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 June 30, 2012
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 August 2, 2012, was 49,776,011.
 


 
 

 
 
TABLE OF CONTENTS
 
   
Page
     
PART I FINANCIAL INFORMATION
     
ITEM 1 –
 
 
2-3
 
4
 
5
 
6
 
7
 
8 - 27
     
ITEM 2 –
28 - 43
     
ITEM 3 –
44 - 45
     
ITEM 4 –
46
     
PART II OTHER INFORMATION
     
ITEM 1 –
47
     
ITEM 1A – 
47
     
ITEM 2 –
47
     
ITEM 3 –
47
     
ITEM 4 –
47
     
ITEM 5 –
47
     
ITEM 6 –
48
     
49
 

PART 1 - FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended June 30,

         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands, except share data)
 
Revenues
           
Premiums earned
           
Gross
  $ 248,581     $ 209,676  
Ceded
    (37,278 )     (28,206 )
Net earned premiums
    211,303       181,470  
Net commissions and fees
    8,552       7,897  
Net investment income
    13,683       13,765  
Realized gains (losses):
               
Total other-than-temporary impairments on securities
    -       -  
Portion of loss recognized in other comprehensive income
    -       -  
Net other-than-temporary impairments on securities recognized in earnings
    -       -  
Net realized gains excluding other-than-temporary impairments on securities
    1,567       1,094  
Net realized gains
    1,567       1,094  
Total revenues
    235,105       204,226  
                 
Expenses
               
Losses and loss adjustment expenses
    196,976       141,356  
Reinsurance recoveries
    (31,218 )     (19,953 )
Net losses and loss adjustment expenses
    165,758       121,403  
Policy acquisition and other underwriting expenses
    68,993       62,694  
General, selling and administrative expenses
    6,327       5,631  
General corporate expenses
    758       (719 )
Amortization expense
    1,307       1,206  
Interest expense
    2,033       2,082  
Total expenses
    245,176       192,297  
(Loss) income before taxes and equity earnings
    (10,071 )     11,929  
Federal and state income tax (benefit) expense
    (1,782 )     2,323  
Equity earnings of affiliates, net of tax
    562       173  
Equity (losses) earnings of unconsolidated subsidiaries, net of tax
    (5 )     1  
Net (loss) income
  $ (7,732 )   $ 9,780  
                 
(Losses) Earnings Per Share
               
Basic
  $ (0.15 )   $ 0.18  
Diluted
  $ (0.15 )   $ 0.18  
                 
Weighted average number of common shares
               
Basic
    50,251,591       53,100,479  
Diluted
    50,251,591       53,248,573  
                 
Dividends paid per common share
  $ 0.05     $ 0.04  

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Six Months Ended June 30,

         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands, except share data)
 
Revenues
           
Premiums earned
           
Gross
  $ 476,027     $ 410,362  
Ceded
    (71,909 )     (58,234 )
Net earned premiums
    404,118       352,128  
Net commissions and fees
    17,517       16,335  
Net investment income
    27,415       27,337  
Realized gains (losses):
               
Total other-than-temporary impairments on securities
    -       (84 )
Portion of loss recognized in other comprehensive income
    -       -  
Net other-than-temporary impairments on securities recognized in earnings
    -       (84 )
Net realized gains excluding other-than-temporary impairments on securities
    2,299       1,990  
Net realized gains
    2,299       1,906  
Total revenues
    451,349       397,706  
                 
Expenses
               
Losses and loss adjustment expenses
    358,495       270,079  
Reinsurance recoveries
    (59,990 )     (43,414 )
Net losses and loss adjustment expenses
    298,505       226,665  
Policy acquisition and other underwriting expenses
    132,106       120,851  
General, selling and administrative expenses
    12,666       11,875  
General corporate expenses
    2,131       636  
Amortization expense
    2,723       2,438  
Interest expense
    4,010       4,254  
Total expenses
    452,141       366,719  
(Loss) income before taxes and equity earnings
    (792 )     30,987  
Federal and state income tax expense
    73       7,782  
Equity earnings of affiliates, net of tax
    1,250       1,246  
Equity losses of unconsolidated subsidiaries, net of tax
    (13 )     (22 )
Net income
  $ 372     $ 24,429  
                 
Earnings Per Share
               
Basic
  $ 0.01     $ 0.46  
Diluted
  $ 0.01     $ 0.46  
                 
Weighted average number of common shares
               
Basic
    50,583,368       53,175,824  
Diluted
    50,583,368       53,323,802  
                 
Dividends paid per common share
  $ 0.10     $ 0.08  

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
3

 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Three Months Ended June 30,

         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands)
 
