing the competitive position of insurance companies. Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors they believe are important to policyholders. Ratings evaluations are not directed to potential purchasers of our common stock and are not recommendations to buy, hold, or sell our securities and should not be relied upon as such.

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MEADOWBROOK INSURANCE GROUP, INC.

As a result of the foregoing rating changes, our results of operations could be materially and adversely impacted.  The adverse impact could include loss of current and potential independent agents and insureds who may choose to transact their business with more highly rated competitors. In addition, we may face a significant reduction in the number of insurance contracts we write and the loss of substantial business to our competitors that maintain higher ratings, which would cause premiums and earnings to decrease. The rating changes could negatively impact our ability to raise capital and have a negative impact on our overall liquidity.  Because lenders and reinsurers will use our A.M. Best ratings as a factor in deciding whether to transact business with us, the current ratings of our Insurance Company Subsidiaries or their failure to maintain the current ratings may dissuade a financial institution or reinsurance company from conducting any business with us or may increase our interest or reinsurance costs.  There can be no assurance that the Company will not be further downgraded.

In response to the downgrade by A.M. Best, on August 4, 2013, the Insurance Company Subsidiaries entered into a 100% quota share reinsurance agreement(s) with State National Insurance Company, National Specialty Insurance Company and United Specialty Insurance Company (collectively, “SNIC”), which will provide the 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.  The costs associated with these agreements could negatively impact our results of operations. A further downgrade could increase the cost for this agreement, as well as require us to post additional collateral. There can be no assurance that the Company will not need to enter into additional similar agreements as a result of any other downgrade.

 

We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.

Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. To the extent that our present capital is insufficient to meet future operating requirements and/or cover losses, we may need to raise additional funds through financings. If we had to raise additional capital, equity or debt financing may not be available or may be on terms that are not favorable to us in our current environment. In the case of equity financings, dilution to our shareholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the shares currently outstanding. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition could be adversely affected.

We compete with a large number of other companies in our selected lines of business. Many of our competitors are substantially larger and may enjoy better name recognition, substantially greater financial resources, higher financial strength ratings by rating agencies, broader and more diversified product lines and more widespread agency relationships than us. Insurers in our markets generally compete on the basis of price, consumer recognition, coverages offered, claims handling, financial stability, customer service and geographic coverage.  Although pricing is influenced to some degree by that of our competitors, it is not in our best interests to compete solely on price, and we may from time-to-time experience a loss of market share during period of intense price competition.  A number of new, proposed or potential legislative or industry developments could further increase competition in our industry including, but not limited to:

New competition resulting from these and other developments could make the property and casualty insurance marketplace more competitive by increasing the supply of insurance capacity. In that event, the current market may soften further, and it may negatively influence our ability to maintain or increase rates. Consequently, our profitability could be adversely impacted by increased competition.

Various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, have been negotiated to limit our exposure to certain types of risks and expanding theories of legal liability. In addition, many of our policies limit the period during which a policyholder may bring a claim under the policy, which period in many cases is shorter than the statutory period under which these claims can be brought by our policyholders.  While these exclusions and limitations help us assess and control our loss exposure, it is possible that a court or regulatory authority could nullify or void an exclusion, or legislation could be enacted that modifies or voids the use of such endorsements and limitations in a way that could have a materially adverse impact on our financial condition and operating results.  Such actions could result in higher than anticipated losses and LAE by extending coverage beyond our underwriting intent or increasing the number or size of claims, which could have a material adverse effect on our operating results. In some instances, these changes may not become apparent until sometime after we have issued the insurance policies that are affected by the changes and litigation relating to the insurance policy interpretation has been resolved. As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued.

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MEADOWBROOK INSURANCE GROUP, INC.

Our geographic concentration ties our performance to the business, economic, natural perils, man-made perils, and regulatory conditions within our most concentrated region.

Our revenues and profitability are subject to the prevailing regulatory, legal, economic, political, demographic, competitive, weather and other conditions in the principal states in which we do business.  Changes in any of these conditions could make it less attractive for us to do business in such states and would have a more pronounced effect on us compared to companies that are more geographically diversified.  In addition, our exposure to severe losses from localized perils, such as earthquakes, hurricanes, tropical storms, tornadoes, wind, ice storms, hail, fires, terrorism, riots and explosions, is increased in those areas where we have written significant numbers of insurance policies.

One of our predominate lines of business is workers’ compensation (47.2% of net earned premiums in 2013), which has a high concentration in California. Accordingly, unfavorable business, economic or regulatory conditions in this state could negatively impact our business. California is also exposed to climate and environmental changes, natural perils such as earthquakes, water supplies, and the possibility of pandemics or terrorist acts. Because our business is concentrated in this manner, we may be exposed to economic and regulatory risks or risk from natural perils that are greater than the risks associated with greater geographic diversification. Refer to Note 5 ~ Reinsurance for further information regarding our reinsurance structure related to workers’ compensation business.

Our success depends on our ability to appropriately price the risks we underwrite.

Our financial results depend on our ability to underwrite and collect adequate premium rates for a wide variety of risks. Rate adequacy is necessary to generate sufficient premiums to pay losses, loss expenses, and underwriting expenses and to earn a profit. To price our products accurately, we must collect and properly analyze a substantial amount of data, develop, test and apply appropriate rating formulas, monitor and react to changes in trends and project both severity and frequency of losses with reasonable accuracy. These activities are subject to a number of risks and uncertainties that are outside our control, including:

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availability of sufficient reliable data and our ability to properly analyze available data;

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uncertainties that inherently characterize estimates and assumptions;

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selection and application of appropriate rating and pricing techniques;

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changes in legal standards, claim settlement practices, medical care expenses and restoration costs;

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changes in mandated rates or benefits set by the state regulators; and

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legislative actions.

Consequently, we could underprice risks, which would negatively affect our profit margins, or we could overprice risks, which could reduce our sales volume and competitiveness. In either event, our profitability could be materially and adversely affected.

 

Market conditions beyond our control determine the availability and cost of the reinsurance we purchase, which may affect the level of our business and profitability. Our reinsurance facilities are generally subject to annual renewal. We may be unable to maintain our current reinsurance facilities or to obtain other reinsurance in adequate amounts and at favorable rates. Increases in the cost of reinsurance would adversely affect our profitability. In addition, if we are unable to renew our expiring facilities or to obtain new reinsurance on favorable terms, either our net exposure to risk would increase or, if we are unwilling to bear an increase in net risk exposures, we would have to reduce the amount of risk we underwrite.

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MEADOWBROOK INSURANCE GROUP, INC.

Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, the ceding of insurance does not discharge us of our primary liability to our policyholder. As a result, ceded reinsurance arrangements do not limit our ultimate obligations to policyholders to pay claims.  Therefore, we are subject to credit risk with respect to the obligations of our reinsurers. We are also subject to the risk that their reinsurers may dispute their obligations to pay our claims.  In addition, our reinsurance agreements are subject to specified limits and we would not have reinsurance coverage to the extent that it exceeds those limits.  Should an unlikely event occur that exceeds our reinsurance coverage, then the amounts in excess of our reinsurance coverage could adversely impact our financial condition or results of operations.  In order to minimize our exposure to significant losses from reinsurer insolvencies, we evaluate the financial condition of our reinsurers and monitor the economic characteristics of the reinsurers on an ongoing basis and, if appropriate, we may require trust agreements to collateralize reinsurers’ financial obligation to us. Nevertheless, if our reinsurers fail to pay us or fail to pay on a timely basis, our financial results and financial condition could be adversely affected.

Difficult conditions in the global capital markets and the economy potentially could materially and adversely affect our business and results of operations.

Our results of operations are materially affected by conditions in the global capital markets and the United States economy generally, both in the United States and elsewhere around the world. Recently, concerns over the slow economic recovery, level of United States national debt, the U.S. mortgage market, inflation levels, energy costs and geopolitical issues have contributed to increased volatility and diminished expectations for the economy and global capital markets going forward. These factors, combined with volatile oil prices, reduced business and consumer confidence and continued high unemployment, have negatively impacted the United States economy.  Although liquidity has improved, the market for fixed income instruments continues to experience some price volatility, credit downgrade events and elevated probabilities of default.

Factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, investor and consumer confidence and inflation levels all affect the business and economic environment and, ultimately, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment, negative investor sentiment and lower consumer spending, the demand for our insurance products could be adversely affected. Our policyholders may choose to defer paying insurance premiums or stop paying insurance premiums altogether. In addition, we may experience an elevated incidence of claims and lapses or surrenders of policies. Adverse changes in the economy could negatively affect our net income and could have a material adverse effect on our business, results of operations and financial condition.

In addition, continuing market turmoil has resulted in, and may continue to raise the possibility of, legislative, regulatory and governmental actions. We cannot predict whether or when such actions may occur, or what impact, if any, such actions could have on our business, results of operations and financial condition.

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MEADOWBROOK INSURANCE GROUP, INC.

Our investment portfolio is subject to market and credit risks, which could affect our financial results and ability to conduct business.

Our investment portfolio is subject to overall market risk and credit risk of the individual issuers of securities. The value of investments in marketable securities is subject to impairment as a result of deterioration in the creditworthiness of the issuer. Although we try to manage this risk by diversifying our portfolio and emphasizing credit quality, our investments are subject to losses as a result of a general downturn in the economy. A severe economic downturn could have a material adverse impact on our results from operations and our financial condition.

We could be forced to sell investments to meet our liquidity requirements.

If we are unable to successfully introduce new products or services or fail to keep pace with advances in technology, our business, financial condition and results of operations will be adversely affected.

The successful implementation of our business model depends on our ability to adapt to evolving technologies and industry standards and introduce new products and services. We cannot assure you that we will be able to introduce new products, or that any new products will achieve market acceptance. Moreover, competitors may develop competitive products that could adversely affect our results of operations. A failure by us to introduce planned products or other new products could have an adverse effect on our business, financial condition and results of operations.

If we cannot adapt to changing technologies, our products and services may become obsolete, and our business could suffer. Our success will depend, in part, on our ability to continue to enhance our existing products and services, develop new technology that addresses the increasingly sophisticated and varied needs of our prospective customers and respond to technological advances on a timely and cost-effective basis. We may not be successful in using new technologies effectively or adapting our proprietary technology to evolving customer requirements, and, as a result, our business could suffer.

Changes in federal regulation could impose significant burdens on us and otherwise adversely impact our results.

While the U.S. federal government has not historically regulated the insurance business, in 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) established a Federal Insurance Office (the FIO) within the U.S. Department of the Treasury. The FIO has limited regulatory authority and is empowered to gather data and information regarding the insurance industry and insurers. In December 2013, the FIO released a report recommending ways to modernize and improve the system of insurance regulation in the United States. While the report did not recommend full federal regulation of insurance, it did suggest an expanded federal role in some circumstances. In addition, the report suggested that Congress should consider direct federal involvement to fill regulatory gaps identified in the report, should those gaps persist, for example, by considering either establishing a federal coordinating body or a direct regulator of select aspects of the industry, such as large complex institutions or institutions that seek a federal charter, if a law is passed to allow a federal charter. It is not clear as to the extent, if any, the report will lead to regulatory changes or how any such changes would impact the Company.

As a result of the foregoing, the Dodd-Frank Act, or other additional federal regulation that is adopted in the future, could impose significant burdens on us, including impacting the ways in which we conduct our business, increasing compliance costs and duplicating state regulation, and could result in a competitive disadvantage, particularly relative to other insurers that may not be subject to the same level of regulation. Changes in the U.S. regulatory framework could impact the overall competitive environment by imposing additional burdens on us and allowing other competitors not subject to these same burdens to enter or expand their insurance businesses.

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MEADOWBROOK INSURANCE GROUP, INC.

Even if we are not subject to additional regulation by the federal government, significant financial sector regulatory reform, including the Dodd-Frank Act, could have a significant impact on us. For example, regulatory reform could have an unexpected impact on our rights as a creditor or on our competitive position.

Other potential changes in U.S. federal legislation, regulation and/or administrative policies, including the potential repeal of the McCarran-Ferguson Act (which exempts insurance from most federal regulation) and potential changes in federal taxation, could also significantly harm the insurance industry, including us.

Our ability to meet ongoing cash requirements and pay dividends may be limited by our holding company structure and regulatory constraints restricting dividends or other distributions by our Insurance Company Subsidiaries.

We are a holding company that transacts the majority of our business through our Insurance Company Subsidiaries. Our ability to meet our obligations on our outstanding debt, and to pay our expenses and shareholder dividends, depends upon the dividend paying capacity of our Insurance Company Subsidiaries. We will be limited by the earnings of our Insurance Company Subsidiaries, and the distribution or other payment of such earnings to it in the form of dividends, loans, advances or the reimbursement of expenses.  Payments of dividends to us by our Insurance Company Subsidiaries are subject to various business considerations and restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, and could be subject to revised restrictions in the future. The ability to pay ordinary and extraordinary dividends must be reviewed in relation to the impact on key financial measurement ratios, including Risk Based Capital (RBC) ratios and A.M. Best’s Capital Adequacy Ratio (“BCAR”).  The Insurance Company Subsidiaries’ ability to pay future dividends without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon the Insurance Company Subsidiaries generating net income. As a result, at times, we may not be able to receive dividends from our Insurance Company Subsidiaries in amounts necessary to meet our debt obligations, to pay shareholder dividends on our capital stock or to pay corporate expenses.  Therefore, the inability of our Insurance Company Subsidiaries to pay dividends or make other distributions could have a material adverse effect on our business and financial condition.

