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

FORM 10-Q

T QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2013
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 T 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 T 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 T 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 T

The aggregate number of shares of the Registrant’s Common Stock, $.01 par value, outstanding on August 12, 2013, was 49,887,200.



TABLE OF CONTENTS
 
 
 
Page
 
 
 
PART I FINANCIAL INFORMATION
 
 
 
ITEM 1 –
FINANCIAL STATEMENTS
 
 
2-3
 
4
 
5
 
6
 
7
 
8-33
 
 
 
ITEM 2 –
34-52
 
 
 
ITEM 3 –
53-55
 
 
 
ITEM 4 –
55
 
 
 
PART II OTHER INFORMATION
 
 
 
ITEM 1 –
56
 
 
 
ITEM 1A – 
56
 
 
 
ITEM 2 –
68
 
 
 
ITEM 3 –
68
 
 
 
ITEM 4 –
68
 
 
 
ITEM 5 –
68
 
 
 
ITEM 6 –
69
 
 
 
70
1


PART 1 - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended June 30,

 
 
2013
   
2012
 
 
 
(Unaudited)
 
 
 
(In thousands, except share data)
 
Revenues
 
   
 
Premiums earned
 
   
 
Gross
 
$
264,853
   
$
248,581
 
Ceded
   
(89,072
)
   
(37,278
)
Net earned premiums
   
175,781
     
211,303
 
Net commissions and fees
   
8,539
     
8,552
 
Net investment income
   
11,768
     
13,683
 
Realized gains:
               
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
   
2,869
     
1,567
 
Net realized gains
   
2,869
     
1,567
 
Total revenues
   
198,957
     
235,105
 
 
               
Expenses
               
Losses and loss adjustment expenses
   
200,807
     
196,976
 
Reinsurance recoveries
   
(55,436
)
   
(31,218
)
Net losses and loss adjustment expenses
   
145,371
     
165,758
 
Policy acquisition and other underwriting expenses
   
58,450
     
68,993
 
General, selling and administrative expenses
   
5,901
     
6,327
 
General corporate expenses
   
760
     
758
 
Amortization expense
   
1,038
     
1,307
 
Goodwill impairment expense
   
115,397
     
-
 
Interest expense
   
3,653
     
2,033
 
Total expenses
   
330,570
     
245,176
 
Loss before taxes and equity earnings
   
(131,613
)
   
(10,071
)
Federal and state income tax benefit
   
(17,604
)
   
(1,782
)
Equity earnings of affiliates, net of tax
   
945
     
562
 
Equity earnings (losses) of unconsolidated subsidiaries, net of tax
   
6
     
(5
)
Net loss
 
$
(113,058
)
 
$
(7,732
)
 
               
Losses Per Share
               
Basic
 
$
(2.27
)
 
$
(0.15
)
Diluted
 
$
(2.27
)
 
$
(0.15
)
 
               
Weighted average number of common shares
               
Basic
   
49,887,200
     
50,251,591
 
Diluted
   
49,887,200
     
50,251,591
 
 
               
Dividends paid per common share
 
$
0.02
   
$
0.05
 

The accompanying notes are an integral part of the Consolidated Financial Statements.
 
2


MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME

For the Six Months Ended June 30,

 
 
2013
   
2012
 
 
 
(Unaudited)
 
 
 
(In thousands, except share data)
 
Revenues
 
   
 
Premiums earned
 
   
 
Gross
 
$
529,195
   
$
476,027
 
Ceded
   
(182,826
)
   
(71,909
)
Net earned premiums
   
346,369
     
404,118
 
Net commissions and fees
   
18,173
     
17,517
 
Net investment income
   
22,908
     
27,415
 
Realized gains:
               
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
   
3,185
     
2,299
 
Net realized gains
   
3,185
     
2,299
 
Total revenues
   
390,635
     
451,349
 
 
               
Expenses
               
Losses and loss adjustment expenses
   
392,781
     
358,495
 
Reinsurance recoveries
   
(125,594
)
   
(59,990
)
Net losses and loss adjustment expenses
   
267,187
     
298,505
 
Policy acquisition and other underwriting expenses
   
109,055
     
132,106
 
General, selling and administrative expenses
   
11,924
     
12,666
 
General corporate expenses
   
2,276
     
2,131
 
Amortization expense
   
2,109
     
2,723
 
Goodwill impairment expense
   
115,397
     
-
 
Interest expense
   
5,850
     
4,010
 
Total expenses
   
513,798
     
452,141
 
Loss before taxes and equity earnings
   
(123,163
)
   
(792
)
Federal and state income tax (benefit) expense
   
(15,768
)
   
73
 
Equity earnings of affiliates, net of tax
   
1,383
     
1,250
 
Equity losses of unconsolidated subsidiaries, net of tax
   
36
     
(13
)
Net (loss) income
 
$
(105,976
)
 
$
372
 
 
               
(Losses) Earnings Per Share
               
Basic
 
$
(2.13
)
 
$
0.01
 
Diluted
 
$
(2.13
)
 
$
0.01
 
 
               
Weighted average number of common shares
               
Basic
   
49,855,716
     
50,583,368
 
Diluted
   
49,855,716
     
50,583,368
 
 
               
Dividends paid per common share
 
$
0.04
   
$
0.10
 

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,

 
 
2013
   
2012
 
 
 
(Unaudited)
 
 
 
(In thousands)
 
Net loss
 
$
(113,058
)
 
$
(7,732
)
Other comprehensive loss, net of tax:
               
Unrealized (losses) gains on securities
   
(32,487
)
   
7,325
 
Unrealized gains in affiliates and unconsolidated subsidiaries
   
50
     
16
 
Increase on non-credit other-than-temporary impairments on securities
   
-
     
34
 
Net deferred derivative gains (losses) - hedging activity
   
2,233
     
(413
)
Less reclassification adjustment for investment gains included in net income
   
(1,890
)
   
(1,070
)
Other comprehensive (losses) gains, net of tax
   
(32,094
)
   
5,892
 
Comprehensive loss
 
$
(145,152
)
 
$
(1,840
)

MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Six Months Ended June 30,

 
 
2013
   
2012
 
 
 
(Unaudited)
 
 
 
(In thousands)
 
Net (loss) income
 
$
(105,976
)
 
$
372
 
Other comprehensive (loss) income, net of tax:
               
Unrealized (losses) gains on securities
   
(35,269
)
   
6,908
 
Unrealized gains in affiliates and unconsolidated subsidiaries
   
62
     
165
 
Increase on non-credit other-than-temporary impairments on securities
   
-
     
292
 
Net deferred derivative gains (losses) - hedging activity
   
3,038
     
(113
)
Less reclassification adjustment for investment gains included in net income
   
(2,077
)
   
(1,532
)
Other comprehensive (loss) gains, net of tax
   
(34,246
)
   
5,720
 
Comprehensive (loss) income
 
$
(140,222
)
 
$
6,092
 

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


MEADOWBROOK INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS

 
 
June 30,
   
December 31,
 
 
 
2013
   
2012
 
 
 
(Unaudited)
   
 
 
 
(In thousands, except share data)
 
ASSETS
 
   
 
Investments
 
   
 