                 
Net (loss) income
  $ (7,732 )   $ 9,780  
Other comprehensive (loss) income, net of tax:
               
Unrealized gain on securities
    7,900       13,528  
Unrealized gains in affiliates and unconsolidated subsidiaries
    16       50  
Increase (decrease) on non-credit other-than-temporary impairments on securities
    34       (231 )
Net deferred derivative losses - hedging activity
    (413 )     (381 )
Less reclassification adjustment for investment gains included in net income
    (1,645 )     (1,070 )
Other comprehensive gains
    5,892       11,896  
Comprehensive (loss) income
  $ (1,840 )   $ 21,676  

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
For the Six Months Ended June 30,

         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands)
 
                 
Net income
  $ 372     $ 24,429  
Other comprehensive income, net of tax:
               
Unrealized gains on securities
    7,732       11,148  
Unrealized gains (losses) in affiliates and unconsolidated subsidiaries
    165       (1 )
Increase on non-credit other-than-temporary impairments on securities
    292       85  
Net deferred derivative (losses) gains - hedging activity
    (113 )     285  
Less reclassification adjustment for investment gains included in net income
    (2,356 )     (1,880 )
Other comprehensive gains
    5,720       9,637  
Comprehensive income
  $ 6,092     $ 34,066  

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
4

 
MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS

         
As Adjusted
 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
   
(Unaudited)
       
   
(In thousands, except share data)
 
ASSETS
           
Investments
           
Debt securities available for sale, at fair value (amortized cost of $1,352,554 and $1,252,775)
  $ 1,466,000     $ 1,358,749  
Equity securities available for sale, at fair value (cost of $23,065 and $25,176)
    25,823       27,174  
Cash and cash equivalents
    88,159       101,757  
Accrued investment income
    14,528       13,757  
Premiums and agent balances receivable, net
    216,485       183,160  
Reinsurance recoverable on:
               
Paid losses
    12,788       9,870  
Unpaid losses
    349,361       315,884  
Prepaid reinsurance premiums
    37,678       33,754  
Deferred policy acquisition costs
    80,554       74,467  
Goodwill
    121,041       120,792  
Other intangible assets
    32,837       34,483  
Other assets
    102,351       96,251  
Total assets
  $ 2,547,605     $ 2,370,098  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Liabilities
               
Losses and loss adjustment expenses
  $ 1,301,002     $ 1,194,977  
Unearned premiums
    424,760       386,750  
Debt
    61,000       28,375  
Debentures
    80,930       80,930  
Accounts payable and accrued expenses
    39,233       38,716  
Funds held and reinsurance balances payable
    34,264       25,903  
Payable to insurance companies
    6,059       4,321  
Deferred income taxes, net
    8,966       8,453  
Other liabilities
    16,407       16,522  
Total liabilities
    1,972,621       1,784,947  
                 
Shareholders' Equity
               
Common stock, $0.01 par value; authorized 75,000,000 shares; 49,776,011 and 51,050,204 shares issued and outstanding
    505       520  
Additional paid-in capital
    272,198       279,005  
Retained earnings
    229,459       238,539  
Note receivable from officer
    (752 )     (767 )
Accumulated other comprehensive income
    73,574       67,854  
Total shareholders' equity
    574,984       585,151  
Total liabilities and shareholders' equity
  $ 2,547,605     $ 2,370,098  

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
5

 
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, 2011 (As previously reported)
  $ 520     $ 279,005     $ 245,816     $ (767 )   $ 67,854     $ 592,428  
Cumulative effect of adjustment resulting from adoption of new accounting guidance
    -       -       (7,277 )     -       -       (7,277 )
As Adjusted Balances December 31, 2011
    520       279,005       238,539       (767 )     67,854       585,151  
Net income
    -       -       372       -       -       372  
Dividends declared
    -       -       (5,057 )     -       -       (5,057 )
Change in unrealized gain or loss on available for sale securities, net of tax
    -       -       -       -       5,351       5,351  
Change in valuation allowance on deferred tax assets
    -       -       -       -       317       317  
Net deferred derivative loss - hedging activity
    -       -       -       -       (113 )     (113 )
Stock award
    -       194       -       -       -       194  
Long term incentive plan; stock award for 2012 plan years
    -       106       -       -       -       106  
Change in investment of affiliates, net of tax
    -       -       -       -       156       156  
Change in investment of unconsolidated subsidiaries
    -       -       -       -       9       9  
Repurchase of 1,267,300 shares of common stock
    (15 )     (7,107 )     (4,395 )     -       -       (11,517 )
Note receivable from officer
    -       -       -       15       -       15  
Balances June 30, 2012
  $ 505     $ 272,198     $ 229,459     $ (752 )   $ 73,574     $ 574,984  