Our insurance company subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these requirements could subject us to regulatory action.

Our Insurance Company Subsidiaries are subject to minimum capital and surplus requirements (which we are in compliance with as of December 31, 2013) imposed under the laws of their respective states of domicile and each state in which they issue policies. Any failure by one of our Insurance Company Subsidiaries to meet minimum capital and surplus requirements imposed by applicable state law will subject it to corrective action.  This may include requiring adoption of a comprehensive financial plan, revocation of its license to sell insurance products or placing the subsidiary under state regulatory control. A decline in the risk based capital ratios of our Insurance Company Subsidiaries could limit their ability to make a dividend to us and could be a factor in causing rating agencies to downgrade our ratings. Any new minimum capital and surplus requirements adopted in the future may require us to increase the capital and surplus of our Insurance Company Subsidiaries, which we may not be able to do.

At times, we may investigate and pursue acquisition opportunities if we believe such opportunities are consistent with our long-term objectives and that the expected benefits exceed the risks.  Achieving such benefits is subject to a number of uncertainties, including whether the combined businesses are integrated in an efficient and effective manner; assumption of unknown material liabilities, including deficient provisions for unpaid claims; diversion of management’s attention from other business concerns; failure to achieve financial or operating objectives; potential loss of policyholders or key employees of acquired companies; and general competitive factors in the marketplace.  We believe we have a robust due diligence process; however, integrating an acquired company or business can be a complex and costly endeavor.  Integration may result in the loss of key employees, disruption to the existing business or the business of the acquired company, or otherwise harm our ability to retain customers and employees or achieve the anticipated benefits of the acquisition.  Also, the negative effect of any financial commitments required by regulatory authorities or rating agencies in acquisitions or business combinations may be greater than expected.  We may be unable to integrate or profitably operate any business, operations, personnel, services or products that we may acquire in the future, which could materially impact our projected benefits from the transaction, business, financial condition, results of operations, and cash flows.

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MEADOWBROOK INSURANCE GROUP, INC.

On August 2, 2013, the Company announced that its board of directors is undertaking a review of strategic alternatives.  The pursuit of strategic alternatives raises some of the same risks associated with pursuing acquisitions, including diversion of management’s attention from other business concerns; failure to achieve financial or operating objectives; potential loss of policyholders or key employees of acquired companies; and volatility in the Company’s stock price.

One of our core selected producers accounts for a large portion of our premium volume, loss of business provided by this entity could adversely affect us.

Our largest producer in 2013 was Midwest General, which in combination with its affiliates, accounted for 14.5% of our gross written premium. No other producer was responsible for more than 10% of our gross written premium. We do not have an exclusive relationship with Midwest General, and there can be no assurance that this relationship will continue in the future.  If Midwest General reduces it’s marketing of our products or moves some or all of its business to another carrier, then our business, financial condition, results of operations and cash flows may be adversely affected.

The success of our business is dependent on our ability to retain and motivate our senior management and key management personnel and their efforts. The loss of the services of any of our executive officers or other key employees could have a material adverse effect on our business, financial condition, results of operations, and cash flows. We have existing employment or severance agreements with Robert S. Cubbin, Christopher J. Timm, Karen M. Spaun, Michael G. Costello, and other senior executives. We maintain a “key person” life insurance policy on Robert S. Cubbin, our President and CEO. The loss of any of these officers or other key personnel could cause our ability to implement our business strategies to be delayed or hindered.

Our future success also will depend on our ability to attract, train, motivate and retain other highly skilled technical, managerial, marketing, and customer service personnel. Competition for these employees is strong and we may not be able to successfully attract, integrate or retain sufficiently qualified personnel in our current environment. In addition, our future success depends on our ability to attract, retain and motivate our agents and other producers. Our failure to attract and retain the necessary personnel and producers could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

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MEADOWBROOK INSURANCE GROUP, INC.

We rely on our information technology and telecommunications systems to conduct our business.

Our business is dependent upon the uninterrupted functioning of our information technology and telecommunication systems. We rely upon our systems, as well as the systems of our vendors, to underwrite and process our business; make claim payments; provide customer service; provide policy administration services, such as endorsements, cancellations and premium collections; comply with insurance regulatory requirements; and perform actuarial and other analytical functions necessary for pricing and product development. Our operations are dependent upon our ability to timely and efficiently process our business and protect our information and telecommunications systems from physical loss, telecommunications failure or other similar catastrophic events, as well as from security breaches. While we have implemented business contingency plans and other reasonable and appropriate internal controls to protect our systems from interruption, loss or security breaches, a sustained business interruption or system failure could adversely impact our ability to process our business, provide customer service, pay claims in a timely manner or perform other necessary business functions. Likewise, a security breach of our computer systems could also interrupt or damage our operations or harm our reputation in the event confidential customer information is disclosed to third–parties. We could also be subject to fines and penalties from a security breach. The cost to remedy a severe security breach could also be substantial. These circumstances could have a material adverse effect upon our financial condition, results of operations, cash flows, and reputation.

While technological enhancements and initiatives can streamline several business processes and ultimately reduce the costs of operations, these initiatives can present short-term costs and implementation risks. Projections of associated costs, implementation timelines, and the benefits of those results may be inaccurate and such inaccuracies could increase over time. In addition, there are risks associated with not achieving the anticipated efficiencies from technology implementation that could impact our financial condition, results of operations, and cash flows.

Our internal controls are not fail-safe.

We continually enhance our operating procedures and internal controls to effectively support our business and comply with our regulatory and financial reporting requirements. As a result of the inherent limitations in all control systems, no system of controls can provide absolute assurance that all control objectives have been or will be met, and that every instance of error or fraud has been or will be detected. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by individual acts or by collusion of two or more persons. The design of any system of controls is based in part upon assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Internal controls may also become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Further, the design of a control system must reflect resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in a cost-effective control system, misstatement due to error or fraud may occur and not be detected. Accordingly, our internal controls and procedures are designed to provide reasonable, not absolute, assurance that the control objectives are met.

The property and casualty insurance industry is cyclical in nature, which may affect our overall financial performance.

Because the cyclicality of our industry is due in large part to the actions of competitors and general economic conditions, we cannot predict with certainty the timing or duration of changes in the market cycle.

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MEADOWBROOK INSURANCE GROUP, INC.

The majority of our property business is exposed to the risk of severe weather conditions and other catastrophes. Catastrophes can be caused by various events, including natural events, such as hurricanes, winter weather, tornadoes, windstorms, earthquakes, hailstorms, severe thunderstorms and fires, and other events, such as explosions, terrorist attacks and riots. The incidence and severity of catastrophes and severe weather conditions are inherently unpredictable. Generally, these losses result in an increase in the number of claims incurred as well as the amount of compensation sought by claimants.