Debt securities available for sale, at fair value (amortized cost of $1,431,965 and $1,211,794)
 
$
1,445,076
   
$
1,286,807
 
Equity securities available for sale, at fair value (cost of $101,625 and $20,389)
   
108,723
     
22,661
 
Cash and cash equivalents
   
118,048
     
342,124
 
Accrued investment income
   
13,966
     
11,167
 
Premiums and agent balances receivable, net
   
218,191
     
208,743
 
Reinsurance recoverable on:
               
Paid losses
   
22,432
     
13,612
 
Unpaid losses
   
445,100
     
381,905
 
Prepaid reinsurance premiums
   
100,735
     
143,180
 
Deferred policy acquisition costs
   
54,904
     
45,417
 
Deferred income taxes, net
   
42,057
     
10,929
 
Goodwill
   
5,644
     
121,041
 
Other intangible assets
   
26,155
     
28,264
 
Other assets
   
131,865
     
97,424
 
Total assets
 
$
2,732,896
   
$
2,713,274
 
 
               
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Liabilities
               
Losses and loss adjustment expenses
 
$
1,531,849
   
$
1,455,980
 
Unearned premiums
   
411,974
     
439,418
 
Debt
   
162,975
     
78,500
 
Debentures
   
80,930
     
80,930
 
Accounts payable and accrued expenses
   
28,360
     
29,190
 
Funds held and reinsurance balances payable
   
54,290
     
49,622
 
Payable to insurance companies
   
3,926
     
5,641
 
Other liabilities
   
39,126
     
15,714
 
Total liabilities
   
2,313,430
     
2,154,995
 
 
               
Shareholders' Equity
               
Common stock, $0.01 par value; authorized 75,000,000 shares; 49,887,200 and 49,776,011 shares issued and outstanding
   
499
     
505
 
Additional paid-in capital
   
276,024
     
272,472
 
Retained earnings
   
129,223
     
237,351
 
Note receivable from officer
   
(722
)
   
(737
)
Accumulated other comprehensive income
   
14,442
     
48,688
 
Total shareholders' equity
   
419,466
     
558,279
 
Total liabilities and shareholders' equity
 
$
2,732,896
   
$
2,713,274
 

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, 2012
 
$
505
   
$
272,472
   
$
237,351
   
$
(737
)
 
$
48,688
   
$
558,279
 
Net loss
   
-
     
-
     
(105,976
)
   
-
     
-
     
(105,976
)
Dividends declared
   
-
     
-
     
(1,995
)
   
-
     
-
     
(1,995
)
Change in unrealized gain or loss on available for sale securities, net of tax
   
-
     
-
     
-
     
-
     
(37,192
)
   
(37,192
)
Change in valuation allowance on deferred tax assets
   
-
     
-
     
-
     
-
     
(154
)
   
(154
)
Net deferred derivative gain - hedging activity
   
-
     
-
     
-
     
-
     
3,038
     
3,038
 
Stock award
   
1
     
190
     
-
     
-
     
-
     
191
 
Long term incentive plan; stock award for 2012 and 2013 plan years
   
-
     
212
     
-
     
-
     
-
     
212
 
Change in investment of affiliates, net of tax
   
-
     
-
     
-
     
-
     
33
     
33
 
Change in investment of unconsolidated subsidiaries
   
-
     
-
     
-
     
-
     
29
     
29
 
Stock warrant issuance
   
-
     
3,023
     
-
     
-
     
-
     
3,023
 
Other reclass
   
(7
)
   
127
     
(157
)
   
-
     
-
     
(37
)
Note receivable from officer
   
-
     
-
     
-
     
15
     
-
     
15
 
Balances June 30, 2013
 
$
499
   
$
276,024
   
$
129,223
   
$
(722
)
 
$
14,442
   
$
419,466
 

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,

 
 
2013
   
2012
 
 
 
(Unaudited)
 
 
 
(In thousands)
 
Cash Flows From Operating Activities
 
   
 
Net (loss) income
 
$
(105,976
)
 
$
372
 
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:
               
Amortization of other intangible assets
   
2,109
     
2,723
 
Amortization of deferred debenture issuance costs
   
63
     
63
 
Impairment of goodwill
   
115,397
     
-
 
Depreciation of furniture, equipment, and building
   
2,384
     
2,821
 
Net amortization of discount and premiums on bonds
   
5,270
     
2,990
 
Accretion of issued debt/original issue discount
   
417
     
-
 
Amortization of capitalized convertible note fees
   
118
     
-
 
Gain on sale of investments
   
(3,195
)
   
(2,356
)
Gain on sale of fixed assets
   
(44
)
   
(44
)
Long-term incentive plan expense
   
212
     
106
 
Stock award
   
191
     
194
 
Equity earnings of affiliates, net of taxes
   
(1,383
)
   
(1,250
)
Equity (earnings) losses of unconsolidated subsidiaries, net of tax
   
(36
)
   
13
 
Deferred income tax expense (benefit)
   
(13,053
)    
(2,075
)
Goodwill adjustment
   
-
     
(249
)
Write-off of book of business
   
-
     
123
 
Changes in operating assets and liabilities:
               
(Increase) decrease in:
               
Premiums and agent balances receivable
   
(9,448
)
   
(33,325
)
Reinsurance recoverable on paid and unpaid losses
   
(72,015
)
   
(36,395
)
Prepaid reinsurance premiums
   
42,445
     
(3,924
)
Deferred policy acquisition costs
   
(9,487
)
   
(6,087
)
Other assets
   
(20,530
)
   
(3,561
)
Increase (decrease) in:
               
Losses and loss adjustment expenses
   
75,869
     
106,025
 
Unearned premiums
   
(27,444
)
   
38,010
 
Payable to insurance companies
   
(1,715
)
   
1,738
 
Funds held and reinsurance balances payable
   
4,668
     
8,361
 
Other liabilities
   
13,684
     
(1,233
)
Total adjustments
   
104,477
     
72,668
 
Net cash (used in) provided by operating activities
   
(1,499
)
   
73,040
 
Cash Flows From Investing Activities
               
Purchase of debt securities available for sale
   
(334,138
)
   
(169,329
)
Proceeds from sales and maturities of debt securities available for sale
   
109,397
     
69,247
 
Purchase of equity securities available for sale
   
(93,641
)
   
-
 
Proceeds from sales of equity securities available for sale
   
14,240
     
2,506
 
Capital expenditures
   
(764
)
   
(958
)
Other investing activities
   
228
     
(4,367
)
Net cash used in investing activities
   
(304,678
)
   
(102,901
)
Cash Flows From Financing Activities
               
Proceeds from line of credit
   
-
     
10,000
 
Proceeds from FHLB advance
   
-
     
30,000
 
Payments on term loan
   
(3,000
)
   
(7,375
)
Proceeds from convertible senior notes
   
96,324
     
-
 
Payments for convertible senior notes hedge
   
(12,942
)
   
-
 
Proceeds from issuance of warrants
   
3,023
     
-
 
Book overdrafts
   
676
     
197
 
Dividends paid on common stock
   
(1,995
)
   
(5,057
)
Share repurchases
   
-
     
(11,517
)
Other financing activities
   
15
     
15
 
Net cash provided by financing activities
   
82,101
     
16,263
 
Net decrease in cash and cash equivalents
   
(224,076
)
   
(13,598
)
Cash and cash equivalents, beginning of period
   
342,124
     
101,757
 
Cash and cash equivalents, end of period
 
$
118,048
   
$
88,159
 
Supplemental Disclosure of Cash Flow Information:
               
Interest paid
 
$
3,590
   
$
3,695
 
Net income taxes paid (1)
 
$
1,165
   
$
3,476
 
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
               
Stock-based employee compensation
 
$
191
   
$
194
 

(1) Tax return refunds were received in first quarter of 2013 and 2012 for $3,067 and $475, 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 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, 2013 are not necessarily indicative of the results expected for the full year. In addition, certain amounts in the 2012 financial statements have been reclassified to conform to the 2013 presentation as a result of adopting the new Accumulated Other Comprehensive guidance noted below.

