form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C.  20549
_________

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
or
o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from        to

Commission File Number 1-14094

Meadowbrook Insurance Group, Inc.
(Exact name of Registrant as specified in its charter)
 
Michigan   38-2626206
(State of Incorporation)   (IRS Employer Identification No.)
 
26255 American Drive, Southfield, Michigan  48034
(Address, zip code of principal executive offices)

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

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 whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or smaller reporting company.  See 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).  Yeso No x
 
The aggregate number of shares of the Registrant’s Common Stock, $.01 par value, outstanding on November 2, 2011, was 51,050,204.



 
 

 
 
TABLE OF CONTENTS

 
Page
PART I FINANCIAL INFORMATION
 
   
ITEM 1 –    FINANCIAL STATEMENTS
 
2-3
4
5
6
7
8-27
   
28-45
   
45-47
   
ITEM 4 –    CONTROLS AND PROCEDURES
48
   
PART II OTHER INFORMATION
 
   
ITEM 1 –    LEGAL PROCEEDINGS
49
   
ITEM 1A – RISK FACTORS
49
   
49
   
ITEM 6 –    EXHIBITS
50
   
51
 
 
1


PART 1 - FINANCIAL INFORMATION
 
ITEM 1.  FINANCIAL STATEMENTS
 
MEADOWBROOK INSURANCE GROUP, INC.
 
CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended September 30,

   
2011
   
2010
 
   
(Unaudited)
 
   
(In thousands, except share data)
 
Revenues
           
Premiums earned
           
Gross
  $ 225,219     $ 200,918  
Ceded
    (31,632 )     (29,054 )
Net earned premiums
    193,587       171,864  
Net commissions and fees
    7,293       9,869  
Net investment income
    13,502       13,715  
Realized gains (losses):
               
Total other-than-temporary impairments on securities
    -       (25 )
Portion of loss recognized in other comprehensive income
    -       -  
Net other-than-temporary impairments on securities recognized in earnings
    -       (25 )
Net realized gains excluding other-than-temporary impairments on securities
    363       308  
Net realized gains
    363       283  
Total revenues
    214,745       195,731  
                 
Expenses
               
Losses and loss adjustment expenses
    153,809       122,044  
Reinsurance recoveries
    (24,853 )     (16,105 )
Net losses and loss adjustment expenses
    128,956       105,939  
Policy acquisition and other underwriting expenses
    64,665       59,013  
General, selling and administrative expenses
    5,876       5,881  
General corporate expenses
    273       1,163  
Amortization expense
    1,208       1,235  
Interest expense
    2,066       2,405  
Total expenses
    203,044       175,636  
Income before taxes and equity earnings
    11,701       20,095  
Federal and state income tax expense
    2,590       5,500  
Equity earnings of affiliates, net of tax
    649       425  
Equity earnings of unconsolidated subsidiaries, net of tax
    (8 )     16  
Net income
  $ 9,752     $ 15,036  
                 
Earnings Per Share
               
Basic
  $ 0.19     $ 0.28  
Diluted
  $ 0.19     $ 0.28  
                 
Weighted average number of common shares
               
Basic
    52,240,813       53,418,314  
Diluted
    52,355,581       53,698,954  
                 
Dividends paid per common share
  $ 0.04     $ 0.04  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME
For the Nine Months Ended September 30,

   
2011
   
2010
 
   
(Unaudited)
 
   
(In thousands, except share data)
 
Revenues
           
Premiums earned
           
Gross
  $ 635,581     $ 573,320  
Ceded
    (89,866 )     (87,255 )
Net earned premiums
    545,715       486,065  
Net commissions and fees
    23,628       26,872  
Net investment income
    40,839       40,198  
Realized gains (losses):
               
Total other-than-temporary impairments on securities
    (84 )     (437 )
Portion of loss recognized in other comprehensive income
    -       -  
Net other-than-temporary impairments on securities recognized in earnings
    (84 )     (437 )
Net realized gains excluding other-than-temporary impairments on securities
    2,353       878  
Net realized gains
    2,269       441  
Total revenues
    612,451       553,576  
                 
Expenses
               
Losses and loss adjustment expenses
    423,889       340,941  
Reinsurance recoveries
    (68,268 )     (48,310 )
Net losses and loss adjustment expenses
    355,621       292,631  
Policy acquisition and other underwriting expenses
    184,553       168,262  
General, selling and administrative expenses
    17,751       17,108  
General corporate expenses
    909       4,409  
Amortization expense
    3,646       3,757  
Interest expense
    6,320       7,259  
Total expenses
    568,800       493,426  
Income before taxes and equity earnings
    43,651       60,150  
Federal and state income tax expense
    10,709       17,896  
Equity earnings of affiliates, net of tax
    1,895       1,591  
Equity earnings of unconsolidated subsidiaries, net of tax
    (30 )     486  
Net income
  $ 34,807     $ 44,331  
                 
Earnings Per Share
               
Basic
  $ 0.66     $ 0.82  
Diluted
  $ 0.66     $ 0.81  
                 
Weighted average number of common shares
               
Basic
    52,860,729       54,229,706  
Diluted
    52,974,390       54,508,592  
                 
Dividends paid per common share
  $ 0.12     $ 0.10  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Three Months Ended September 30,

   
2011
   
2010
 
   
(Unaudited)
 
   
(In thousands)
 
Net income
  $ 9,752     $ 15,036  
Other comprehensive income, net of tax:
               
Unrealized gains on securities
    16,788       16,556  
Unrealized gains in affiliates and unconsolidated subsidiaries
    23       105  
Increase on non-credit other-than-temporary impairments on securities
    74       333  
Net deferred derivative losses - hedging activity
    (275 )     (705 )
Less reclassification adjustment for investment gains included in net income
    (342 )     (314 )
Other comprehensive gains, net of tax
    16,268       15,975  
Comprehensive income
  $ 26,020     $ 31,011  

MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Nine Months Ended September 30,
 
   
2011
   
2010
 
   
(Unaudited)
 
   
(In thousands)
 
Net income
  $ 34,807     $ 44,331  
Other comprehensive income, net of tax:
               
Unrealized gains on securities
    27,936       34,823  
Unrealized gains in affiliates and unconsolidated subsidiaries
    22       245  
Increase on non-credit other-than-temporary impairments on securities
    159       818  
Net deferred derivative gains (losses) - hedging activity
    10       (1,330 )
Less reclassification adjustment for investment gains included in net income
    (2,222 )     (374 )
Other comprehensive gains, net of tax
    25,905       34,182  
Comprehensive income
  $ 60,712     $ 78,513  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
4

 
MEADOWBROOK INSURANCE GROUP, INC.
 