One or more catastrophic or other events could result in claims that substantially exceed our expectations, which could have an adverse effect on our results of operations or financial condition.  Along with other insurers in the industry, we use models in assessing our exposure to catastrophe losses that assume various conditions and probability scenarios. However, these models do not necessarily accurately predict future losses or accurately measure losses currently incurred. Catastrophe models use historical information about various catastrophes and detailed information about our in-force business. While we use this information in connection with our pricing and risk management activities, there are limitations with respect to their usefulness in predicting losses in any reporting period. Such limitations lead to questionable predictive capability and post-event measurements that have not been well understood or proven to be sufficiently reliable. In addition, the models are not necessarily reflective of our or state-specific policy language, demand surge for labor and materials or loss settlement expenses, all of which are subject to wide variation by catastrophe.

Litigation may have an adverse effect on our business

 

Because we are heavily regulated by the states in which we operate, we may be limited in the way we operate.

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MEADOWBROOK INSURANCE GROUP, INC.

Our Insurance Company Subsidiaries are subject to assessments in most states where we are licensed for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies.  These assessments, which are levied by guaranty associations within the state up to prescribed limits, are imposed on all member insurers in the applicable state on the basis of the proportionate share of the premiums written by member insures in the lines of business in which the impaired, insolvent or failed insurer was engaged.  Accordingly, the assessments levied on us by the states in which we are licensed to write insurance may increase as we increase our premiums written.  Maximum contributions required by law in any one year vary by state, and have historically been less than one percent of annual premiums written. In addition, as a condition to the ability to conduct business in certain states, insurance companies are required to participate in mandatory reinsurance funds.  We cannot predict with certainty the amount of future assessments or level of participation in mandatory reinsurance funds. Significant assessments and the effect of mandatory reinsurance arrangements, or changes therein, could have a material adverse effect on our financial condition and results of operations.

The price of our common stock may be volatile.

The trading price of our common stock may fluctuate substantially due to a variety of factors, some of which are beyond our control and may not be related to our operating performance. These fluctuations could be significant and could cause a loss in the amount invested in our shares of common stock. Factors that could cause fluctuations include, but are not limited to, the following:

•

Variations in our actual or anticipated operating results or changes in the expectations of financial market analysts with respect to our results;

•

Investor perceptions of the insurance industry in general and the Company in particular;

•

Market conditions in the insurance industry and any significant volatility in the market;

•

Major catastrophic events; and

•

Departure of key personnel.

The Michigan Business Corporation Act contains “anti-takeover” provisions. Chapter 7A (the “Fair Price Act”) of the Business Corporation Act applies to us and may have an anti-takeover effect and may delay, defer or prevent a tender offer or takeover attempt that a shareholder might consider in their best interest, including those attempts that might result in shareholders receiving a premium over market price for their shares.

In general, subject to certain exceptions, the Fair Price Act prohibits a Michigan corporation from engaging in a “business combination” with an “interested shareholder” for a period of five years following the date that such shareholder became an interested shareholder, unless (i) prior to such date, the board of directors approved the business combination or (ii) on or subsequent to such date, the business combination is approved by at least 90% of the votes of each class of the corporation’s stock entitled to vote and by at least two-thirds of such voting stock not held by the interested shareholder or such shareholder’s affiliates.  The Fair Price Act defines a “business combination” to include certain mergers, consolidations, dispositions of assets or shares and recapitalizations.  An “interested shareholder” is defined by the Fair Price Act to include a beneficial owner, directly or indirectly, of 10% or more of the voting power of the outstanding voting shares of the corporation.

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MEADOWBROOK INSURANCE GROUP, INC.

Our articles of incorporation allow our Board of Directors to issue one or more classes or series of preferred stock with voting rights, preferences and other privileges as the Board of Directors may determine. The possible issuance of preferred shares could adversely affect the holders of our common stock and could prevent, delay, or defer a change of control.

We are also subject to the laws of Michigan, Ohio, California, Washington D.C., Missouri, and other states, which govern insurance holding companies. Under these laws, a person generally must obtain the applicable Insurance Department’s approval to acquire, directly or indirectly, five to ten percent or more of the outstanding voting securities of our Insurance Company Subsidiaries. An Insurance Department’s determination of whether to approve an acquisition would be based on a variety of factors, including an evaluation of the acquirer’s financial stability, the competence of its management, and whether competition in that state would be reduced. These laws may prevent, delay or defer a change of control of us or our Insurance Company Subsidiaries.

Although we have paid cash dividends in the past, we may not pay cash dividends in the future.

The declaration and payment of dividends is subject to the discretion of our Board of Directors and will depend on our financial condition, results of operations, cash flows, cash requirements, future prospects, regulatory and contractual restrictions on the payment of dividends by our Insurance Company Subsidiaries and other factors deemed relevant by our Board of Directors. There is no requirement that we must, and we cannot assure you that we will, declare and pay any dividends in the future. Our Board of Directors may determine to retain such capital for general corporate or other purposes.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not Applicable

ITEM 2. PROPERTIES

We own the land and an approximately 72,000 square foot corporate headquarters building in Southfield, Michigan. We expect that our corporate headquarters building will be adequate for our current and expected future operations.

With the ProCentury Merger, we assumed the lease of ProCentury’s corporate headquarters in Westerville, Ohio.  The lease agreement for this building expired in 2013. We executed a new lease agreement for 60,000 square feet of office space in Westerville, Ohio commencing in 2013.

We are also a party to various leases for other locations in which we have offices. We do not consider any of these leases to be material.

ITEM 3. LEGAL PROCEEDINGS

The Company, and its subsidiaries, are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business as further disclosed in Note 15 ~ Commitments and Contingencies.  Where appropriate, the Company vigorously defends such claims, lawsuits and proceedings.  Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant.   Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by the policy of insurance at issue. We account for such activity through the establishment of unpaid loss and loss expense reserves.  We also maintain errors and omissions insurance and extra-contractual coverage under reinsurance treaties related to the policy of insurance at issue or other appropriate insurance.  In terms of any retentions or deductibles associated with such insurance, the Company has established accruals for such retentions or deductibles, when necessary, based upon current available information.  In accordance with accounting guidance, if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is reasonably estimable; then an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets.  Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income.  Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters.  On the basis of current information, the Company does not believe that there is a reasonable possibility that, other than with regard to the arbitration disclosed in Note 15 ~ Commitments and Contingencies, any material loss exceeding amounts already accrued, if any, will result from any of the claims, lawsuits and proceedings to which the Company is subject to, either individually, or in the aggregate.

ITEM 4. MINE SAFETY DISCLOSURES

Not Applicable

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MEADOWBROOK INSURANCE GROUP, INC.