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 fiscal year ended December 31, 2012.

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 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.

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, 2013 and December 31, 2012, the Company did not have any unrecognized tax benefits and had no accrued interest or penalties related to uncertain tax positions.

Recent Accounting Pronouncements

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income

In February 2013, the FASB issued guidance to improve the reporting of reclassifications out of accumulated other comprehensive income. The guidance requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. The guidance is to be applied prospectively for reporting periods beginning after December 15, 2012. The Company adopted this new guidance on January 1, 2013 and included the required disclosures in note 10 ~ Accumulated Other Comprehensive Income.
9


 
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, 2013 and December 31, 2012 were as follows (in thousands):

 
 
June 30, 2013
 
 
 
Cost or
   
Gross Unrealized
   
 
 
 
 
Amortized
   
   
   
Non-Credit
   
Estimated
 
 
 
Cost
   
Gains
   
Losses
   
OTTI
   
Fair Value
 
Debt Securities:
 
   
   
   
   
 
U.S. Government and agencies
 
$
24,438
   
$
670
   
$
(159
)
 
$
-
   
$
24,949
 
Obligations of states and political subs
   
741,419
     
28,203
     
(19,807
)
   
-
     
749,815
 
Corporate securities
   
484,266
     
16,013
     
(12,257
)
   
-
     
488,022
 
Redeemable preferred stocks
   
854
     
362
     
-
     
-
     
1,216
 
Residential mortgage-backed securities
   
131,759
     
2,744
     
(3,441
)
   
-
     
131,062
 
Commercial mortgage-backed securities
   
33,357
     
1,007
     
(944
)
   
-
     
33,420
 
Other asset-backed securities
   
15,872
     
745
     
(25
)
   
-
     
16,592
 
Total debt securities available for sale
   
1,431,965
     
49,744
     
(36,633
)
   
-
     
1,445,076
 
Equity Securities:
                                       
Perpetual preferred stock
   
6,007
     
1,393
     
-
     
-
     
7,400
 
Common stock
   
95,618
     
6,837
     
(1,132
)
   
-
     
101,323
 
Total equity securities available for sale
   
101,625
     
8,230
     
(1,132
)
   
-
     
108,723
 
Total securities available for sale
 
$
1,533,590
   
$
57,974
   
$
(37,765
)
 
$
-
   
$
1,553,799
 


 
 
December 31, 2012
 
 
 
Cost or
   
Gross Unrealized
   
 
 
 
Amortized
   
   
   
Non-Credit
   
Estimated
 
 
 
Cost
   
Gains
   
Losses
   
OTTI
   
Fair Value
 
Debt Securities:
 
   
   
   
   
 
U.S. Government and agencies
 
$
26,788
   
$
918
   
$
(22
)
 
$
-
   
$
27,684
 
Obligations of states and political subs
   
587,276
     
43,124
     
(1,427
)
   
-
     
628,973
 
Corporate securities
   
482,290
     
25,569
     
(858
)
   
-
     
507,001
 
Redeemable preferred stocks
   
1,743
     
436
     
-
     
-
     
2,179
 
Residential mortgage-backed securities
   
73,530
     
4,393
     
(41
)
   
-
     
77,882
 
Commercial mortgage-backed securities
   
33,732
     
1,800
     
-
     
-
     
35,532
 
Other asset-backed securities
   
6,435
     
1,125
     
(4
)
   
-
     
7,556
 
Total debt securities available for sale
   
1,211,794
     
77,365
     
(2,352
)
   
-
     
1,286,807
 
Equity Securities:
                                       
Perpetual preferred stock
   
6,930
     
1,578
     
-
     
-
     
8,508
 
Common stock
   
13,459
     
901
     
(207
)
   
-
     
14,153
 
Total equity securities available for sale
   
20,389
     
2,479
     
(207
)
   
-
     
22,661
 
Total securities available for sale
 
$
1,232,183
   
$
79,844
   
$
(2,559
)
 
$
-
   
$
1,309,468
 
10


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, 2013 and December 31, 2012 were as follows (in thousands):

 
 
June 30,
2013
   
December 31,
2012
 
Unrealized gains
 
$
57,974
   
$
79,844
 
Unrealized losses
   
(37,765
)
   
(2,559
)
Non-credit OTTI
   
-
     
-
 
Net unrealized gains
   
20,209
     
77,285
 
Deferred federal income tax expense
   
(7,073
)
   
(26,957
)
Net unrealized gains on investments, net of deferred federal income taxes
 
$
13,136
   
$
50,328
 

Net realized gains (losses including OTTI) on securities, for the three months and six months ended June 30, 2013 and 2012 were as follows (in thousands):

 
 
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Realized gains (losses):
 
   
   
   
 
Debt securities:
 
   
   
   
 
Gross realized gains
 
$
1,500
   
$
1,328
   
$
1,530
   
$
1,994
 
Gross realized losses
   
(162
)
   
(21
)
   
(170
)
   
(33
)
Total debt securities
   
1,338
     
1,307
     
1,360
     
1,961
 
Equity securities:
                               
Gross realized gains
   
1,570
     
338
     
1,845
     
395
 
Gross realized losses
   
(1
)
   
-
     
(10
)
   
-
 
Total equity securities
   
1,569
     
338
     
1,835
     
395
 
Net realized gains
 
$
2,907
   
$
1,645
   
$
3,195
   
$
2,356
 
 
                               
OTTI included in realized losses on securities above
 
$
-
   
$
-
   
$
-
   
$
-
 

Proceeds from the sales of debt and equity securities available for sale were $69.7 million and $9.6 million for the three months ended June 30, 2013 and 2012, respectively. Proceeds from the sales of debt and equity securities available for sale were $76.2 million and $20.4 million for the six months ended June 30, 2013 and 2012, respectively.
11


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

At June 30, 2013, 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
 
$
43,167
   
$
43,678
 
Due after one year through five years
   
371,017
     
383,473
 
Due after five years through ten years
   
627,935
     
635,550
 
Due after ten years
   
208,858
     
201,301
 
Mortgage-backed securities, collateralized obligations and asset-backed securities
   
180,988
     
181,074
 
 
 
$
1,431,965
   
$
1,445,076
 

Net investment income for the three months and six months ended June 30, 2013 and 2012 was as follows (in thousands):