CONSOLIDATED BALANCE SHEETS

   
September 30,
   
December 31,
 
   
2011
   
2010
 
    (Unaudited)        
    (In thousands, except share data)  
ASSETS
           
Investments
           
Debt securities available for sale, at fair value (amortized cost of $1,242,614 and $1,170,795)
  $ 1,339,544     $ 1,226,360  
Equity securities available for sale, at fair value (cost of $25,176 and $25,632)
    26,995       28,483  
Cash and cash equivalents
    76,348       90,414  
Accrued investment income
    13,821       13,021  
Premiums and agent balances receivable, net
    193,695       169,866  
Reinsurance recoverable on:
               
Paid losses
    12,981       13,342  
Unpaid losses
    304,870       280,854  
Prepaid reinsurance premiums
    34,710       28,208  
Deferred policy acquisition costs
    88,221       78,755  
Deferred income taxes, net
    -       5,569  
Goodwill
    118,842       118,842  
Other intangible assets
    33,154       36,637  
Other assets
    98,818       87,290  
Total assets
  $ 2,341,999     $ 2,177,641  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Liabilities
               
Losses and loss adjustment expenses
  $ 1,157,453     $ 1,065,056  
Unearned premiums
    397,913       352,585  
Debt
    27,562       37,750  
Debentures
    80,930       80,930  
Accounts payable and accrued expenses
    36,825       38,645  
Funds held and reinsurance balances payable
    34,233       28,824  
Payable to insurance companies
    2,809       2,754  
Deferred income taxes, net
    8,250       -  
Other liabilities
    15,706       23,996  
Total liabilities
    1,761,681       1,630,540  
                 
Shareholders' Equity
               
Common stock, $0.01 stated value; authorized 75,000,000 shares; 51,050,204 and 53,236,542 shares issued and outstanding
    520       520  
Additional paid-in capital
    279,727       292,705  
Retained earnings
    239,565       219,298  
Note receivable from officer
    (774 )     (797 )
Accumulated other comprehensive income
    61,280       35,375  
Total shareholders' equity
    580,318       547,101  
Total liabilities and shareholders' equity
  $ 2,341,999     $ 2,177,641  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
MEADOWBROOK INSURANCE GROUP, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

   
Common 
Stock
   
Additional 
Paid-In Capital
   
Retained 
Earnings
   
Note
Receivable
from Officer
   
Accumulated Other
Comprehensive
Income
   
Total
Shareholders'
Equity
 
   
(Unaudited, In thousands)
 
Balances December 31, 2010
  $ 520     $ 292,705     $ 219,298     $ (797 )   $ 35,375     $ 547,101  
Net income
    -       -       34,807       -       -       34,807  
Dividends declared and paid
    -       -       (6,336 )     -       -       (6,336 )
Change in unrealized on available for sale securities, net of tax
    -       -       -       -       26,216       26,216  
Change in valuation allowance on deferred tax assets
    -       -       -       -       (343 )     (343 )
Net deferred derivative gain - hedging activity
    -       -       -       -       10       10  
Stock award
    -       454       -       -       -       454  
Long term incentive plan; stock award for 2009-2011 plan years
    -       (1,195 )     -       -       -       (1,195 )
Change in investment of affiliates, net of tax
    -       -       -       -       22       22  
Repurchase of 2,225,000 shares of common stock
    -       (12,237 )     (8,204 )     -       -       (20,441 )
Note receivable from officer
    -       -       -       23       -       23  
Balances September 30, 2011
  $ 520     $ 279,727     $ 239,565     $ (774 )   $ 61,280     $ 580,318  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
6

 
MEADOWBROOK INSURANCE GROUP, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended September 30,

   
2011
   
2010
 
   
(Unaudited)
 
   
(In thousands)
 
Cash Flows From Operating Activities
           
Net income
  $ 34,807     $ 44,331  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Amortization of other intangible assets
    3,646       3,757  
Amortization of deferred debenture issuance costs
    94       192  
Depreciation of furniture, equipment, and building
    3,916       4,194  
Net amortization of discount and premiums on bonds
    3,092       2,405  
Gain on sale of investments, net
    (2,222 )     (374 )
Gain on sale of fixed assets
    (47 )     (66 )
Long-term incentive plan expense
    (1,195 )     753  
Stock award
    454       458  
Equity earnings of affiliates, net of taxes
    (1,895 )     (1,591 )
Equity loss (earnings) of unconsolidated subsidiaries, net of tax
    30       (486 )
Deferred income tax expense
    (8,908 )     (1,213 )
Changes in operating assets and liabilities:
               
Decrease (increase) in:
               
Premiums and agent balances receivable
    (23,829 )     (21,866 )
Reinsurance recoverable on paid and unpaid losses
    (23,655 )     (18,405 )
Prepaid reinsurance premiums
    (6,502 )     5,483  
Deferred policy acquisition costs
    (9,466 )     (9,917 )
Other assets
    (3,409 )     (3,935 )
Increase (decrease) in:
               
Losses and loss adjustment expenses
    92,397       94,586  
Unearned premiums
    45,328       27,865  
Payable to insurance companies
    55       (513 )
Funds held and reinsurance balances payable
    5,409       (2,126 )
Other liabilities
    (13,225 )     4,515  
Total adjustments
    60,068       83,716  
Net cash provided by operating activities
    94,875       128,047  
Cash Flows From Investing Activities
               
Purchase of debt securities available for sale
    (170,746 )     (185,759 )
Proceeds from sales and maturities of debt securities available for sale
    104,272       84,207  
Proceeds from sales of equity securities available for sale
    700       1,020  
Capital expenditures
    (5,606 )     (3,311 )
Acquisition of rights renewals
    (164 )     (148 )
Other investing activities
    132       (231 )
Net cash used in investing activities
    (71,412 )     (104,222 )
Cash Flows From Financing Activities
               
Payments on term loan
    (10,188 )     (8,875 )
Book overdrafts
    (593 )     737  
Dividends paid on common stock
    (6,336 )     (4,878 )
Cash payment for payroll taxes associated with long-term incentive plan net stock issuance
    -       (35 )
Share repurchases
    (20,441 )     (20,719 )
Other financing activities
    29       21  
Net cash used in financing activities
    (37,529 )     (33,749 )
Net decrease in cash and cash equivalents
    (14,066 )     (9,924 )
Cash and cash equivalents, beginning of period
    90,414       86,319  
Cash and cash equivalents, end of period
  $ 76,348     $ 76,395  
Supplemental Disclosure of Cash Flow Information:
               