PART II

ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Shareholder Relations and Form 10-K

A copy of our 2013 Annual Report and Form 10-K, as filed with the Securities and Exchange Commission, may be obtained upon written request to our Financial Reporting Department at our corporate headquarters, or contact:

 

Karen M. Spaun, Senior Vice President and Chief Financial Officer

(248) 204-8178; karen.spaun@meadowbrook.com

Shareholder Investment Plan

Our Shareholder Investment Plan (“Plan”) offers a simple and systematic way to purchase our common stock without paying brokerage fees or commissions.  With the Plan’s many flexible features, an account may be customized to reflect individual financial and investment objectives.  If you would like additional information including a prospectus and an application, please contact:

Computershare Shareowner Services LLC

1-800-442-8134

Or visit their website at www.cpushareownerservices.com

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MEADOWBROOK INSURANCE GROUP, INC.

Share Price and Dividend Information

Our common stock is traded on the New York Stock Exchange under the symbol “MIG.”  The following table sets forth the high and low sale prices of our common shares as reported by the NYSE and our quarterly dividends declared for each period shown:

When evaluating the declaration of a dividend, our Board of Directors considers a variety of factors, including but not limited to, our cash flow, liquidity needs, results of operations strategic plans, industry conditions, our overall financial condition and other relevant factors.  As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from our subsidiaries which may be subject to limitations under applicable insurance regulations.  In 2013 and 2012, the Insurance Company Subsidiaries paid dividends to our holding company of $14.0 million and $12.5 million, respectively. 

For additional information regarding dividend restrictions, refer to the Liquidity and Capital Resources section of Management’s Discussion and Analysis.

Shareholders of Record

As of February 21, 2014, there were 244 shareholders of record of our common stock.  For purposes of this determination, Cede & Co., the nominee for the Depositary Trust Company is treated as one holder.

Purchase of Equity Securities by the Issuer

On October 28, 2011, our Board of Directors authorized us to purchase up to 5.0 million shares of our common stock in market transactions for a period not to exceed twenty-four months.  The Share Repurchase Plan expired on October 28, 2013.

The following table presents information with respect to repurchases of our common stock made during the quarterly period ended December 31, 2013:

 

Period

Total Number of Shares Repurchased

Average Price Paid Per Share

Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs

Maximum Number of Shares that may still be Repurchased Under the Plans or Programs

October 1 - October 28, 2013

-

$

-

-

-

Total

-

$

-

-

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MEADOWBROOK INSURANCE GROUP, INC.

Performance Graph

 

The following graph sets forth, for the five year period ended December 31, 2013, the cumulative total stockholder return for the Company’s common stock, the Russell 2000 Index, and a published industry index.  The graph assumes the investment of $100 on December 31, 2008 in Common Stock of the Company, the Russell 2000 Index, and a Peer Group index.  The stock price performance represented on the following graph is not necessarily indicative of future stock price performance.

 

The performance graph shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be deemed to be incorporated by reference into any future filing of the Company under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent the Company specifically incorporates it by reference into such filing.

 

 

 

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MEADOWBROOK INSURANCE GROUP, INC.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

MEADOWBROOK INSURANCE GROUP, INC.

SELECTED CONSOLIDATED FINANCIAL DATA

(1) 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 net premiums written (expense ratio).  The combined ratios above have been modified to reflect GAAP accounting, as management evaluates 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 net 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.

(2) 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 management with an assessment of the specific policy year’s profitability (which matches policy pricing with related losses) and assists management in their evaluation of product pricing levels and quality of business written. Management uses 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.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This 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 and lowering the outlook for this rating from “stable” to “negative” and 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.

For additional information with respect to certain of these and other factors, refer to “Risk Factors” above 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.

Critical Accounting Policies

 

General

 

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 on an on-going basis based on a variety of factors.  There can be no assurance, however, the 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.  We believe the following policies, along with those disclosed in Note 1 ~ Summary of Significant Accounting Policies, are the most sensitive to estimates and judgments.

Losses and Loss Adjustment Expenses

Significant periods of time can elapse between the occurrence of a loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss.  To recognize liabilities for unpaid losses and loss adjustment expenses (“LAE”), insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and LAE.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

We establish a liability for losses and LAE, which represents case based estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported losses (“IBNR”) and LAE.  Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the ultimate liability may be greater or less than the estimate.  As of December 31, 2013 and 2012, we have accrued $1,616.5 million and $1,456.0 million of gross loss and LAE reserves, respectively.

The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, at December 31, 2013 (in thousands):

 

		Case				IBNR				Total
Direct		$	543,141			$	911,263			$	1,454,404
Assumed-Directly Managed (1)			48,616				57,835				106,451
Assumed-Residual Markets (2)			9,041				12,099				21,140
Assumed-MFH			11,627				5,766				17,393
Assumed-Other			5,175				11,958				17,133
Gross			617,600				998,921				1,616,521
Less Ceded			134,479				370,952				505,431
Net		$	483,121			$	627,969			$	1,111,090

 

(1) “Directly Managed” represents business managed and processed by our underwriting, claims, and loss control departments, utilizing our internal systems and related controls.

(2) “Residual Markets” represent mandatory pooled workers’ compensation business allocated to individual insurance company writers based on the insurer’s market share in a given state.

The reserves referenced in the above table related to our direct and assumed-directly managed business are established through transactions processed through our internal systems and related controls.  Likewise, business assumed from Midwest Insurance Company is defined as assumed business related to our partial ownership of Midwest Financial Holding, LLC (“MFH”), where we have direct access to their paid and case reserve loss data.  Accordingly, case reserves are established on a current basis, therefore, there is no delay or lag in reporting of losses from a ceding company, and IBNR is determined utilizing various actuarial methods based upon historical data.  Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag between the date of the evaluation and the receipt of the estimate from the National Council on Compensation Insurance (“NCCI”), and include an estimated reserve determined based upon internal actuarial methods for this lag.  Relative to assumed business from other sources, we receive case and paid loss data within a forty-five day reporting period and develop our estimates for IBNR based on both current and historical data.

The completeness and accuracy of data received from cedants on assumed business that we do not manage directly is verified through monthly reconciliations to detailed statements, inception-to-date roll-forwards of claim data, actuarial estimates of historical trends, field audits, and a series of management oversight reports on a program basis.

The following table sets forth our net case and IBNR reserves for losses and LAE by line of business at December 31, 2013 (in thousands):

		Net Case				Net IBNR				Total
Workers' Compensation		$	237,108			$	240,305			$	477,413
Residual Markets			9,321				13,256				22,577
Commercial Multiple Peril/General Liability			159,306				300,644				459,950
Commercial Automobile			57,244				61,131				118,375
Other			20,142				12,633				32,775
Total		$	483,121			$	627,969			$	1,111,090

 

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

When a claim is reported to one of our Insurance Company Subsidiaries or our affiliate MFH, for the majority of claims, our claims personnel within our risk management subsidiary will establish a case reserve for the estimated amount of the ultimate payment.  The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses.  The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, which focus on the ultimate probable cost of each reported claim, as well as the experience and knowledge of the claims person.  Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments, new information, or periodic reviews.