 
 
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Net Investment Income Earned From:
 
   
   
   
 
Debt securities
 
$
11,016
   
$
13,507
   
$
21,704
   
$
26,800
 
Equity securities
   
930
     
370
     
1,550
     
876
 
Cash and cash equivalents
   
199
     
143
     
393
     
417
 
Total gross investment income
   
12,145
     
14,020
     
23,647
     
28,093
 
Less investment expenses
   
377
     
337
     
739
     
678
 
Net investment income
 
$
11,768
   
$
13,683
   
$
22,908
   
$
27,415
 

Other-Than-Temporary Impairments of Securities and Unrealized Losses on Investments

Available for sale securities are reviewed for declines in fair value, excluding other-than-temporary declines. For a debt security, if the Company intends to sell a security and it is more likely than not that 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 that 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.
12


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 that 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, sales 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 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/or
· 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 of the cost of the security 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 of the cost of the security, 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.
13


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The Company reviewed its investment portfolio in relation to its OTTI policy and determined that the Company did not record a credit related OTTI loss or recognize a non-credit related OTTI loss in other comprehensive income for the three months and six months ended June 30, 2013 and 2012.

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, 2013
 
 
 
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
   
8
   
$
8,325
   
$
(159
)
   
-
   
$
-
   
$
-
     
8
   
$
8,325
   
$
(159
)
Obligations of states and political subs
   
111
     
324,046
     
(19,807
)
   
-
     
-
     
-
     
111
     
324,046
     
(19,807
)
Corporate securities
   
133
     
285,814
     
(12,257
)
   
-
     
-
     
-
     
133
     
285,814
     
(12,257
)
Redeemable preferred stocks
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Residential mortgage-backed securities
   
13
     
85,963
     
(3,440
)
   
1
     
23
     
(1
)
   
14
     
85,986
     
(3,441
)
Commercial mortgage-backed securities
   
6
     
13,093
     
(944
)
   
-
     
-
     
-
     
6
     
13,093
     
(944
)
Other asset-backed securities
   
2
     
4,369
     
(25
)
   
-
     
-
     
-
     
2
     
4,369
     
(25
)
Total debt securities
   
273
     
721,610
     
(36,632
)
   
1
     
23
     
(1
)
   
274
     
721,633
     
(36,633
)
Equity Securities:
                                                                       
Perpetual preferred stock
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Common stock
   
33
     
17,635
     
(766
)
   
2
     
4,514
     
(366
)
   
35
     
22,149
     
(1,132
)
Total equity securities
   
33
     
17,635
     
(766
)
   
2
     
4,514
     
(366
)
   
35
     
22,149
     
(1,132
)
Total securities
   
306
   
$
739,245
   
$
(37,398
)
   
3
   
$
4,537
   
$
(367
)
   
309
   
$
743,782
   
$
(37,765
)
14


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
 
December 31, 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
   
5
   
$
7,063
   
$
(22
)
   
-
   
$
-
   
$
-
     
5
   
$
7,063
   
$
(22
)
Obligations of states and political subs
   
23
     
69,016
     
(1,427
)
   
-
     
-
     
-
     
23
     
69,016
     
(1,427
)
Corporate securities
   
50
     
113,348
     
(858
)
   
-
     
-
     
-
     
50
     
113,348
     
(858
)
Redeemable preferred stocks
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Residential mortgage-backed securities
   
1
     
10,219
     
(40
)
   
1
     
24
     
(1
)
   
2
     
10,243
     
(41
)
Commercial mortgage-backed securities
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Other asset-backed securities
   
2
     
463
     
(4
)
   
-
     
-
     
-
     
2
     
463
     
(4
)
Total debt securities
   
81
     
200,109
     
(2,351
)
   
1
     
24
     
(1
)
   
82
     
200,133
     
(2,352
)
Equity Securities:
                                                                       
Perpetual preferred stock
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Common stock
   
-
     
-
     
-
     
2
     
4,583
     
(207
)
   
2
     
4,583
     
(207
)
Total equity securities
   
0
     
-
     
-
     
2
     
4,583
     
(207
)
   
2
     
4,583
     
(207
)
Total securities
   
81
   
$
200,109
   
$
(2,351
)
   
3
   
$
4,607
   
$
(208
)
   
84
   
$
204,716
   
$
(2,559
)

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, 2012
 
$
(156
)
Additional credit impairments on:
       
Previously impaired securities
   
-
 
Securities for which an impairment was not previously recognized
   
-
 
Reductions
   
156
 
Balance as of June 30, 2013
 
$
-
 
 
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:
15


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 7.1% 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 92.7% 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 0.2% 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.
16


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 17 securities totaling $3.7 million or 0.2% 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 16 holdings.

Also included in Level 3 valuation are the conversion feature within the Notes (as defined below) and the convertible senior notes hedge. The estimated fair values of the both the conversion feature and the convertible senior notes hedge are obtained from the third party financial institution counterparties valued using non-binding broker quotations and significant unobservable inputs.
17


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, 2013 (in thousands):

 
 
   
Fair Value Measurements Using
 
 
 
June 30, 2013
   
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
 
$
24,949
   
$
-
   
$
24,949
   
$
-
 
Obligations of states and political subs
   
749,815
     
-
     
749,815
         
Corporate securities
   
488,022
             
487,063
     
959
 
Redeemable preferred stocks
   
1,216
     
1,216
     
-
     
-
 
Residential mortgage-backed securities
   
131,062
     
-
     
131,062
     
-
 
Commercial mortgage-backed securities
   
33,420
     
-
     
33,241
     
179
 
Other asset-backed securities
   
16,592
     
-
     
14,073
     
2,519
 
Total debt securities available for sale
   
1,445,076
     
1,216
     
1,440,203
     
3,657
 
Equity Securities:
                               
Perpetual preferred stock
   
7,400
     
7,183
     
217
     
-
 
Common stock
   
101,323
     
101,323
     
-
     
-
 
Total equity securities available for sale
   
108,723
     
108,506
     
217
     
-
 
Total securities available for sale
 
$
1,553,799
   
$
109,722
   
$
1,440,420
   
$
3,657
 
Derivatives:
                               
Derivatives - interest rate swaps
 
$
145
   
$
-
   
$
145
   
$
-
 
Cash conversion feature of cash convertible notes
   
(12,967
)
   
-
     
-
     
(12,967
)
Purchased cash convertible note hedge
   
12,967
     
-
     
-
     
12,967
 
Total derivatives
 
$
145
   
$
-
   
$
145
   
$
-
 
 
                               
Total securities available for sale and derivatives
 
$
1,553,944
   
$
109,722
   
$
1,440,565
   
$
3,657
 
18


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table presents changes in Level 3 available for sale investments and derivatives measured at fair value on a recurring basis as of June 30, 2013 (in thousands):

 
 
Fair Value Measurement Using Significant Unobservable Inputs - Level 3
 
Balance as of December 31, 2012
 
$
5,444
 
 
       
Total gains or losses (realized/unrealized):
       
Included in earnings
   
721
 
Included in other comprehensive income
   
(476
)
 
       
Purchases
   
-
 
Issuances
   
-
 
Settlements
   
(2,032
)
 
       
Transfers in and out of Level 3
   
-
 
Balance as of June 30, 2013
 
$
3,657
 

There were no credit 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 three months and six months ended June 30, 2013, no transfers into or out of Levels 1, 2 and 3 were required.