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
6

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

         
As Adjusted
 
   
2012
   
2011
 
   
(Unaudited)
 
   
(In thousands)
 
Cash Flows From Operating Activities
           
Net income
  $ 372     $ 24,429  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Amortization of other intangible assets
    2,723       2,438  
Amortization of deferred debenture issuance costs
    63       63  
Depreciation of furniture, equipment, and building
    2,821       2,697  
Net amortization of discount and premiums on bonds
    2,990       1,829  
Gain on sale of investments, net
    (2,356 )     (1,880 )
Gain on sale of fixed assets
    (44 )     (44 )
Long-term incentive plan expense (benefit)
    106       (973 )
Stock award
    194       366  
Equity earnings of affiliates, net of taxes
    (1,250 )     (1,246 )
Equity losses of unconsolidated subsidiaries, net of tax
    13       22  
Deferred income tax benefit
    (2,075 )     (522 )
Goodwill adjustment
    (249 )     -  
Write-off of book of business
    123       -  
Changes in operating assets and liabilities:
               
Decrease (increase) in:
               
Premiums and agent balances receivable
    (33,325 )     (25,634 )
Reinsurance recoverable on paid and unpaid losses
    (36,395 )     (11,771 )
Prepaid reinsurance premiums
    (3,924 )     (292 )
Deferred policy acquisition costs
    (6,087 )     (5,115 )
Other assets
    (3,561 )     (285 )
Increase (decrease) in:
               
Losses and loss adjustment expenses
    106,025       60,160  
Unearned premiums
    38,010       27,257  
Payable to insurance companies
    1,738       2,373  
Funds held and reinsurance balances payable
    8,361       2,825  
Other liabilities
    (1,233 )     (14,826 )
Total adjustments
    72,668       37,442  
Net cash provided by operating activities
    73,040       61,871  
Cash Flows From Investing Activities
               
Purchase of debt securities available for sale
    (169,329 )     (133,777 )
Proceeds from sales and maturities of debt securities available for sale
    69,247       78,352  
Proceeds from sales of equity securities available for sale
    2,506       200  
Capital expenditures
    (958 )     (3,970 )
Acquisition of rights renewals
    -       (129 )
Other investing activities
    (4,367 )     592  
Net cash used in investing activities
    (102,901 )     (58,732 )
Cash Flows From Financing Activities
               
Proceeds from line of credit and FHLBI
    40,000       -  
Payments on term loan
    (7,375 )     (6,500 )
Book overdrafts
    197       (1,785 )
Dividends paid on common stock
    (5,057 )     (4,262 )
Share repurchases
    (11,517 )     (3,904 )
Other financing activities
    15       20  
Net cash used in financing activities
    16,263       (16,431 )
Net decrease in cash and cash equivalents
    (13,598 )     (13,292 )
Cash and cash equivalents, beginning of period
    101,757       90,414  
Cash and cash equivalents, end of period
  $ 88,159     $ 77,122  
Supplemental Disclosure of Cash Flow Information:
               
Interest paid
  $ 3,695     $ 4,070  
Net income taxes paid (1)
  $ 3,476     $ 14,678  
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
               
Stock-based employee compensation
  $ 194     $ 366  

(1)
Tax return refunds were received in first quarter of 2012 and 2011 for $475 and $732, respectively.

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
 
7


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 six months ended June 30, 2012 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, 2011.

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.

Assumed premium estimates include business where the Company accepts a portion of the risk from a ceding carrier as well as the mandatory assumed pool business from the National Council on Compensation Insurance (“NCCI”), or residual market business. The majority of the assumed premium is from an established book of workers’ compensation business produced by a ceding company in which the Company has an equity stake.
 
 
8

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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.  Commission adjustments that occur subsequent to the issuance of the policy, because of cancellation typically are recognized when the policy is effectively cancelled.  Profit sharing commissions from insurance companies are recognized when determinable, which is when such commissions are received.