In addition to case reserves and in accordance with industry practice, we maintain estimates of reserves for losses and LAE incurred but not yet reported.  We project an estimate of ultimate losses and LAE at each reporting date.  The difference between the projected ultimate loss and LAE reserves and the case loss reserves and LAE reserves, is carried as IBNR reserves.  By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, we estimate the ultimate liability for losses and LAE, net of reinsurance recoverables.

In developing claim and claim adjustment expense reserve estimates, we perform a complete and detailed reserve analyses each quarter. To perform this analysis, the data is organized at a “reserve category” level. A reserve category can be a line of business such as commercial automobile liability, or it may be a particular geographical area within a line of business such as California workers’ compensation. The reserves within a reserve category level are characterized as either short tail or long tail.  About 98% of our reserves can be characterized as coming from long tail lines of business. For long tail business, several years may lapse between the time the business is written and the time when all claims are settled. Our long-tail exposures include workers’ compensation, commercial automobile liability, general liability, professional liability, products liability, aviation liability, excess, and umbrella. Short-tail exposures include property, commercial automobile physical damage, a portion of ocean marine, a portion of aviation, and inland marine. The analyses generally review losses both gross and net of reinsurance.

The standard actuarial methods that we use to project ultimate losses for both long-tail and short-tail exposures include, but are not limited to, the following:

·

Paid Development Method

·

Incurred Development Method

·

Paid Bornhuetter-Ferguson Method

·

Reported Bornhuetter-Ferguson Method

·

Initial Expected Loss Method

·

Paid Roll-forward Technique

·

Incurred Roll-forward Technique

All of these methods are consistently applied to each reserve category for which they are applicable and they create indications for each accident year.  We use judgment selecting the best estimate from within these estimates or adjusted estimates.  As such, no one method or group of methods is strictly used for any line of business or reserve category within a line of business.  The individual selections by year are our best judgments based on the strengths and weaknesses of the method, indications, the inherent variability in the data and the specific modifications to selections for data characteristics.

A brief description of the methods and some discussion of their inherent strengths, weaknesses and uses are as follows:

This method uses historical, cumulative paid losses by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment environment, and to the extent necessary supplemented by analyses of the development of broader industry data.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

Selection of the paid loss pattern requires analysis of several factors including the impact of inflation on claims costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, the impact of large claim payments, and other factors. Claim cost inflation itself requires evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors. Because this method assumes that losses are paid at a consistent rate, changes in any of these factors can impact the results. Since the method does not rely on case reserves, it is not directly influenced by changes in the adequacy of case reserves.

This is a method that assigns partial weight to the initial expected losses and partial weight to observed reported loss dollars (paid losses plus case reserves). The weights assigned to the initial expected losses decrease as the accident year matures.

The use of case incurred losses instead of paid losses can result in development patterns that are less variable than paid patterns. However, the inclusion of case reserves can lead to distortions if changes in case reserving have taken place, and the method requires analysis of all the factors that need to be reviewed for the expected loss ratio and incurred development methods.

This method is used directly, and as an input to the Bornhuetter-Ferguson methods. Initial expected losses for an accident year are based on adjusting prior accident year projections to the current accident year levels using underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments specific to the line of business.

This method may be useful if loss development patterns are inconsistent, losses emerge very slowly, or there is relatively little loss history from which to estimate future losses. The selection of the expected loss ratio requires analysis of loss ratios from earlier accident years or pricing studies and analysis of inflationary trends, frequency trends, rate changes, underwriting changes, and other applicable factors.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

Claims for short-tail lines of business settle quicker than long-tail lines of business, and in general, loss development factors for short-tail lines are smaller than long-tail lines.  For long-tail lines, we tend to rely on initial expected loss methods throughout the current accident year then typically move to development factor based methods for older accident years.  Development methods on short-tail lines are generally reliable in the third and fourth quarter of the initial accident year and recorded loss ratios reflect a blend of the development and forecast methods.  Short-tail lines represent 2% of our total reserves at December 31, 2013.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events.  In particular, the development factor based methods all have as a key assumption that the development of losses in the future will follow a pattern similar to those measured by past experience and as adjusted either explicitly or by actuarial judgment.  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 and varied factors.  With respect to the ultimate estimates for losses and LAE, the key methods remained consistent for the years ended December 31, 2013 and 2012. We reviewed the key assumptions that underlie the actuarial standard methods and made the appropriate adjustments to reflect the emergence of claim activity.

By its nature, the estimate of ultimate losses and LAE is subject to variability due to differences between our assumptions and actual events in the future.  Although many factors influence the actual cost of claims and our corresponding reserve estimates, we do not measure and estimate values for all of these variables individually.  This is due to the fact that many of the factors known to impact the cost of claims cannot be measured directly, such as the impact on claim costs due to economic inflation, coverage interpretations, and jury determinations.  In most instances, we rely on our historical experience or industry information to estimate the values for the variables that are explicitly used in our reserve analyses.  We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of the future effects of these factors.  Where we have reason to expect a change in the effect of one of these factors, we perform analyses to perform the necessary adjustments.

One implicit assumption underlying development patterns is that the claims inflation trends will continue into the future similar to their past patterns. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, our actuarial department derives expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2013 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. General inflation trends have been fairly stable over the past several years but there have been fluctuations of one to two percent over the past ten years and therefore we used a one percent annual inflation variance factor. The effect differed by line of business but overall was a four percent change in reserve adequacy or approximately $30.5 million effect on after tax net income.  A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.

An explicit assumption used in the analysis is the set of initial expected loss ratios (“IELRs”) used in the current accident year reserve projections and in some of the prior accident year ultimate loss indications.  To estimate the sensitivity of the estimated ultimate loss to a change in IELRs, the actuarial department recasted the loss reserve indications using a set of IELRs all one percent higher than the final IELRs. The overall impact of a one percent change in IELRS would be a corresponding one percent change in reserve adequacy or a $5.8 million effect on after tax net income.  Often the loss ratios by line of business will vary from the IELR in different directions causing them to partially offset each other.  A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.

The other factors having influence upon the loss and LAE reserve levels are too numerous and interdependent to efficiently model and test for sensitivity.  Likewise, the development factors by reserve category and age are too numerous to model and test for sensitivity.  Instead, ranges are estimated by reserve category considering past history, fluctuations in the development patterns, emerging issues, trends, and other factors.  The ranges are compiled and the total range is estimated considering the sensitivity to all of the underlying factors together.  The resulting range is our best estimate of the expected ongoing variability in the loss reserves.