Interest paid
  $ 6,074     $ 6,490  
Net income taxes paid
  $ 18,279     $ 16,445  
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
               
Stock-based employee compensation
  $ 454     $ 458  
 
The accompanying notes are an integral part of the Consolidated Financial Statements.
 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



NOTE 1 – Summary of Significant Accounting Policies

Basis of Presentation and Management Representation

The consolidated financial statements include accounts, after elimination of intercompany accounts and transactions, of Meadowbrook Insurance Group, Inc. (the “Company” or “Meadowbrook”), its wholly owned subsidiary Star Insurance Company (“Star”), and Star’s wholly owned subsidiaries, Savers Property and Casualty Insurance Company (“Savers”), Williamsburg National Insurance Company (“Williamsburg”), and Ameritrust Insurance Corporation (“Ameritrust”).  The consolidated financial statements also include Meadowbrook, Inc., Crest Financial Corporation, and their respective subsidiaries.  In addition, the consolidated financial statements also include ProCentury Corporation (“ProCentury”) and its wholly owned subsidiaries.  ProCentury’s wholly owned subsidiaries consist of Century Surety Company (“Century”) and its wholly owned subsidiary ProCentury Insurance Company (“PIC”).  In addition, ProCentury Risk Partners Insurance Company, Ltd., is a wholly owned subsidiary of ProCentury.  Star, Savers, Williamsburg, Ameritrust, Century, and PIC are collectively referred to as the Insurance Company Subsidiaries.

In the opinion of management, the consolidated financial statements reflect all normal recurring adjustments necessary to present a fair statement of the results for the interim period.  Preparation of financial statements under generally accepted accounting principles (“GAAP”) requires management to make estimates.  Actual results could differ from those estimates.  The results of operations for the three months and nine months ended September 30, 2011 are not necessarily indicative of the results expected for the full year.

These financial statements and the notes thereto should be read in conjunction with the Company’s audited financial statements and accompanying notes included in its Annual Report on Form 10-K, as filed with the United States Securities and Exchange Commission, for the year ended December 31, 2010.

Revenue Recognition

Premiums written, which include direct, assumed and ceded amounts are recognized as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written that are applicable to the unexpired terms of policies in force. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received and actuarial estimates.
 
 
8

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Assumed premium estimates are specifically related to an established book of workers compensation business on which the Company has established an equity ownership relationship and the mandatory assumed pool business from the National Council on Compensation Insurance (“NCCI”), or residual market business.  The pool cedes workers’ compensation business to participating companies based upon the individual company’s market share by state.  The activity is reported from the NCCI to participating companies on a two quarter lag. To accommodate this lag, the Company estimates premium and loss activity based on historical and market based results.  Historically, the Company has not experienced any material difficulties or disputes in collecting balances from NCCI; therefore, no provision for doubtful accounts is recorded related to the assumed premium estimate.

Fee income, which includes risk management consulting, loss control, and claims services, is recognized during the period the services are provided.  Depending on the terms of the contract, claims processing fees are recognized as revenue over the estimated life of the claims, or the estimated life of the contract.  For those contracts that provide services beyond the expiration or termination of the contract, fees are deferred in an amount equal to management’s estimate of the Company’s obligation to continue to provide services in the future.

Commission income, which includes reinsurance placement, is recorded on the later of the effective date or the billing date of the policies on which they were earned.  Commission income is reported net of any sub-producer commission expense.  Any commission adjustments that occur subsequent to the earnings process are recognized upon notification from the insurance companies.  Profit sharing commissions from insurance companies are recognized when determinable, which is when such commissions are received.

Income Taxes

As of September 30, 2011 and December 31, 2010, the Company did not have any unrecognized tax benefits.

Interest costs and penalties related to income taxes are classified as interest expense and other administrative expenses, respectively. As of September 30, 2011 and December 31, 2010, the Company had no accrued interest or penalties related to uncertain tax positions.

Recent Accounting Pronouncements

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts

In October 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to assist in a consistent application of accounting for costs related to acquiring or renewing insurance contracts among industry practice. The new guidance restricts the capitalization of a contract’s acquisition costs to those that are directly related to the successful acquisition of a new or renewing insurance contract. The new guidance is effective for interim and annual reporting periods beginning after December 15, 2011. The Company is still evaluating the impact of adoption on its financial condition and results of operations, but currently does not anticipate it having a material impact.
 
 
9


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs

In May 2011, the FASB issued guidance to achieve common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards (IFRSs).  The guidance explains how to measure fair value and does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting.  The guidance is to be applied prospectively for interim and annual periods beginning after December 15, 2011. The Company is still evaluating the impact of adoption on its financial condition and results of operations.

Presentation of Comprehensive Income

In June 2011, the FASB issued guidance to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The guidance requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The guidance is to be applied retrospectively and is effective for interim and annual periods beginning after December 15, 2011, with early adoption permitted. The Company has not yet adopted this guidance and will not have a material impact on its financial condition and results of operations.

Testing Goodwill for Impairment

In September 2011, the FASB issued guidance on how to  test goodwill for impairment through use of a qualitative approach. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not (defined as having a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles-Goodwill and Other. The guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company is still evaluating the impact of adoption on its financial condition and results of operations.
 
 
10

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 2 – Investments

The estimated fair value of investments in securities is determined primarily based upon published market quotations and broker/dealer quotations. The cost or amortized cost, gross unrealized gains, losses, non-credit other-than-temporary impairments (“OTTI”) and estimated fair value of investments in securities classified as available for sale at September 30, 2011 and December 31, 2010 were as follows (in thousands):
 
   
September 30, 2011
 
   
Cost or
Amortized
Cost
   
Gross Unrealized
   
Estimated
Fair Value
 
   
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 23,301     $ 1,893     $ -     $ -     $ 25,194  
Obligations of states and political subs
    550,708       42,486       (26 )     -       593,168  
Corporate securities
    450,436       37,531       (1,501 )     -       486,466  
Redeemable preferred stocks
    1,924       301       -       -       2,225  
Residential mortgage-backed securities
    163,676       12,635       (27 )     (152 )     176,132  
Commercial mortgage-backed securities
    37,848       2,258       -       -       40,106  
Other asset-backed securities
    14,721       2,008       (30 )     (446 )     16,253  
Total debt securities available for sale
    1,242,614       99,112       (1,584 )     (598 )     1,339,544  
Equity Securities:
                                       