NOTE 4 – Debt

Credit Facilities

On August 29, 2012, the Company executed $130.0 million in senior credit facilities (the “Credit Facilities”). The Credit Facilities include a $30.0 million term loan facility and a $100.0 million revolving credit facility.

The term loan facility has a four year term with a $30.0 million borrowing limit, which, subject to certain exceptions, can be increased up to an additional $25.0 million. As of June 30, 2013, the outstanding balance on its term loan facility was $25.5 million. The Company had $20.0 million outstanding under its revolving credit facility as of June 30, 2013, and $0.5 million in letters of credit had been issued as of June 30, 2013. The undrawn portion of the revolving credit facility, which was $79.5 million as of June 30, 2013, is available to finance working capital and for other general corporate purposes, including but not limited to, surplus contributions to its Insurance Company Subsidiaries to support premium growth or strategic acquisitions. These Credit Facilities replaced the Company’s former term loan and revolving credit agreement, which were terminated upon the closing of the Credit Facilities. At December 31, 2012, the Company had an outstanding balance of $28.5 million on its term loan and a $20.0 million outstanding balance on its revolving credit facility. There was $0.5 million in letters of credit that had been issued as of December 31, 2012.
19


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The principal amount outstanding under the Credit Facilities provides for interest at either the Alternative Base Rate (“ABR”) or the London interbank offered rate (“LIBOR”). ABR borrowings under the Agreement will bear interest at the greatest of (a) the Administrative Agent’s prime rate, (b) the federal funds effective rate plus 0.5%, or (c) the adjusted LIBOR for a one-month period plus 1.0%, in each case, plus a margin that is adjusted on the basis of Company’s consolidated leverage ratio. Eurodollar borrowings under the Agreement will bear interest at the adjusted LIBOR for the interest period in effect plus a margin that is adjusted on the basis of Company’s consolidated leverage ratio. In addition, the Credit Facilities provide for an unused facility fee ranging between twenty basis points and thirty basis points, based on the Company’s consolidated leverage ratio as defined by the Credit Facilities. At June 30, 2013, the interest rate on the Company’s term loan was 2.72%, which consisted of a weighted fixed rate of 0.72%, plus an applicable margin of 2.00%, as described in Note 5 ~ Derivative Instruments. At June 30, 2013, the interest rate on the Company’s revolving credit facility was 0.31%, plus a 2.00% margin.

The financial covenants applicable to the Credit Facilities consist of: (1) minimum consolidated net worth starting at eighty percent of December 31, 2011 consolidated shareholders’ equity, with quarterly increases thereafter of fifty percent of net income (2) minimum Risk Based Capital Ratio for Star of 1.50 to 1.00 and all other Insurance Company Subsidiaries of 1.75 to 1.00, (3) maximum permitted consolidated leverage ratio of 0.35 to 1.00, (4) minimum consolidated fixed charge coverage ratio of 1.25 to 1.00, and (5) minimum A.M. Best rating of “B++.” As of June 30, 2013, the Company was not in compliance with the minimum consolidated net worth and the maximum permitted consolidated leverage ratio covenants as a result of the goodwill impairment recorded in the second quarter of 2013, as described in Note 11 ~ Subsequent Events. Pursuant to the credit agreement, the lenders may take either or both of the following actions related to the non-compliance with the covenants: (i) immediate termination of the loan commitments, and (ii) declaration of the $45.5 million outstanding loans to be due and payable in whole together with accrued interest. As a result of the non-compliance with these covenants, the Company is currently in discussions with the lending group to amend the loan agreements that may include obtaining a waiver and revision of the financial covenants. While the Company remains in discussions with the lending group, the Company has not obtained, and there can be no assurance that the Company will obtain such an amendment.
20


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
FHLBI

During 2011, several of the Insurance Company 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 at relatively low borrowing rates providing a source of liquidity. As of June 30, 2013, the Company had borrowed $30.0 million from the FHLBI after pledging as collateral residential mortgage-backed securities (“RMBS”) having a carrying value of $45.6 million, and making a FHLBI common stock investment of approximately $1.6 million. The Company has the ability to increase its borrowing capacity through purchasing additional investments in FHLBI and pledging additional securities. The Company retains all the rights regarding the collateralized RMBS.

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 June 30, 2013 (1)
   
Principal Amount
 
 
 
 
   
 
 
 
   
 
2003
 
Junior subordinated debentures
 
2008
   
2033
 
Three-month LIBOR, plus 4.05%
   
4.32
%
 
$
10,310
 
2004
 
Senior debentures
 
2009
   
2034
 
Three-month LIBOR, plus 4.00%
   
4.28
%
   
13,000
 
2004
 
Senior debentures
 
2009
   
2034
 
Three-month LIBOR, plus 4.20%
   
4.47
%
   
12,000
 
2005
 
Junior subordinated debentures
 
2010
   
2035
 
Three-month LIBOR, plus 3.58%
   
3.85
%
   
20,620
 
 
 
Junior subordinated debentures (2)
 
2007
   
2032
 
Three-month LIBOR, plus 4.00%
   
4.28
%
   
15,000
 
 
 
Junior subordinated debentures (2)
 
2008
   
2033
 
Three-month LIBOR, plus 4.10%
   
4.38
%
   
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 issuances 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 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.
21


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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.

Cash Convertible Senior Notes

On March 18, 2013, the Company issued $100.0 million of 5.0% cash convertible senior notes (the “Notes”), which mature on March 15, 2020. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing September 15, 2013. Until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their Notes solely into cash at any time on or after September 15, 2019 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. The notes are not convertible into Meadowbrook common stock or any other securities under any circumstances. The initial conversion rate is 108.8732 shares of common stock per $1,000 principal amount of the Notes (equivalent to an initial conversion price of approximately $9.18 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require the Company to repurchase the Notes for a cash price equal to 100% of the principal, plus any accrued and unpaid interest. The proceeds from the issuance of the Notes were bifurcated into a debt component and an embedded conversion option component.

Due to the bifurcation, the debt component reflects an original issue discount (“OID”) of $12.9 million. The OID and deferred issuance costs of $3.7 million will be amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the OID, the Notes’ effective interest rate is 7.4%. Interest expense, including amortization of deferred issuance costs, recognized on the Notes was $1.7 million and $2.0 million for the three and six months ended June 30, 2013, respectively.
22


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table shows the amounts recorded for the debt component of the Notes as of June 30, 2013 (in thousands):

Outstanding principal
 
$
100,000
 
Unamortized OID
   
(12,525
)
Total debt component
 
$
87,475
 
 
As the conversion feature is structured under the cash settlement method, the embedded conversion option is reported as a derivative liability.

In connection with the offering of the Notes, the Company also entered into cash convertible senior notes hedge transactions (the “Note Hedges”) and warrant transactions (the “Warrants”) with respect to its common stock with certain counter-parties. Upon conversion, the Note Hedges are intended to offset potential cash payments in excess of the principal of the Notes. The Note Hedges and Warrants are separate transactions, entered into by the Company with certain counter-parties and are not part of the terms of the Notes.