Our range of loss and LAE reserves table shows that presently we estimate them as going from favorable development of 12.5% to unfavorable of 8.9%.  The range was evaluated based on the ultimate loss estimates from the actuarial methods described above.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

 

Pre-tax Impact on Earnings from a Variance in Future Loss Payments and Case Reserves as of December 31, 2013 (in thousands)
Line of Business		Minimum Reserve Range								Maximum Reserve Range
Workers' Compensation		$	(36,809	)			-7.7	%		$	34,501				7.2	%
Residual Markets			(1,581	)			-7.0	%			676				3.0	%
Commercial Multiple Peril / General Liability			(83,243	)			-18.1	%			57,967				12.6	%
Commercial Automobile			(14,763	)			-12.5	%			3,106				2.6	%
Other			(2,943	)			-9.0	%			2,703				8.2	%
Total		$	(139,339	)			-12.5	%		$	98,953				8.9	%

 

The range of loss and LAE reserves at December 31, 2013 had a minimum reserve estimate of $971.8 million and a maximum reserve estimate of $1,210.0 million.

 

The range of loss and LAE reserves at December 31, 2012 had a minimum reserve estimate of $953.3 million and a maximum reserve estimate of $1,164.4 million. At December 31, 2012 we recorded the loss and LAE reserves at 1,074.1 million.  At December 31, 2013, re-estimated loss and LAE reserves for December 31, 2012 were $1,142.5 million which was within our 2012 loss and LAE estimated reserve range.

 

The sensitivity around our workers’ compensation reserves primarily reflects the size and the maturity of the underlying book of business.  Our workers’ compensation reserves represent 45% of our total reserves at December 31, 2013.

The sensitivity around our commercial multiple peril / general liability reserves primarily reflects the longer duration of reserves relating to our liability excess program, which started in 2003 and was cancelled in 2012, and our construction defect exposure, which together represent approximately 37% of the $460.0 million reserves in this line of business as of December 31, 2013.  These lines of business are subject to greater uncertainty and volatility than the remainder of our book of business.

The sensitivity around our commercial automobile reserves primarily reflects the speed of reporting of the underlying losses, as well as the maturity of the case law surrounding automobile liability.

The sensitivity around the other lines of business primarily reflects the size of the underlying book of business.  Our other reserves represent 3% of total reserves at December 31, 2013.  A large portion of these reserves represent professional liability programs which tend to be claims-made and reinsured at lower limits, therefore reducing the volatility that is inherent in a smaller book of business.  Another large portion represents property claims, which have a shorter reporting and payout pattern than liability and workers’ compensation claims.

All of our reserves are sensitive to changes in the underlying claim payment and case reserving practices, as well as the other sources of variations mentioned above.

Reinsurance Recoverables

Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR losses and LAE.  Such recoverables, by necessity, are based upon estimates.  Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded.  Instead of being netted against the appropriate liabilities, ceded unearned premiums and reinsurance recoverables on paid and unpaid losses and LAE are reported separately as assets in our consolidated balance sheets.  Reinsurance recoverable balances are also subject to credit risk associated with the particular reinsurer.  In our selection of reinsurers, we continually evaluate their financial stability.  While we believe our reinsurance recoverables are collectible, the ultimate ceded reserve recoverable may be greater or less than the amount accrued.  At December 31, 2013 and 2012, reinsurance recoverables on paid and unpaid losses were $519.9 million and $395.5 million, respectively.

In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, or on the portion of risk either ceded to the captives, or retained by the clients.  The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs.  We collateralize balances due from our risk-sharing partners through funds withheld trusts or stand-by letters of credit issued by highly rated banks.  We have historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which may be in dispute.  At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility.  At December 31, 2013, we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners.  No assurance can be given, however, regarding the future ability of our risk-sharing partners to meet their obligations.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

Legal Contingencies

The Company, and its subsidiaries, are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business as further disclosed in Note 15 ~ Commitments and Contingencies.  Where appropriate, the Company vigorously defends such claims, lawsuits and proceedings.  Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant.   Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by the policy of insurance at issue. We account for such activity through the establishment of unpaid loss and loss expense reserves.  We also maintain errors and omissions insurance and extra-contractual coverage under reinsurance treaties related to the policy of insurance at issue or other appropriate insurance.  In terms of any retentions or deductibles associated with such insurance, the Company has established accruals for such retentions or deductibles, when necessary, based upon current available information.  In accordance with accounting guidance, if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is reasonably estimable; then an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets.  Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income.  Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters.  On the basis of current information, the Company does not believe that there is a reasonable possibility that, other than with regard to the arbitration disclosed in Note 15 ~ Commitments and Contingencies, any material loss exceeding amounts already accrued, if any, will result from any of the claims, lawsuits and proceedings to which the Company is subject to, either individually, or in the aggregate.

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:

Statutory Consolidated Surplus							488,220
Statutory to GAAP differences:
Deferred policy acquisition costs			62,773
Unrealized gain (loss) on investments			(5,649	)
Non-admitted assets and other			(5,255	)
Total Statutory to GAAP differences							51,869
Total Non-Regulated Entities							(126,675	)
GAAP Consolidated Shareholders' Equity							413,413

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

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 nor 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:

 

		For the Years Ended December 31,
		2013				2012				2011
		(In thousands, except share and per share data)
Net operating (loss) income (1)		$	(117,908	)		$	(28,401	)		$	40,333
Net realized gains, net of tax			5,598				40,150				2,699
Net income		$	(112,310	)		$	11,749			$	43,032
Diluted earnings per common share:
Net operating (loss) income		$	(2.36	)		$	(0.57	)		$	0.77
Net income		$	(2.25	)		$	0.23			$	0.82
Diluted weighted average common shares outstanding			49,871,587				50,177,484				52,404,377

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. In 2013, realized gains before tax were $7.8 million, compared to $55.3 million of realized gains in 2012 that were generated by the sale of a large portion of our investment portfolio.  Realized gains in 2011 were $3.0 million. 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.

Accident Year Loss and LAE 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:

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

		For the Years Ended December 31,
		2013				2012				2011
Accident year loss and LAE ratio			68.9	%			69.3	%			65.3	%
Increase in net ultimate loss estimates on prior year loss reserves			9.8	%			10.0	%			1.0	%
Net loss & LAE ratio			78.7	%			79.3	%			66.3	%

 

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 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 and LAE ratio and net loss and LAE ratio separately when reviewing and evaluating our performance.

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.

On February 21, 2014, A.M. Best Company, insurance industry rating agency, lowered Meadowbrook's issuer credit rating from BBB+ to BBB.  While affirming the Company’s B++ financial strength rating A.M. Best lowered the outlook for this rating from “stable” to “negative.”

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 year ended December 31, 2013, we assumed $170.2 million, respectively, in direct written premium from SNIC. The impact of the Front Fee on the year ended December 31, 2013 expense ratios was 0.5%.

Termination of Multiple Line Quota Share Reinsurance Treaty

The multiple line quota share reinsurance treaty entered into December 31, 2012 was terminated, by mutual agreement of the parties, in the third quarter for business effective October 1, 2013 and after. At December 31, 2013, we had ceded unearned premium of $20.3 million, which will be earned over the next nine months, based on the premium effective date.  The total pre-tax costs remaining, are $1.4 million (7% of the $20.3 million in ceded unearned premium), or $0.03 per share.