Income Taxes

As of June 30, 2012 and December 31, 2011, the Company did not have any unrecognized tax benefits and 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 adopted this guidance retrospectively on January 1, 2012 and has adjusted its previously issued financial information.
 
 
9

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The effect of adoption of this new guidance on the consolidated balance sheet and shareholders’ equity statements as of December 31, 2011 was as follows:

   
December 31, 2011
 
(In thousands)
 
As Previously
Reported
   
Adjustment
   
As Adjusted
Reported
 
Deferred policy acquisition costs
  $ 85,663     $ (11,196 )   $ 74,467  
Total assets
    2,381,294       (11,196 )     2,370,098  
Deferred income tax, net
    12,372       (3,919 )     8,453  
Total liabilities
    1,788,866       (3,919 )     1,784,947  
Retained earnings
    245,816       (7,277 )     238,539  
Total shareholders' equity
    592,428       (7,277 )     585,151  
Total liabilities and shareholders' equity
    2,381,294       (11,196 )     2,370,098  

The effect of adoption of this new guidance on the consolidated income and comprehensive income statements for the three months and six months ended June 30, 2011 was as follows:

   
Three Months Ended June 30, 2011
 
(In thousands)
 
As Previously
Reported
   
Adjustment
   
As Adjusted
Reported
 
Policy acquisition and other underwriting expenses
  $ 62,450     $ 244     $ 62,694  
Total expenses
    192,053       244       192,297  
Income before taxes and equity earnings
    12,173       (244 )     11,929  
Federal and state income tax expense
    2,408       (85 )     2,323  
Net income
    9,939       (159 )     9,780  
Comprehensive income
    21,835       (159 )     21,676  
                         
Earnings per share
                       
Basic
  $ 0.19     $ (0.01 )   $ 0.18  
Diluted
  $ 0.19     $ (0.01 )   $ 0.18  

   
Six Months Ended June 30, 2011
 
(In thousands)
 
As Previously
Reported
   
Adjustment
   
As Adjusted
Reported
 
Policy acquisition and other underwriting expenses
  $ 119,888     $ 963     $ 120,851  
Total expenses
    365,756       963       366,719  
Income before taxes and equity earnings
    31,950       (963 )     30,987  
Federal and state income tax expense
    8,119       (337 )     7,782  
Net income
    25,055       (626 )     24,429  
Comprehensive income
    34,692       (626 )     34,066  
                         
Earnings per share
                       
Basic
  $ 0.47     $ (0.01 )   $ 0.46  
Diluted
  $ 0.47     $ (0.01 )   $ 0.46  

 
10

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The effect of adoption of this new guidance on the consolidated cash flows statement for the six months ended June 30, 2011 was as follows:
 
   
Six Months Ended June 30, 2011
 
(In thousands)
 
As Previously
Reported
   
Adjustment
   
As adjusted
Reported
 
Net income
  $ 25,055     $ (626 )   $ 24,429  
Deferred income tax expense
    (185 )     (337 )     (552 )
Deferred policy acquisition costs
    (6,078 )     963       (5,115 )
 
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, nor is it 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 adopted this guidance in the first quarter of 2012. The adoption did not have a material impact 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 adopted this guidance in the first quarter of 2012. The adoption of this guidance did not have a material impact on its financial condition and results of operations.

Testing Indefinite-Lived Intangible Assets for Impairment

In July 2012, the FASB issued guidance on how to test indefinite-lived intangible assets 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 an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, Intangibles—Goodwill and Other—General Intangibles Other than Goodwill. The guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company is still evaluating the impact of adoption on its financial condition and results of operations.
 
 
11

 
MEADOWBROOK INSURANCE GROUP, INC.

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

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 June 30, 2012 and December 31, 2011 were as follows (in thousands):
 
   
June 30, 2012
 
   
Cost or
Amortized
Cost
   
Gross Unrealized
   
Estimated
Fair Value
 
 
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 21,077     $ 1,772     $ -     $ -     $ 22,849  
Obligations of states and political subs
    598,436       50,344       (371 )     -       648,409  
Corporate securities
    547,966       47,728       (525 )     -       595,169  
Redeemable preferred stock
    1,743       460       -       -       2,203  
Residential mortgage-backed securities
    134,203       10,294       (112 )     -       144,385  
Commercial mortgage-backed securities
    37,066       2,633       -       -       39,699  
Other asset-backed securities
    12,063       1,596       (373 )     -       13,286  
Total debt securities available for sale
    1,352,554       114,827       (1,381 )     -       1,466,000  
Equity Securities:
                                       