The Company paid $12.9 million for the Note Hedges, which are exercisable upon conversion of the Notes. The Note Hedges are structured under the cash settlement method and are accounted for as a derivative asset.

The Company received $3.0 million for the warrants sold to certain counter-parties. The warrants have a strike price of $11.69 and will be net share settled; meaning the Company will issue a number of shares per warrant corresponding to the difference between its share price on each warrant exercise date and the exercise price. The warrants meet the definition of derivatives under the guidance in ASC 815; however, because these instruments have been determined to be indexed to the Company’s own stock and meet the criteria for equity classification under ASC 815-40, the warrants have been accounted for as an adjustment to the Company’s paid-in-capital.

If the market value per share of the Company’s common stock exceeds the strike price of the warrants, the warrants will have a dilutive effect on the Company’s net income per share and the Company will use the “treasury stock” method in calculating the dilutive effect on earnings per share.
23


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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.

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 June 30, 2013
 
 
 
 
 
 
   
 
6/30/2013
6/30/2023
Junior subordinated debentures
Three-month LIBOR, plus 4.05%
   
6.340
%
 
$
10,000
 
4/29/2013
4/29/2023
Senior debentures
Three-month LIBOR, plus 4.00%
   
6.250
%
   
13,000
 
9/28/2012
8/30/2016
Term loan (1)
Three-month LIBOR
   
0.724
%
   
25,500
 
8/15/2008
8/15/2013
Junior subordinated debentures (2)(3)
Three-month LIBOR
   
3.780
%
   
10,000
 
9/4/2008
9/4/2013
Junior subordinated debentures (2)(3)
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
 
 
 
 
    
 
Total
   
$
105,500
 

(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 2.00% in accordance with the Credit Facilities.

(2) During the quarter ended June 30, 2012, the Company entered into forward starting interest rate swaps. The swaps will replace the identified interest rate swap, upon their expiration in 2013. The fixed rates on the forward starting interest rate swaps are approximately 150 basis points less than the fixed rates on the current swaps in place. Additionally, the forward starting interest rate swaps will expire ten years from the effective date.

(3) 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 June 30, 2013 and 2012, was approximately $0.6 million and $0.7 million, respectively. The net interest expense incurred for the six months ended June 30, 2013 and 2012, was approximately $1.3 million and $1.5 million, respectively.
24


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

As of June 30, 2013 and December 31, 2012, the total fair value of the interest rate swaps were unrealized gains (losses) of $0.1 million and ($4.5 million), respectively. At June 30, 2013 and December 31, 2012, accumulated other comprehensive income included accumulated gain (loss) on the cash flow hedge, net of taxes, of approximately $0.1 million and ($2.9 million), respectively.

In March 2012, the Company replaced its existing $5.6 million convertible note and $664,000 demand note receivables with an unaffiliated insurance agency into new debt instruments with a related limited liability company. The new instruments were effective January 1, 2012 and consist of a $2 million convertible note and a $4.2 million term loan. The interest rate on the convertible note is 3% and is due on January 1, 2022. This note is convertible at the option of the Company based upon a pre-determined formula. The interest rate on the term loan is 5.5% and is due on April 30, 2016. As security for the note and term loan, the borrower granted the Company a first lien on all of its accounts receivable, cash, general intangibles, and other assets. As additional collateral for the note and term loan, the Company obtained guaranties of payment and performance from certain affiliated companies of the borrower, as well as related individuals, which guaranties are secured by additional collateral.

Cash Convertible Senior Notes and Note Hedges

As discussed in Note 4 ~ Debt, the Company issued the Notes. Holders may convert their cash convertible notes subject to certain conversion provisions. In order to offset the risk associated with the cash conversion feature, the Company entered into convertible note hedges with certain counterparties. Both the cash conversion feature and the purchased convertible note hedges are measured at fair value with gains and losses recorded in the Company’s Consolidated Statements of Income.

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”). No restricted stock awards were issued in 2012 or 2013. 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 $82,000 of restricted stock awards compensation expense for both the three months ended June 30, 2013 and 2012, respectively. The Company recorded approximately $164,000 and $128,000 of restricted stock awards compensation expense for the six months ended June 30, 2013 and 2012, respectively.
25


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

On February 13, 2013, and February 23, 2012 the Company issued 2,400 and 1,500 non-restricted stock awards, respectively, to members of the Board of Directors, which vested immediately. The Company recorded zero non-restricted stock awards compensation expense for the three months ended June 30, 2013 and 2012, respectively. The Company recorded approximately $137,000 and $148,500 of non-restricted stock awards compensation expense for the six months ended June 30, 2013 and 2012, respectively.

NOTE 7 – Shareholders’ Equity

At June 30, 2013, shareholders’ equity was $419.5 million, or a book value of $8.41 per common share, compared to $558.3 million, or a book value of $11.22 per common share, at December 31, 2012. The decrease in shareholders’ equity from year end primarily relates to the goodwill impairment expense that was recorded in the three months ended June 30, 2013, as described in Note 11 ~ Subsequent Events.

On October 28, 2011, 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 six months ended June 30, 2013, there were no share repurchases. For the three months and six months ended June 30, 2012, the Company purchased and retired approximately 0.7 million and 1.3 million shares of common stock for a total cost of approximately $6.5 million and $11.5 million, respectively.

For the six months ended June 30, 2013, the Company paid dividends to its common shareholders of $2.0 million. For the six months ended June 30, 2012, cash dividends paid to common shareholders totaled $5.1 million.

On July 26, 2013, the Company’s Board of Directors declared a quarterly dividend of $0.02 per common share. The dividend is payable on August 26, 2013, to shareholders of record as of August 12, 2013. In addition, so long as the Company is in default under its Credit Facilities, it is prohibited by the terms thereof from paying any dividends without breaching the Credit Facilities. Refer to Note 4 ~ Debt, for additional information specific to the Company’ financial covenants.

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, regulatory constraints related to the Insurance Company Subsidiaries, 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.
26


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 for the three months and six months ended June 30 (in thousands, except per share amounts):

 
 
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Net (loss) income
 
$
(113,058
)
 
$
(7,732
)
 
$
(105,976
)
 
$
372
 
 
                               
Common shares:
                               
Basic
                               
Weighted average shares outstanding
   
49,887,200
     
50,251,591
     
49,855,716
     
50,583,368
 
 
                               
Diluted
                               
Weighted average shares outstanding
   
49,887,200
     
50,251,591
     
49,855,716
     
50,583,368
 
Dilutive effect of:
                               
Share awards under long term incentive plan
   
-
     
-
     
-
     
-
 
Total
   
49,887,200
     
50,251,591
     
49,855,716
     
50,583,368
 
 
                               
Net (loss) income per common share
                               
Basic
 
$
(2.27
)
 
$
(0.15
)
 
$
(2.13
)
 
$
0.01
 
Diluted
 
$
(2.27
)
 
$
(0.15
)
 
$
(2.13
)
 
$
0.01
 

NOTE 9 – Commitments and Contingencies

The Company, and its subsidiaries, are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, the Company vigorously defends such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by the policy of insurance at issue, errors and omissions insurance, extra-contractual coverage under the reinsurance treaty related to the policy of insurance at issue or other appropriate insurance. In terms of any retentions or deductibles associated with such insurance, the Company has established accruals for such retentions or deductibles, when necessary, based upon current available information. In accordance with accounting guidance, if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is reasonably estimable, then an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets. Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income. Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, the Company does not expect the outcome of the claims, lawsuits and proceedings to which the Company is a party to will have a material adverse effect on the Company’s financial condition.
27


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Other than with regard to the arbitration described below, the Company does not believe there is a reasonable possibility that any material loss exceeding the amounts already accrued for these matters, if any, has been incurred. However, the ultimate resolutions of these matters are inherently unpredictable. As such, the Company’s financial condition and results of operations could be adversely affected in any particular period by the unfavorable resolution of one or more of the above-mentioned matters.