Perpetual preferred stock
    10,413       1,817       (69 )     -       12,161  
Common stock
    14,763       409       (338 )     -       14,834  
Total equity securities available for sale
    25,176       2,226       (407 )     -       26,995  
Total securities available for sale
  $ 1,267,790     $ 101,338     $ (1,991 )   $ (598 )   $ 1,366,539  
 
   
December 31, 2010
 
   
Cost or
Amortized
Cost
   
Gross Unrealized
   
Estimated
Fair Value
 
   
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 25,375     $ 1,363     $ (24 )   $ -     $ 26,714  
Obligations of states and political subs
    527,080       22,176       (2,125 )     -       547,131  
Corporate securities
    379,974       21,555       (1,355 )     (3 )     400,171  
Redeemable preferred stocks
    3,368       1,044       -       -       4,412  
Residential mortgage-backed securities
    181,966       12,182       (694 )     (151 )     193,303  
Commercial mortgage-backed securities
    34,942       1,236       (478 )     -       35,700  
Other asset-backed securities
    18,090       1,476       (33 )     (604 )     18,929  
Total debt securities available for sale
    1,170,795       61,032       (4,709 )     (758 )     1,226,360  
Equity Securities:
                                       
Perpetual preferred stock
    10,869       2,006       (6 )     -       12,869  
Common stock
    14,763       1,255       (404 )     -       15,614  
Total equity securities available for sale
    25,632       3,261       (410 )     -       28,483  
Total securities available for sale
  $ 1,196,427     $ 64,293     $ (5,119 )   $ (758 )   $ 1,254,843  
 
 
11

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Gross unrealized gains, losses, and non-credit OTTI on available for sale securities as of September 30, 2011 and December 31, 2010 were as follows (in thousands):
 
   
September 30,
2011
   
December 31,
2010
 
Unrealized gains
  $ 101,338     $ 64,293  
Unrealized losses
    (1,991 )     (5,119 )
Non-credit OTTI
    (598 )     (758 )
Net unrealized gains
    98,749       58,416  
Deferred federal income tax expense
    (34,562 )     (20,445 )
Net unrealized gains on investments, net of deferred federal income taxes
  $ 64,187     $ 37,971  
 
Net realized gains (losses, including OTTI) on securities, for the three months and nine months ended September 30, 2011 and 2010 were as follows (in thousands):

   
For the Three Months
Ended September 30,
   
For the Nine Months
Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Realized gains (losses):
                       
Debt securities:
                       
Gross realized gains
  $ 274     $ 257     $ 2,141     $ 630  
Gross realized losses
    (22 )     (22 )     (163 )     (390 )
Total debt securities
    252       235       1,978       240  
Equity securities:
                               
Gross realized gains
    90       90       244       206  
Gross realized losses
    -       (11 )     -       (72 )
Total equity securities
    90       79       244       134  
Net realized gains
  $ 342     $ 314     $ 2,222     $ 374  
                                 
OTTI included in realized losses on securities above
  $ -     $ (25 )   $ (84 )   $ (437 )
 
Proceeds from the sales of fixed maturity securities available for sale were $1.1 million and $0.1 million for the three months ended September 30, 2011 and 2010, respectively. Proceeds from the sales of fixed maturity securities available for sale were $28.5 million and $1.2 million for the nine months ended September 30, 2011 and 2010, respectively.
 
 
12

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
At September 30, 2011, the amortized cost and estimated fair value of available for sale debt securities by contractual maturity are shown below. Expected maturities may differ from contractual maturities, because certain borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands):

   
Available for Sale
 
   
Amortized
Cost
   
Estimated
Fair Value
 
Due in one year or less
  $ 30,264     $ 30,647  
Due after one year through five years
    270,327       282,478  
Due after five years through ten years
    599,735       658,912  
Due after ten years
    126,043       135,016  
Mortgage-backed securities, collateralized obligations and asset-backed securities
    216,245       232,491  
    $ 1,242,614     $ 1,339,544  
 
Net investment income for the three months and nine months ended September 30, 2011 and 2010 was as follows (in thousands):

   
For the Three Months
Ended September 30,
   
For the Nine Months
Ended September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Net Investment Income Earned From:
                       
Debt securities
  $ 13,207     $ 13,232     $ 39,834     $ 38,783  
Equity securities
    452       565       1,431       1,626  
Cash and cash equivalents
    176       196       567       605  
Total gross investment income
    13,835       13,993       41,832       41,014  
Less investment expenses
    333       278       993       816  
Net investment income
  $ 13,502     $ 13,715     $ 40,839     $ 40,198  
 
Other-Than-Temporary Impairments of Securities and Unrealized Losses on Investments

Available for sale securities are reviewed for declines in fair value that are determined to be other-than-temporary.  For a debt security, if the Company intends to sell a security and it is more likely than not the Company will be required to sell a debt security before recovery of its amortized cost basis and the fair value of the debt security is below amortized cost, the Company concludes that an OTTI has occurred and the amortized cost is written down to current fair value, with a corresponding charge to realized loss in the Consolidated Statements of Income.  If the Company does not intend to sell a debt security and it is not more likely than not the Company will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), the Company concludes that an OTTI has occurred.  In this instance, accounting guidance requires the bifurcation of the total OTTI into the amount related to the credit loss, which is recognized in earnings and the non-credit OTTI, which is recorded in Other Comprehensive Income as an unrealized non-credit OTTI in the Consolidated Statements of Comprehensive Income.
 
 
13


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
When assessing the Company’s intent to sell a debt security, if it is more likely than not the Company will be required to sell a debt security before recovery of its cost basis, facts and circumstances such as, but not limited to, decisions to reposition the security portfolio, sale of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing, are evaluated.  In order to determine the amount of the credit loss for a debt security, the Company calculates the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows expected to be recovered.  The discount rate is the effective interest rate implicit in the underlying debt security upon issuance.  The effective interest rate is the original yield or the coupon if the debt security was previously impaired.  If an OTTI exists and there is not sufficient cash flows or other information to determine a recovery value of the security, the Company concludes that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss in the Consolidated Statements of Income.