Perpetual preferred stock
    8,302       2,029       (10 )     -       10,321  
Common stock
    14,763       971       (232 )     -       15,502  
Total equity securities available for sale
    23,065       3,000       (242 )     -       25,823  
Total securities available for sale
  $ 1,375,619     $ 117,827     $ (1,623 )   $ -     $ 1,491,823  

   
December 31, 2011
 
   
Cost or
Amortized
Cost
   
Gross Unrealized
   
Estimated
Fair Value
 
 
Gains
   
Losses
   
Non-Credit
OTTI
 
Debt Securities:
                             
U.S. Government and agencies
  $ 20,510     $ 1,856     $ -     $ -     $ 22,366  
Obligations of states and political subs
    556,265       49,742       (5 )     -       606,002  
Corporate securities
    469,770       40,591       (1,292 )     -       509,069  
Redeemable preferred stock
    1,924       330       -       -       2,254  
Residential mortgage-backed securities
    152,719       11,534       (40 )     (228 )     163,985  
Commercial mortgage-backed securities
    37,191       2,337       -       -       39,528  
Other asset-backed securities
    14,396       1,695       (33 )     (513 )     15,545  
Total debt securities available for sale
    1,252,775       108,085       (1,370 )     (741 )     1,358,749  
Equity Securities:
                                       
Perpetual preferred stock
    10,413       1,792       (58 )     -       12,147  
Common stock
    14,763       597       (333 )     -       15,027  
Total equity securities available for sale
    25,176       2,389       (391 )     -       27,174  
Total securities available for sale
  $ 1,277,951     $ 110,474     $ (1,761 )   $ (741 )   $ 1,385,923  
 
 
12

 
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 June 30, 2012 and December 31, 2011 were as follows (in thousands):

   
June 30, 2012
   
December 31, 2011
 
Unrealized gains
  $ 117,827     $ 110,474  
Unrealized losses
    (1,623 )     (1,761 )
Non-credit OTTI
    -       (741 )
Net unrealized gains
    116,204       107,972  
Deferred federal income tax expense
    (40,671 )     (37,790 )
Net unrealized gains on investments, net of deferred federal income taxes
  $ 75,533     $ 70,182  
 
Net realized gains (losses including OTTI) on securities, for the three months and six months ended June 30, 2012 and 2011 were as follows (in thousands):

   
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Realized gains (losses):
                       
Debt securities:
                       
Gross realized gains
  $ 1,328     $ 942     $ 1,994     $ 1,866  
Gross realized losses
    (21 )     (27 )     (33 )     (141 )
Total debt securities
    1,307       915       1,961       1,725  
Equity securities:
                               
Gross realized gains
    338       154       395       154  
Gross realized losses
    -       -       -       -  
Total equity securities
    338       154       395       154  
Net realized gains
  $ 1,645     $ 1,069     $ 2,356     $ 1,879  
                                 
OTTI included in realized losses on securities above
  $ -     $ -     $ -     $ (84 )
 
Proceeds from the sales of fixed maturity securities available for sale were $9.6 million and $11.1 million for the three months ended June 30, 2012 and 2011, respectively. Proceeds from the sales of fixed maturity securities available for sale were $20.4 million and $27.4 million for the six months ended June 30, 2012 and 2011, respectively.
 
 
13

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
At June 30, 2012, 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
  $ 31,634     $ 32,007  
Due after one year through five years
    329,713       346,905  
Due after five years through ten years
    634,506       705,493  
Due after ten years
    173,369       184,225  
Mortgage-backed securities, collateralized obligations and asset-backed securities
    183,332       197,370  
    $ 1,352,554     $ 1,466,000  
 
Net investment income for the three months and six months ended June 30, 2012 and 2011 was as follows (in thousands):

   
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Net Investment Income Earned From:
                       
Debt securities
  $ 13,507     $ 13,436     $ 26,800     $ 26,628  
Equity Securities
    370       473       876       979  
Cash and cash equivalents
    143       174       417       390  
Total gross investment income
    14,020       14,083       28,093       27,997  
Less investment expenses
    337       318       678       660  
Net investment income
  $ 13,683     $ 13,765     $ 27,415     $ 27,337  
 
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.
 
 
14

 
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.

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, the cause of the decline and a fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer.
 