Legal Proceedings

Arbitration
 
The Company purchased a three year underlying per occurrence excess of loss reinsurance agreement (the “Retention Buy Down Treaty”) reinsuring the Company’s statutory workers’ compensation business for the period of January 1, 1999 through January 1, 2002.  Under the Retention Buy Down Treaty, the Company has ceded losses to the reinsurer of approximately $42.6 million. The Company was also a party to an unrelated excess of loss treaty with another reinsurer for its workers compensation business covering the same periods (the “Excess of Loss Treaty”). Under the Excess of Loss Treaty, the Company’s retention was $250,000 per occurrence. The Company purchased the Retention Buy Down Treaty in order to reduce its $250,000 existing retention to $100,000. In approximately 2008, a dispute arose between the parties as to how the Retention Buy Down Treaty applied to certain ceded losses. When the Company and the Reinsurer could not come to a mutual understanding, the Company initiated arbitration proceedings. On July 23, 2013, the Arbitration Panel issued an interim final award finding that the Retention Buy Down Treaty did not include certain ceded losses that the Company believed were subject to the Retention Buy Down Treaty.
28


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

During the arbitration, the reinsurer sought from the Company an award of $1.6 million. This amount reflected the difference between what the Company claimed was due from the reinsurer ($2.9 million) and what the reinsurer claimed it was due back from the Company ($4.5 million). The panel awarded the reinsurer $1.6 million, and $2.0 million in interest, plus attorney’s fees. Based upon the panel’s interpretation of the Retention Buy Down Treaty, the Company was required to reverse certain of its ceded incurred losses due from the reinsurer. The Company recorded this change in ceded incurred losses during the second quarter of 2013. Notwithstanding the Panel’s netting of the outstanding balances, the panel requested the Company submit additional documentation listing all programs covered by the Retention Buy Down Treaty and the Company's retained limit for each program. The Company will be submitting additional documentation to the panel. The reinsurer will be allowed to respond, as well as submit its claim for attorney fees. The Company continues to explore all of its legal remedies as allowed by law. Resolution of this matter is inherently unpredictable. Given the inherent uncertainty surrounding the conclusion of this proceeding, an adverse outcome in this matter could have a material impact on our results of operations or cash flows on a particular quarter or annual period. At this time, an estimate of possible loss or range of loss cannot be made. The $1.6 million and the interest of $2.0 million were expensed by the Company during the second quarter and an estimate for the attorney fee portion of the award was also reserved for by the Company in the second quarter of 2013 in an amount that would fully pay the attorney fee request of the reinsurer.
29


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 10 – Accumulated Other Comprehensive Income

The Company’s comprehensive income includes net earnings plus unrealized gain or loss on available-for-sale investment securities, net of tax. In reporting comprehensive earnings on a net basis in the income statement, we used a 35 percent tax rate. The following table illustrates the amounts reclassified from accumulated other comprehensive income:

Reclassifications out of accumulated other comprehensive income: Three Months Ended June 30, 2013 (in thousands)

Details about accumulated other comprehensive income components
 
Amount reclassified from accumulated other comprehensive income
 
Affected line item in the statement where net income is presented
 
 
 
   
Unrealized gain or loss on available for sale securities
 
 
  
 
 
$
2,907
 
Net realized gains
 
   
(1,017
)
Tax expense
 
 
$
1,890
 
Net of tax

Reclassifications out of accumulated other comprehensive income: Three Months Ended June 30, 2012 (in thousands)

Details about accumulated other comprehensive income components
 
Amount reclassified from accumulated other comprehensive income
 
Affected line item in the statement where net income is presented
 
 
 
   
Unrealized gain or loss on available for sale securities
 
 
  
 
 
$
1,645
 
Net realized gains
 
   
(575
)
Tax expense
 
 
$
1,070
 
Net of tax

Reclassifications out of accumulated other comprehensive income: Six Months Ended June 30, 2013 (in thousands)

Details about accumulated other comprehensive income components
 
Amount reclassified from accumulated other comprehensive income
 
Affected line item in the statement where net income is presented
 
 
 
   
Unrealized gain or loss on available for sale securities
 
 
  
 
 
$
3,195
 
Net realized gains
 
   
(1,118
)
Tax expense
 
 
$
2,077
 
Net of tax

Reclassifications out of accumulated other comprehensive income: Six Months Ended June 30, 2012 (in thousands)

Details about accumulated other comprehensive income components
 
Amount reclassified from accumulated other comprehensive income
 
Affected line item in the statement where net income is presented
 
 
 
   
Unrealized gain or loss on available for sale securities
 
 
  
 
 
$
2,356
 
Net realized gains
 
   
(824
)
Tax expense
 
 
$
1,532
 
Net of tax
30


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 11 – Subsequent Events

Adverse Reinsurance Arbitration Award

On July 23, 2013, the Company was notified of an adverse interim final award in a reinsurance arbitration against it on ceded losses that relate to a reinsurance treaty in place for the 1999 to 2001 policy periods, a provision for these ceded losses was recorded as a $5.2 million allowance for ceded recoverables. With an accrual for other items of approximately $2.9 million, the total pre-tax impact was $8.2 million and the after-tax impact was $5.3 million, or $0.11 per diluted share. This subsequent event was recorded in the second quarter 2013 financial statements. Refer to Note 9 ~ Commitments and Contingencies, for additional information specific to the arbitration award.

A.M. Best Downgrades the Company’s Financial Strength Rating

On August 2, 2013, A.M. Best Company (“A.M. Best”) , insurance industry rating agency, lowered Meadowbrook’s issuer credit rating, as well its financial strength ratings and downgraded the Company’s Insurance Company Subsidiaries’ financial strength rating from “A-” (Excellent) with a “negative” outlook to “B++” (Good) with a “stable” outlook. The Company cannot make an estimate of the financial effect to the Company as a result of the A.M. Best downgrades.

 Agreement to Provide “A” Rated Policy Insurance Solution

On August 4, 2013, the Company’s Insurance Company Subsidiaries entered into agreements with State National Insurance Company and its affiliates, which will provide the Company’s Insurance Company Subsidiaries the use of an “A” rated policy insurance company for a portion of its business where an “A” rated policy issuer is required. The Company cannot make an estimate of the financial effect to the Company as a result of the agreements.