To determine the recovery period of a debt security, the Company considers the facts and circumstances surrounding the underlying issuer including, but not limited to the following:
 
 ●
Historical and implied volatility of the security;
 
 ●
Length of time and extent to which the fair value has been less than amortized cost;
 
 ●
Conditions specifically related to the security such as default rates, loss severities, loan to value ratios, current levels of subordination, third party guarantees, and vintage;
 
 ●
Specific conditions in an industry or geographic area;
 
 ●
Any changes to the rating of the security by a rating agency;
 
 ●
Failure, if any, of the issuer of the security to make scheduled payments; and
 
 ●
Recoveries or additional declines in fair value subsequent to the balance sheet date.

In periods subsequent to the recognition of an OTTI, the security is accounted for as if it had been purchased on the measurement date of the OTTI.  Therefore, for a fixed maturity security, the discount or reduced premium is reflected in net investment income over the contractual term of the investment in a manner that produces a constant effective yield.
 
 
14

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
For an equity security, if the Company does not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, the Company concludes that an OTTI has occurred, and the cost of the equity security is written down to the current fair value, with a corresponding charge to realized loss within the Consolidated Statements of Income. When assessing the Company’s ability and intent to hold the equity security to recovery, the Company considers, among other things, the severity and duration of the decline in fair value of the equity security, as well as the cause of decline, a fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer.

After reviewing the Company’s investment portfolio in relation to this policy, the Company did not record any credit related OTTI for the three months ended September 30, 2011. The Company recorded $84,000 of credit related OTTI for the nine months ended September 30, 2011. No non-credit related OTTI was recognized for the three months and nine months ended September 30, 2011 in other comprehensive income.  For the three months and nine months ended September 30, 2010, the Company recorded an OTTI loss of $25,000 and $437,000, respectively, of which no non-credit related OTTI losses were recognized in other comprehensive income.

The fair value and amount of unrealized losses segregated by the time period the investment has been in an unrealized loss position were as follows (in thousands):

    September 30, 2011  
   
Less than 12 months
   
Greater than 12 months
   
Total
 
   
Number
of Issues
   
Fair Value of
Investments
with
Unrealized
Losses
   
Gross
Unrealized
Losses and
Non-Credit
OTTI
   
Number
of
Issues
   
Fair Value of
Investments
with Unrealized
Losses
   
Gross
Unrealized
Losses and
Non-Credit
OTTI
   
Number
of
Issues
   
Fair Value of
Investments
with Unrealized
Losses
   
Gross
Unrealized
Losses and
Non-Credit
OTTI
 
Debt Securities:
                                                     
U.S. Government and agencies
    0     $ -     $ -       -     $ -     $ -       0     $ -     $ -  
Obligations of states and political subs
    3       2,213       (25 )     1       184       (1 )     4       2,397       (26 )
Corporate securities
    27       42,069       (1,501 )     -       -       -       27       42,069       (1,501 )
Redeemable preferred stocks
    -       -       -       -       -       -       -       -       -  
Residential mortgage-backed securities
    3       306       (27 )     1       3,621       (152 )     4       3,927       (179 )
Commercial mortgage-backed securities
    1       1,105       -       -       -       -       1       1,105       -  
Other asset-backed securities
    3       654       (16 )     8       1,301       (460 )     11       1,955       (476 )
Total debt securities
    37       46,347       (1,569 )     10       5,106       (613 )     47       51,453       (2,182 )
Equity Securities:
                                                                       
Perpetual preferred stock
    2       1,059       (69 )     -       -       -       2       1,059       (69 )
Common stock
    1       48       -       3       5,057       (338 )     4       5,105       (338 )
Total equity securities
    3       1,107       (69 )     3       5,057       (338 )     6       6,164       (407 )
Total securities
    40     $ 47,454     $ (1,638 )     13     $ 10,163     $ (951 )     53     $ 57,617     $ (2,589 )

 
15


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
   
December 31, 2010
 
   
Less than 12 months
   
Greater than 12 months
   
Total
 
   
Number
of Issues
   
Fair Value of
Investments
with
Unrealized
Losses
   
Gross
Unrealized
Losses and
Non-Credit
OTTI
   
Number
of
Issues
   
Fair Value of
Investments
with Unrealized
Losses
   
Gross
Unrealized
Losses and
Non-Credit
OTTI
   
Number
of
Issues
   
Fair Value of
Investments
with Unrealized
Losses
   
Gross
Unrealized
Losses and
Non-Credit
OTTI
 
Debt Securities:
                                                     
U.S. Government and agencies
    3     $ 3,381     $ (24 )     -     $ -     $ -       3     $ 3,381     $ (24 )
Obligations of states and political subs
    36       71,422       (2,119 )     2       679       (6 )     38       72,101       (2,125 )
Corporate securities
    40       70,411       (1,358 )     -       -       -       40       70,411       (1,358 )
Redeemable preferred stocks
    -       -       -       -       -       -       -       -       -  
Residential mortgage-backed securities
    5       22,161       (694 )     1       3,631       (151 )     6       25,792       (845 )
Commercial mortgage-backed securities
    2       7,052       (183 )     1       311       (295 )     3       7,363       (478 )
Other asset-backed securities
    2       1,569       (16 )     12       2,617       (621 )     14       4,186       (637 )
Total debt securities
    88       175,996       (4,394 )     16       7,238       (1,073 )     104       183,234       (5,467 )
Equity Securities:
                                                                       
Perpetual preferred stock
    1       995       (6 )     -       -       -       1       995       (6 )
Common stock
    -       -       -       3       5,063       (404 )     3       5,063       (404 )
Total equity securities
    1       995       (6 )     3       5,063       (404 )     4       6,058       (410 )
Total securities
    89     $ 176,991     $ (4,400 )     19     $ 12,301     $ (1,477 )     108     $ 189,292     $ (5,877 )

Changes in the amount of credit loss on fixed maturities for which a portion of an OTTI related to other factors was recognized in other comprehensive income were as follows (in thousands):

Balance as of January 1, 2010
  $ (547 )
Additional credit impairments on:
       
  Previously impaired securities
    (264 )
  Securities for which an impairment was not previously recognized
    -  
Reductions
    89  
Balance as of December 31, 2010
    (722 )
Additional credit impairments on:
       
  Previously impaired securities
    (67 )
  Securities for which an impairment was not previously recognized
    -  
Reductions
    -  
Balance as of September 30, 2011
  $ (789 )
 
NOTE 3 – Fair Value Measurements
 
 
According to accounting guidance for fair value measurements and disclosures, fair value is the price that would be received to sell an asset or would be paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.  The guidance establishes a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (“observable inputs”) and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (“unobservable inputs”).
 