Results of Operations

Executive Overview

Our GAAP combined ratio was 111.0% for the year ended December 31, 2013, compared to 111.4% in 2012.  Excluding the impact of the quota share reinsurance treaty, the GAAP combined ratio was 107.9% for the year ended December 31, 2013.  Our accident year combined ratio was 101.2% for the year ended December 31, 2013, compared to 101.4% in 2012.   Excluding the impact of the quota share reinsurance treaty, the accident year combined ratio was 99.8% for the year ended December 31, 2013.

The year to date 2013 results were also impacted by the increase in net ultimate loss estimates for 2012 and prior accident years, which added 9.1 percentage points to the GAAP combined ratio. Full-year 2013 results also reflect the addition of 3.1 percentage points to the combined ratio related to the impact from the quota share reinsurance treaty that was entered into during the fourth quarter of 2012, and by an adverse interim final award from a reinsurance arbitration, which added 1.2 percentage points to the GAAP combined ratio.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

 

Net operating loss, a non-GAAP measure, for the year ended December 31, 2013 was ($117.9 million), or ($2.36) per diluted share, compared to net operating loss of ($28.4 million), or ($0.57) per diluted share in 2012. The 2013 net loss includes $5.6 million, or $0.11 per diluted share, of after-tax realized gains, compared to $40.2 million, or $0.80 per diluted share, in 2012.

		Net Operating (Loss) Income				Per Share Net Operating (Loss) Income				Combined Ratio
As Reported 2013 Results		$	(117.9	)		$	(2.36	)			111.0	%
Goodwill impairment (pre-tax $115.4)			101.6				2.04				-9.1	%
Prior year development (pre-tax $63.2)			41.5				0.83				-3.1	%
Arbitration impact (pre-tax $8.2)			6.7				0.13				-1.2	%
Multiple line quota share reinsurance treaty impact (pre-tax $10.2)			5.4				0.11				0.0	%
Pro Forma 2013 AY net operating income, including front fee		$	37.3			$	0.75				97.6	%

		Net Operating (Loss) Income				Per Share Net Operating (Loss) Income				Combined Ratio
Contributions to Pro Forma 2013 Accident Year Net Operating Income
Profits from net commissions and fee revenue (pre-tax $13.7)		$	9.0			$	0.18
Net investment income (pre-tax $46.5)			36.8				0.74
2013 accident year underwriting profit (pre-tax $7.9)			5.2				0.10				97.1	%
Equity earnings (reported net of tax)			2.5				0.05
Expenses to Support Capital Sturcture
Front fee (pre-tax $3.5)			(2.3	)			(0.05	)			0.5	%
General Corporate Expenses (pre-tax $4.0)			(2.6	)			(0.05	)
Amortization Expense (pre-tax $4.0)			(2.8	)			(0.06	)
Interest expense (pre-tax $13.0)			(8.5	)			(0.17	)
Pro Forma 2013 AY net operating income, including front fee		$	37.3			$	0.74				97.6	%

Gross written premium decreased $122.6 million, or 11.5%, to $944.0 million in 2013, compared to $1,066.6 million in 2012.  The decline in premium is attributed to the termination of, or premium volume reductions in certain programs where pricing and underwriting did not meet the Company’s underwriting standards and was offset by an overall 12% rate increase, which exceeded the Company’s estimated loss ratio trend of 1.7%.

Results of Operations - 2013 compared to 2012:

The net loss for the year ended December 31, 2013 was ($112.3 million), or ($2.25) per dilutive share, compared to net income of $11.7 million, or $0.23 per dilutive share, for the comparable period of 2012.  Net operating loss, a non-GAAP measure, for the year ended December 31, 2013 was ($117.9 million), or ($2.36) per diluted share, compared to net operating loss of ($28.4 million), or ($0.57) per diluted share for the year ended December 31, 2012.  The 2013 net operating loss, excluding the goodwill impairment, was ($16.3 million), or ($0.21) per diluted share. Total diluted weighted average shares outstanding for the year ended December 31, 2013, were 49,871,587, compared to 50,177,484 the comparable period in 2012.  The decrease reflects the impact of our Share Repurchase Plan in 2012.

Revenues - 2013 compared to 2012

Revenues for the year ended December 31, 2013, decreased $205.6 million, or 20.6%, to $791.2 million, from $996.8 million for the comparable period in 2012.  This decrease primarily reflects reduced premium levels and a decrease in net realized gains.

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

Net earned premiums decreased $156.8 million, or 18.4%, to $697.4 million for the year ended December 31, 2013, from $854.3 million in the comparable period in 2012.  The decrease in premium is attributed to the termination of, or premium volume reductions in certain programs where pricing and underwriting did not meet the Company’s underwriting standards and was offset by an overall 12% rate increase, which exceeded the Company’s estimated loss ratio trend of 1.7%.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued

Net commission and fee revenue increased $5.5 million, or 16.0%, to $39.5 million for the year ended December 31, 2013, from $34.0 million for the comparable period in 2012. This increase was driven primarily by commission revenues generated from our subsidiary US Specialty Underwriters (“USSU”) that are no longer considered intercompany or eliminated in consolidation as they are now written by SNIC carriers. This increase did not impact the Company’s consolidated financial results as there is a corresponding increase in the expenses from net commission and fee operations.

Net investment income decreased by $6.7 million, to $46.5 million for the year ended December 31, 2013, from $53.1 million for the comparable period in 2012. The decrease reflects the impact of lower reinvestment rates in 2013 from the proceeds of the fourth quarter 2012 sale of a portion of our bond portfolio offset by the investment of the proceeds from the cash convertible senior notes.

Net realized gains decreased by $47.5 million, to a $7.8 million gain for the year ended December 31, 2013, from a $55.3 million gain for the comparable period in 2012. The decrease in realized gains relates to the fourth quarter 2012 sale of a portion of our bond portfolio in order to generate realized gains and enhance the statutory surplus of our Insurance Company Subsidiaries.

Expenses - 2013 compared to 2012

Expenses decreased $58.6 million from $995.5 million for the year ended December 31, 2012 to $936.9 million for the year ended December 31, 2013.

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

Net loss and loss adjustment expenses (“LAE”) decreased $128.6 million to $549.0 million for the year ended December 31, 2013, from $677.7 million for the same period in 2012.  Our loss and LAE ratio was 78.7% for the year ended December 31, 2013 and 79.3% for the year ended December 31, 2012.  The loss and LAE ratio for the year ended December 31, 2013 includes a 9.8 percentage point increase from net ultimate loss estimates for accident years 2012 and prior, whereas the 2012 results include a 10.0 percentage point increase from net ultimate loss estimates for accident years 2011 and prior. The accident year loss and LAE ratio was 68.9% for the year ended December 31, 2013, down from 69.3% in the comparable period in 2012. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section.

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MEADOWBROOK INSURANCE GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS - continued