Goodwill Impairment

The Company evaluates existing goodwill for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Goodwill impairment is performed at the reporting unit level.

On August 2, 2013, A.M. Best lowered Meadowbrook's issuer credit rating, as well its financial strength ratings and the issuer credit ratings of its Insurance Company Subsidiaries, following the Company’s reported weaker-than-anticipated second-quarter results. These events represented triggering events for potential goodwill impairment. The Company has performed an interim goodwill impairment evaluation as of June 30, 2013, as required under ASC 350, Goodwill and Other Intangible Assets. Pursuant to ASC 350, goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year or more frequently if management believes indicators of impairment exist. Carrying values are compared with fair values, and if the carrying value exceeds the fair value, the carrying value of the impaired asset or goodwill is reduced to its fair value. The performance of the test requires a two-step process.
31


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Step 1 of the impairment test involves comparing the estimated fair values of the applicable reporting units with their aggregate carrying values, including goodwill. If the carrying amount of a reporting unit exceeds the reporting unit's estimated fair value, the Company performs Step 2 of the goodwill impairment test to determine the amount of impairment, if any. Step 2 of the goodwill impairment test requires comparing the implied fair value of the affected reporting unit's goodwill against the carrying value of that goodwill.

In accordance with accounting guidance, the Company concluded its reporting units to be Specialty Insurance Operations and Agency Operations. The nature of the business and economic characteristics of all agency operations and all Specialty Insurance Operations are similarly based upon, but not limited to, the following; (1) management alignment within each reporting unit, (2) the Company’s Insurance Company Subsidiaries operating under a reinsurance pooling arrangement, and (3) the ability of the Company to leverage its expertise and fixed costs within each reporting unit.

Estimating the fair value of reporting units is a subjective process involving the use of estimates and judgments, particularly related to future cash flows, discount rates (including market risk premiums) and market multiples. The fair values of the reporting units were determined using a blend of two commonly used valuation techniques, the market approach and the income approach. The Company gives consideration to both valuation techniques, as either technique can be an indicator of value. For the market approach, the valuations of the reporting units were based on an analysis of price multiples of net income, net book value and net tangible book value. The peer group price multiples used in the analysis were selected based on management’s judgment. For the income approach, the Company estimated value using a discounted cash flow method (“DCF method”). A DCF method was selected to be comparable to what would be used by market participants to estimate fair value. The DCF method incorporated expected future growth rates, terminal value amounts, and the applicable weighted-average cost of capital to discount estimated cash flows. The projections used in the estimate of fair value are consistent with the Company’s forecast and long-range plans.

The Company completed Step 1 of the impairment test and concluded that a potential impairment existed in its Specialty Insurance Operations reporting unit. The Company is in the process of conducting a Step 2 analysis; however, that analysis remains incomplete as of the date of this report due to the complexity of the required calculations. Step 2 involves determining the potential impairment of goodwill as the difference between the carried goodwill and the hypothetical fair value of enterprise less the fair value of the tangible net assets and less the estimation of identifiable intangible assets, such as agent relationships, licenses, trademarks and other intangibles that may not be carried on the books at fair value. Our preliminary analysis indicates that the estimation of the other identifiable intangible assets is greater than the carrying amount of other intangible assets. To the extent this estimation is greater than the carried amount of other intangibles, we are not permitted to write up the other intangibles to fair value. The Company expects to complete the Step 2 analysis during the third quarter of 2013.
32


MEADOWBROOK INSURANCE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Management has reviewed the results of the Step 1 analysis and concluded that an impairment of goodwill exists at June 30, 2013 and has estimated an impairment amount of $115.4 million. This provisional impairment adjustment will be revised, if necessary, during the third quarter of 2013. Management believes any adjustment to this preliminary charge will not be material; however, until such time as the evaluation is complete any potential changes are uncertain.

The non-cash impairment of goodwill of $115.4 million was recorded in the three months ended June 30, 2013.

The following summarizes the carrying amount of goodwill as of June 30, 2013 (in thousands):

 
 
Agency Operations
   
Specialty Insurance Operations
   
Total
 
Balance at April 1, 2013
 
$
5,644
   
$
115,397
   
$
121,041
 
Goodwill Impairment
   
-
     
(115,397
)
   
(115,397
)
Balance at June 30, 2013
 
$
5,644
   
$
-
   
$
5,644
 
33


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

For the Periods ended June 30, 2013 and 2012

Forward-Looking Statements

This quarterly report may provide information including certain statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These include statements regarding the intent, belief, or current expectations of management, including, but not limited to, those statements that use the words “believes,” “expects,” “anticipates,” “estimates,” or similar expressions. You are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks and uncertainties, and results could differ materially from those indicated by such forward-looking statements. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are: actual loss and loss adjustment expenses exceeding our reserve estimates; competitive pressures in our business; the failure of any of the loss limitation methods we employ; our ability to secure a waiver from our lenders under our credit agreement in connection with the financial covenant non-compliance described under Note 4 - Debt; a  failure of additional capital to be available or only available on unfavorable terms; our geographic concentration and the business, economic, natural perils, man made perils, and regulatory conditions within our most concentrated region; our ability to appropriately price the risks we underwrite; goodwill impairment risk employed as part of our growth strategy and the anticipated impact of the goodwill impairment charge recognized in the second quarter of 2013; efforts with regard to the review of strategic alternatives; actions taken by regulators, rating agencies or lenders, including the impact of the downgrade by A.M. Best of the Company’s Insurance Company Subsidiaries’ financial strength rating; increased risks or reduction in the level of our underwriting commitments due to market conditions; a failure of our reinsurers to pay losses in a timely fashion, or at all; interest rate changes; continued difficult conditions in the global capital markets and the economy generally; market and credit risks affecting our investment portfolio; liquidity requirements forcing us to sell our investments; a failure to introduce new products or services to keep pace with advances in technology; the new federal financial regulatory reform; our holding company structure and regulatory constraints restricting dividends or other distributions by our Insurance Company Subsidiaries; minimum capital and surplus requirements imposed on our Insurance Company Subsidiaries; acquisitions and integration of acquired businesses resulting in operating difficulties, which may prevent us from achieving the expected benefits; our reliance upon producers, which subjects us to their credit risk; loss of one of our core selected producers; our dependence on the continued services and performance of our senior management and other key personnel; our reliance on our information technology and telecommunications systems; managing technology initiatives and obtaining the efficiencies anticipated with technology implementation; a failure in our internal controls; the cyclical nature of the property and casualty insurance industry; severe weather conditions and other catastrophes; the effects of litigation; state regulation; and assessments imposed upon our Insurance Company Subsidiaries to provide funds for failing insurance companies.
34


For additional information with respect to certain of these and other factors, refer to the Item 1A of Part II Report on Form 10-Q for the first quarter ended June 30, 2013 and subsequent filings made with the United States Securities and Exchange Commission. We are not under any obligation to (and expressly disclaim any obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise.

Business Overview

We are a specialty niche focused commercial insurance underwriter and insurance administration services company. We market and underwrite specialty property and casualty insurance programs and products on both an admitted and non-admitted basis through a broad and diverse network of independent retail agents, wholesalers, program administrators and g