 
16

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The estimated fair values of the Company’s fixed investment portfolio are based on prices provided by a third party pricing service and a third party investment manager.  The prices provided by these services are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing.  The third party pricing service and the third party investment manager provide a single price or quote per security and the Company has not historically adjusted security prices.  The Company obtains an understanding of the methods, models and inputs used by the third party pricing service and the third party investment manager, and has controls in place to validate that amounts provided represent fair values.  The Company’s control process includes, but is not limited to, initial and ongoing evaluation of the methodologies used, a review of specific securities and an assessment for proper classification within the fair value hierarchy.  The hierarchy level assigned to each security in the Company’s available for sale portfolio is based upon its assessment of the transparency and reliability of the inputs used in the valuation as of the measurement date. The three hierarchy levels are defined as follows:

Level 1 – Valuations that are based on unadjusted quoted prices in active markets for identical securities. The fair value of exchange-traded preferred and common equities, and mutual funds included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The fair value measurements that were based on Level 1 inputs comprise 2.1% of the fair value of the total investment portfolio.

Level 2 – Valuations that are based on observable inputs (other than Level 1 prices) such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly.  The fair value of securities included in the Level 2 category were based on the market values obtained from a third party pricing service that were evaluated using pricing models that vary by asset class and incorporate available trade, bid and other observable market information.  The third party pricing service monitors market indicators, as well as industry and economic events.  The Level 2 category includes corporate bonds, government and agency bonds, asset-backed, residential mortgage-backed and commercial mortgage-backed securities and municipal bonds.  The fair value measurements that were based on Level 2 inputs comprise 97.5% of the fair value of the total investment portfolio.

Level 3 – Valuations that are derived from techniques in which one or more of the significant inputs are unobservable and/or involve management judgment and/or are based on non-binding broker quotes.  The fair value measurements that were based on Level 3 inputs comprise 0.4% of the fair value of the total investment portfolio.
 
 
17

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
For corporate, government and municipal bonds, the third party pricing service utilizes a pricing model with standard inputs that include benchmark yields, reported trades, issuer spreads, two-sided markets, benchmark securities, market bids/offers, and other reference data observable in the marketplace.  The model uses the option adjusted spread methodology and is a multi-dimensional relational model.  All bonds valued under these techniques are classified as Level 2.

For asset-backed, residential mortgage-backed and commercial mortgage-backed securities, the third party pricing service valuation methodology includes consideration of interest rate movements, new issue data, monthly remittance reports and other pertinent data that is observable in the marketplace.  This information is used to determine the cash flows for each tranche and identifies the inputs to be used such as benchmark yields, prepayment assumptions and collateral performance.  All asset-backed, residential mortgage-backed and commercial mortgage-backed securities valued under these methods are classified as Level 2.

Also included in Level 2 valuation are interest rate swap agreements the Company utilizes to hedge the floating interest rate on its debt, thereby changing the variable rate exposure to a fixed rate exposure for interest on these obligations.  The estimated fair value of the interest rate swaps is obtained from the third party financial institution counterparties and measured using discounted cash flow analysis that incorporates significant observable inputs, including the LIBOR forward curve, derivative counterparty spreads, and measurements of volatility.

The Level 3 securities consist of 12 securities totaling $4.9 million or 0.4% of the total investment portfolio.  These primarily represent asset-backed securities and corporate debt securities that have a principal protection feature supported by a U.S. Treasury strip.  To fair value these securities, the third party investment manager uses a combination of methods.  Non-binding broker/dealer quotes are used on 5 holdings. Benchmarking techniques based upon industry sector, rating and other factors are used on 7 holdings.
 
 
18


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis, classified by the valuation hierarchy as of September 30, 2011 (in thousands):
 
         
Fair Value Measurements Using
 
         
Quoted Prices
in Active
Markets for
Identical
Assets
   
Significant Other
Observable
Inputs
   
Significant
Unobservable
Inputs
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Debt Securities:
                       
U.S. Government and agencies
  $ 25,194     $ -     $ 25,194     $ -  
Obligations of states and political subs
    593,168       -       593,168       -  
Corporate securities
    486,466       -       485,410       1,056  
Redeemable preferred stocks
    2,225       2,225       -       -  
Residential mortgage-backed securities
    176,132       -       176,132       -  
Commercial mortgage-backed securities
    40,106       -       40,106       -  
Other asset-backed securities
    16,253       -       12,447       3,806  
Total debt securities available for sale
    1,339,544       2,225       1,332,457       4,862  
Equity Securities:
                               
Perpetual preferred stock
    12,161       11,436       725       -  
Common stock
    14,834       14,834       -       -  
Total equity securities available for sale
    26,995       26,270       725       -  
Total securities available for sale
  $ 1,366,539     $ 28,495     $ 1,333,182     $ 4,862  
                                 
Derivatives - interest rate swaps
  $ (5,917 )   $ -     $ (5,917 )   $ -  
 
 
19

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The following table presents changes in Level 3 available for sale investments measured at fair value on a recurring basis as of September 30, 2011 (in thousands):

   
Fair Value
Measurement
Using Significant
Unobservable
Inputs - Level 3
 
Balance as of January 1, 2010
  $ 4,161  
         
Total gains or losses (realized/unrealized):
       
Included in earnings
    (3 )
Included in other comprehensive income
    463  
         
Purchases
    -  
Issuances
    -  
Settlements
    (97 )
         
Transfers in and out of Level 3
    (442 )
Balance as of December 31, 2010
    4,082  
         
Total gains or losses (realized/unrealized):
       
Included in earnings
    6  
Included in other comprehensive income
    818  
         
Purchases
    -  
Issuances
    -  
Settlements
    (11 )
         
Transfers in and out of Level 3
    (33 )
Balance as of September 30, 2011
  $ 4,862  

There were no credit related losses for the period included in earnings attributable to the change in unrealized losses on Level 3 assets still held at the reporting date.

The Company’s policy on recognizing transfers between hierarchy levels is applied at the end of a reporting period.  During the quarter ended September 30, 2011, there were no transfers between levels.
 