 
15

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
After the Company’s review of its investment portfolio in relation to this policy, the Company did not record a credit or a non-credit related OTTI loss for the three months or six months ended June 30, 2012. For the three months and six months ended June 30, 2011, the Company recorded no credit OTTI loss and a credit OTTI loss of $84,000, respectively. For the three months and six months ended June 30, 2011, no non-credit related OTTI losses were recognized by the Company 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):

   
June 30, 2012
 
   
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
    1     $ 151     $ -       -     $ -     $ -       1     $ 151     $ -  
Obligations of states and political subs
    13       39,769       (371 )     -       -       -       13       39,769       (371 )
Corporate securities
    10       24,653       (481 )     1       3,005       (44 )     11       27,658       (525 )
Redeemable preferred stock
    -       -       -       -       -       -       -       -       -  
Residential mortgage-backed securities
    2       93       -       3       3,538       (112 )     5       3,631       (112 )
Commercial mortgage-backed securities
    -       -       -       -       -       -       -       -       -  
Other asset-backed securities
    1       1,120       (7 )     9       1,406       (366 )     10       2,526       (373 )
Total debt securities
    27       65,786       (859 )     13       7,949       (522 )     40       73,735       (1,381 )
Equity Securities:
                                                                       
Perpetual preferred stock
    2       4       (10 )     -       -       -       2       4       (10 )
Common stock
    1       279       (11 )     3       4,932       (221 )     4       5,211       (232 )
Total equity securities
    3       283       (21 )     3       4,932       (221 )     6       5,215       (242 )
Total securities
    30     $ 66,069     $ (880 )     16     $ 12,881     $ (743 )     46     $ 78,950     $ (1,623 )
 
 
16

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
   
December 31, 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
    -     $ -     $ -       -     $ -     $ -       -     $ -     $ -  
Obligations of states and political subs
    1       202       (2 )     2       923       (3 )     3       1,125       (5 )
Corporate securities
    15       27,154       (1,292 )     -       -       -       15       27,154       (1,292 )
Redeemable preferred stock
    -       -       -       -       -       -       -       -       -  
Residential mortgage-backed securities
    4       183       (38 )     2       3,561       (230 )     6       3,744       (268 )
Commercial mortgage-backed securities
    1       683       -       -       -       -       1       683       -  
Other asset-backed securities
    3       1,163       (27 )     8       1,831       (519 )     11       2,994       (546 )
Total debt securities
    24       29,385       (1,359 )     12       6,315       (752 )     36       35,700       (2,111 )
Equity Securities:
                                                                       
Perpetual preferred stock
    3       1,079       (58 )     -       -       -       3       1,079       (58 )
Common stock
    1       279       (12 )     3       4,851       (321 )     4       5,130       (333 )
Total equity securities
    4       1,358       (70 )     3       4,851       (321 )     7       6,209       (391 )
Total securities
    28     $ 30,743     $ (1,429 )     15     $ 11,166     $ (1,073 )     43     $ 41,909     $ (2,502 )

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 December 31, 2011
  $ (789 )
Additional credit impairments on:
       
Previously impaired securities
    -  
Securities for which an impairment was not previously recognized
    -  
Reductions
    -  
Balance as of June 30, 2012
  $ (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 in the sale of an asset or would be paid in the transfer of 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”).

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:
 
 
17

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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 1.8% 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 97.9% 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 0.3% of the fair value of the total investment portfolio.

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.
 
 
18

 
MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
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 13 securities totaling $4.8 million or 0.3% of the fair value 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 1 holding.  Benchmarking techniques based upon industry sector, rating and other factors are used on the other12 holdings.
 
 
19

 
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 June 30, 2012 (in thousands):

         
Fair Value Measurements Using
 
   
June 30, 2012
   
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
  $ 22,849     $ -     $ 22,849     $ -  
Obligations of states and political subs
    648,409       -       648,409       -  
Corporate securities
    595,169       -       594,045       1,124  
Redeemable preferred stock
    2,203       2,203       -       -  
Residential mortgage-backed securities
    144,385       -       144,385       -  
Commercial mortgage-backed securities
    39,699       -       39,699       -  
Other asset-backed securities
    13,286       -       9,657       3,629  
Total debt securities available for sale
    1,466,000       2,203       1,459,044       4,753  
Equity Securities:
                               
Perpetual preferred stock
    10,321       9,582       739       -  
Common stock
    15,502       15,502       -       -  
Total equity securities available for sale
    25,823       25,084       739       -  
Total securities available for sale
  $ 1,491,823     $ 27,287     $ 1,459,783