 
20

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE  4 – Debt

Credit Facilities

On July 31, 2008, the Company executed $100 million in senior credit facilities (the “Credit Facilities”).  The Credit Facilities included a $65.0 million term loan facility, which was fully funded upon the closing of its Merger with ProCentury and a $35.0 million revolving credit facility, which was partially funded upon closing of the Merger.  The revolving credit facility includes a letter of credit facility with a sublimit.  The total amount of credit available under the revolving credit facility is $35.0 million, which may include up to $15 million in letters of credit.  As of September 30, 2011, the outstanding balance on its term loan facility was $27.6 million.  The Company had a zero outstanding balance on its revolving credit facility as of September 30, 2011, and $0.5 million in letters of credit had been issued as of September 30, 2011.  The undrawn portion of the revolving credit facility is available to finance working capital and for general corporate purposes, including but not limited to, surplus contributions to its Insurance Company Subsidiaries to support premium growth or strategic acquisitions.  At December 31, 2010, the Company had an outstanding balance of $37.8 million on its term loan and had a zero outstanding balance on its revolving credit facility.

The principal amount outstanding under the Credit Facilities provides for interest at LIBOR, plus the applicable margin, or at the Company’s option, the base rate.  The base rate is defined as the higher of the lending bank’s prime rate or the Federal Funds rate, plus 0.50%, plus the applicable margin.  The applicable margin is determined by the consolidated indebtedness to consolidated total capital ratio.  In addition, the Credit Facilities provide for an unused facility fee ranging between twenty basis points and forty basis points, based on our consolidated leverage ratio as defined by the Credit Facilities.  At September 30, 2011, the interest rate on the Company’s term loan was 5.70%, which consisted of a fixed rate of 3.95%, as described in Note 5 ~ Derivative Instruments, plus an applicable margin of 1.75%.

The debt financial covenants applicable to the Credit Facilities consist of: (1) minimum consolidated net worth starting at eighty percent of pro forma consolidated net worth after giving effect to the acquisition of ProCentury, with quarterly increases thereafter, (2) minimum Risk Based Capital Ratio for Star and Century Surety of 1.75 to 1.00, (3) maximum permitted consolidated leverage ratio of 0.35 to 1.00, (4) minimum consolidated debt service coverage ratio of 1.25 to 1.00, and (5) minimum A.M. Best Company rating of “B++.”  As of September 30, 2011, the Company was in compliance with these debt covenants.
 
 
21


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
During the second quarter of 2011, several of the Company's insurance subsidiaries (Star, Williamsburg, and Ameritrust) became members of the Federal Home Loan Bank of Indianapolis ("FHLBI"). As a member of the FHLBI, these subsidiaries have the ability to borrow on a collateralized basis, providing a source of liquidity. The aggregate investment of approximately $0.5 million by these subsidiaries provides the ability to borrow up to 20 times the total amount of the FHLBI common stock purchased. As of September 30, 2011, based on the subsidiaries’ common stock investment, the Company had the borrowing capacity of up to approximately $10 million from the FHLBI. As of September 30, 2011, the Company did not have any borrowings outstanding from the FHLBI.

Debentures

The following table summarizes the principal amounts and variables associated with the Company’s debentures (in thousands):

Year of
Issuance
Description
Year
Callable
Year Due
Interest Rate Terms
 
Interest Rate at
September 30,
 2011 (1)
   
Principal
Amount
 
                     
2003
Junior subordinated debentures
2008
2033
Three-month LIBOR, plus 4.05%
    4.42 %   $ 10,310  
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.00%
    4.29 %     13,000  
2004
Senior debentures
2009
2034
Three-month LIBOR, plus 4.20%
    4.51 %     12,000  
2005
Junior subordinated debentures
2010
2035
Three-month LIBOR, plus 3.58%
    3.93 %     20,620  
 
Junior subordinated debentures (2)
2007
2032
Three-month LIBOR, plus 4.00%
    4.33 %     15,000  
 
Junior subordinated debentures (2)
2008
2033
Three-month LIBOR, plus 4.10%
    4.39 %     10,000  
           
Total
    $ 80,930  

 (1) The underlying three-month LIBOR rate varies as a result of the interest rate reset dates used in determining the three-month LIBOR rate, which varies for each long-term debt item each quarter.

(2)Represents the junior subordinated debentures acquired in conjunction with the ProCentury Merger on July 31, 2008.

Excluding the junior subordinated debentures acquired in conjunction with the ProCentury Merger, the Company received a total of $53.3 million in net proceeds from the issuance of the above long-term debt, of which $26.2 million was contributed to the surplus of its Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes.  Associated with the issuance of the above long-term debt, the Company incurred approximately $1.7 million in issuance costs for commissions paid to the placement agents in the transactions.

The issuance costs associated with these debentures have been capitalized and are included in other assets on the balance sheet.  As of June 30, 2007, these issuance costs were being amortized over a seven year period as a component of interest expense.  The seven year amortization period represented management’s best estimate of the estimated useful life of the bonds related to both the senior debentures and junior subordinated debentures.  Beginning July 1, 2007, the Company re-evaluated its best estimate and determined a five year amortization period to be a more accurate representation of the estimated useful life.  Therefore, this change in amortization period from seven years to five years has been applied prospectively beginning July 1, 2007.
 
 
22

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The junior subordinated debentures issued in 2003 and 2005 were issued in conjunction with the issuance of $10.0 million and $20.0 million in mandatory redeemable trust preferred securities to a trust formed by an institutional investor from the Company’s unconsolidated subsidiary trusts, Meadowbrook Capital Trust I and Meadowbrook Capital Trust II, respectively.

The junior subordinated debentures acquired in the ProCentury Merger were issued in conjunction with the issuance of $15.0 million and $10.0 million in floating rate trust preferred securities to a trust formed from the Company’s unconsolidated trust, ProFinance Statutory Trust I and ProFinance Statutory Trust II.  The Company also acquired the remaining unamortized portion of the capitalized issuance costs associated with these debentures.  The remaining unamortized portion of the issuance costs acquired was $625,000.  These issuance costs are included in other assets on the balance sheet.  The remaining balance is being amortized over a five year period beginning August 1, 2008, as a component of interest expense.

The junior subordinated debentures are unsecured obligations of the Company and are junior to the right of payment to all senior indebtedness of the Company.  The Company has guaranteed that the payments made to the four trusts mentioned above will be distributed to the holders of the respective trust preferred securities.

The Company estimates that the fair value of the above mentioned junior subordinated debentures and senior debentures issued approximate the gross proceeds of cash received at the time of issuance.
 
NOTE 5 – Derivative Instruments

The Company has entered into interest rate swap transactions to mitigate its interest rate risk on its existing debt obligations. These interest rate swap transactions have been designated as cash flow hedges and are deemed highly effective hedges. These interest rate swap transactions are recorded at fair value on the balance sheet and the effective portion of the changes in fair value are accounted for within other comprehensive income.  The interest differential to be paid or received is accrued and recognized as an adjustment to interest expense.
 
 
23

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The following table summarizes the rates and amounts associated with the Company’s interest rate swaps (in thousands):
Effective Date
Expiration
Date
Debt Instrument
Counterparty Interest Rate Terms
 
Fixed Rate
   
Fixed Amount at
September 30,
 2011
 
                   
4/23/2008
6/30/2013
Junior subordinated debentures
Three-month LIBOR, plus 4.05%
    8.020 %   $ 10,000  
4/29/2008
4/29/2013
Senior debentures
Three-month LIBOR, plus 4.00%
    7.940 %     13,000  
7/31/2008
7/31/2013
Term loan (1)
Three-month LIBOR
    3.950 %     27,562  
8/15/2008
8/15/2013
Junior subordinated debentures (2)
Three-month LIBOR
    3.780 %     10,000  
9/4/2008
9/4/2013
Junior subordinated debentures (2)
Three-month LIBOR
    3.790 %     15,000  
9/8/2010
5/24/2016
Senior debentures
Three-month LIBOR, plus 4.20%
    6.248 %     5,000  
9/16/2010
9/15/2015
Junior subordinated debentures
Three-month LIBOR, plus 3.58%
    6.160 %     10,000  
9/16/2010
9/15/2015
Junior subordinated debentures
Three-month LIBOR, plus 3.58%
    6.190 %     10,000  
5/24/2011
5/24/2016
Senior debentures
Three-month LIBOR, plus 4.20%
    6.472 %     7,000  
 
 (1) The Company is required to make fixed rate interest payments on the current balance of the term loan, amortizing in accordance with the term loan amortization schedule. The Company fixed only the variable interest portion of the loan. The actual interest payments associated with the term loan also include an additional rate of 1.75% in accordance with the credit agreement.

(2) The Company fixed only the variable interest portion of the debt. The actual interest payments associated with the debentures also include an additional rate of 4.10% and 4.00% on the $10.0 million and $15.0 million debentures, respectively.

In relation to the above interest rate swaps, the net interest expense incurred for the three months ended September 30, 2011 and 2010, was approximately $0.9 million and $1.1 million, respectively. The net interest expense incurred for the nine months ended September 30, 2011 and 2010, was approximately $2.8 million and $3.4 million, respectively.

As of September 30, 2011 and December 31, 2010, the total fair value of the interest rate swaps were  approximately ($5.9 million).  Accumulated other comprehensive income at September 30, 2011 and December 31, 2010, included accumulated loss on the cash flow hedge, net of taxes, of approximately $3.8 million and $3.9 million, respectively.

In May 2010, the Company amended its existing $6.0 million convertible note receivable with an unaffiliated insurance agency. The effective interest rate of the convertible note is equal to the three-month LIBOR, plus 5.2% and is due June 30, 2014. The insurance agency has been a producer for the Company for several years.  As security for the loan, the borrower granted the Company a security interest in its accounts, cash, general intangibles, and other intangible property. Also, pledged as collateral are 100% of the common shares of the holding company and its subsidiary insurance agencies, the common shares owned by the shareholder in another agency, and the shareholder also executed a personal guaranty. This note is convertible at the option of the Company based upon a pre-determined formula.
 
 
24

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE  6 – Restricted and Non-Restricted Stock Awards

On February 23, 2011 and 2010, the Company issued 28,500 and 202,500 restricted stock awards, respectively, to executives of the Company, out of its 2002 Amended and Restated Stock Option Plan (the “Plan”). The restricted stock awards vest over a four year period, with the first twenty percent vesting immediately on the date issued (i.e., February 23) and the remaining eighty percent vesting annually on a straight line basis over the requisite four year service period. The unvested restricted stock awards are subject to forfeiture in the event the employee is terminated for “Good Cause” or voluntarily resigns their employment without “Good Reason” as provided for in the employee’s respective employment agreements. The Company recorded approximately $87,000 and $72,000 of restricted stock awards compensation expense for the three months ended September 30, 2011 and 2010, respectively. The Company recorded approximately $305,000 and $453,000 of restricted stock awards compensation expense for the nine months ended September 30, 2011 and 2010, respectively.

On February 23, 2011, the Company issued 1,500 non-restricted stock awards to each outside member of the Board of Directors, which vested immediately. The Company recorded zero and $150,000 of non-restricted stock awards compensation expense for the three months and nine months ended September 30, 2011, respectively. No non-restricted stock awards were issued to the directors in 2010.
 
NOTE 7 – Shareholders’ Equity

At September 30, 2011, shareholders’ equity was $580.3 million, or a book value of $11.37 per common share, compared to $547.1 million, or a book value of $10.28 per common share, at December 31, 2010.

On February 12, 2010, the Company’s Board of Directors approved a Share Repurchase Plan authorizing management to purchase up to 5.0 million shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months.  For the three months and nine months ended September 30, 2011, the Company purchased and retired 1.8 million and 2.2 million shares of common stock for a total cost of approximately $16.5 million and $20.4 million, respectively. For the year ended December 31, 2010, the Company purchased and retired approximately 2.5 million shares of common stock for a total cost of approximately $19.6 million.

At the Company’s regularly scheduled Board of Directors meeting on October 28, 2011, it authorized management to purchase up to 5.0 million shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months.  This Share Repurchase Plan replaced the existing plan, which was previously authorized in February 2010.
 
 
25


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
For the period ended September 30, 2011, the Company paid dividends to its common shareholders of $6.3 million. For the year ended December 31, 2010, the Company paid dividends to its common shareholders of $7.0 million.  On October 27, 2011, the Company’s Board of Directors declared a quarterly dividend of $0.05 per common share.  The dividend is payable on November 28, 2011, to shareholders of record as of November 11, 2011.

When evaluating the declaration of a dividend, the Company’s Board of Directors considers a variety of factors, including but not limited to, cash flow, liquidity needs, results of operations, industry conditions, and our overall financial condition.  As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from its Insurance Company Subsidiaries.
 
NOTE 8– Earnings Per Share

Basic earnings per share are based on the weighted average number of common shares outstanding during the year, while diluted earnings per share includes the weighted average number of common shares and potential dilution from shares issuable pursuant to stock awards using the treasury stock method.

The following table is a reconciliation of the income and share data used in the basic and diluted earnings per share computations f