MEADOWBROOK INSURANCE GROUP INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Forward-Looking Statements
This Form 10-K 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: the frequency and severity of claims; uncertainties inherent in reserve estimates; catastrophic events; a change in the demand for, pricing of, availability or collectability of reinsurance; increased rate pressure on premiums; ability to obtain rate increases in current market conditions; investment rate of return; changes in and adherence to insurance regulation; actions taken by regulators, rating agencies or lenders; attainment of certain processing efficiencies; changing rates of inflation; general economic conditions and other risks identified in our reports and registration statements filed with theSecurities and Exchange Commission . We are not under any obligation to (and expressly disclaim any such 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 publicly traded 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 general agents, who value service, specialized knowledge, and focused expertise. Program business refers to an aggregation of individually underwritten risks that have some unique characteristic and are distributed through a select group of agents. We seek to combine profitable underwriting, income from our net commissions and fees, investment returns and efficient capital management to deliver consistent long-term growth in shareholder value. Through our retail property and casualty agencies, we also generate commission revenue, which represents 1.6% of our total consolidated revenues. Our agencies are located inMichigan ,California , andFlorida and produce commercial, personal lines, life and accident and health insurance that is primarily with unaffiliated insurance carriers. These agencies produce a minimal amount of business for our affiliated Insurance Company Subsidiaries.
We recognize revenue related to the services and coverages within the following categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance placement, investment income, commission revenue, and net realized gains (losses).
We compete in the specialty insurance market. Our wide range of specialty niche insurance expertise allows us to accommodate a diverse distribution network ranging from specialized program agents to retail agents. In the specialty market, competition tends to place considerable focus on availability, service and other tailored coverages in addition to price. Moreover, our broad geographical footprint enables us to function with a local presence on both a regional and national basis. We also have the capacity to write specialty insurance in both the admitted and non-admitted markets. These unique aspects of our business model enable us to compete on factors other than price.
Critical Accounting Policies
General
In certain circumstances, we are required to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on a variety of factors. There can be no assurance, however, the actual results will not be materially different than our estimates and assumptions, and that reported results of operation will not be affected by accounting adjustments needed to reflect changes in these estimates and assumptions. We believe the following policies, along with those disclosed in Note 1 ~ Summary of Significant Accounting Policies, are the most sensitive to estimates and judgments. 27 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Losses and Loss Adjustment Expenses
Significant periods of time can elapse between the occurrence of a loss, the reporting of the loss to the insurer, and the insurer's payment of that loss. To recognize liabilities for unpaid losses and loss adjustment expenses ("LAE"), insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and LAE. We establish a liability for losses and LAE, which represents case based estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported losses ("IBNR") and LAE. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the ultimate liability may be greater or less than the estimate. As ofDecember 31, 2011 and 2010, we have accrued$1,195.0 million and$1,065.1 million of gross loss and LAE reserves, respectively.
Components of Losses and Loss Adjustment Expense
The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, atDecember 31, 2011 (in thousands): Case IBNR Total Direct $ 420,477 $ 667,344 $ 1,087,821 Assumed-Directly Managed (1) 40,078 30,627 70,705 Assumed-Residual Markets (2) 8,888 8,794 17,682 Assumed-MFH 9,966 3294 13,260 Assumed-Other 3,544 1,965 5,509 Gross 482,953 712,024 1,194,977 Less Ceded 97,793 218,091 315,884 Net $ 385,160 $ 493,933 $ 879,093
(1) Directly managed represents business managed and processed by our underwriting, claims, and loss control departments, utilizing our internal systems and related controls.
(2) Residual markets represent mandatory pooled workers' compensation business allocated to individual insurance company writers based on the insurer's market share in a given state. The reserves referenced in the above table related to our direct and assumed-directly managed business are established through transactions processed through our internal systems and related controls. Likewise assumed-MFH is assumed business related to our partial ownership ofMidwest Financial Holdings where we have direct access to their paid and case reserve loss data. Accordingly, case reserves are established on a current basis, therefore there is no delay or lag in reporting of losses from a ceding company, and IBNR is determined utilizing various actuarial methods based upon historical data. Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag between the date of the evaluation and the receipt of the estimate from theNational Council on Compensation Insurance ("NCCI"), and include an estimated reserve determined based upon internal actuarial methods for this lag. Relative to assumed business from other sources, we receive case and paid loss data within a forty-five day reporting period and develop our estimates for IBNR based on both current and historical data. The completeness and accuracy of data received from cedants on assumed business that we do not manage directly is verified through monthly reconciliations to detailed statements, inception to date rollforwards of claim data, actuarial estimates of historical trends, field audits, and a series of management oversight reports on a program basis. 28 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
The following table sets forth our net case and IBNR reserves for losses and LAE by line of business at
Net Case Net IBNR Total Workers' Compensation $ 188,518 $ 169,613 $ 358,131 Residual Markets 8,888 8,794 17,682 Commercial Multiple Peril/General Liability 112,374 240,937 353,311 Commercial Automobile 55,698 61,896 117,594 Other 19,682 12,693 32,375 Total $ 385,160 $ 493,933 $ 879,093
Claim Reserving Process and Methodology
When a claim is reported to one of our Insurance Company Subsidiaries, for the majority of claims, our claims personnel within our risk management subsidiary will establish a case reserve for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, which focus on the ultimate probable cost of each reported claim, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments, new information or periodic reviews of the claims. In addition to case reserves and in accordance with industry practice, we maintain estimates of reserves for losses and LAE incurred but not yet reported. We project an estimate of ultimate losses and LAE at each reporting date. The difference between the projected ultimate loss and LAE reserves and the case loss reserves and LAE reserves, is carried as IBNR reserves. By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, we estimate the ultimate liability for losses and LAE, net of reinsurance recoverables. In developing claim and claim adjustment expense reserve estimates, we perform a complete and detailed reserve analyses each quarter. To perform this analysis, the data is organized at a "reserve category" level. A reserve category can be a line of business such as commercial automobile liability, or it may be a particular geographical area within a line of business such asCalifornia workers' compensation. The reserves within a reserve category level are characterized as either short tail or long tail. About 97% of our reserves can be characterized as coming from long tail lines of business. For long tail business, several years may lapse between the time the business is written and the time when all claims are settled. Our long-tail exposures include workers' compensation, commercial automobile liability, general liability, professional liability, products liability, aviation liability, excess, and umbrella. Short-tail exposures include property, commercial automobile physical damage, a portion of ocean marine, and inland marine. The analyses generally review losses both gross and net of reinsurance. The standard actuarial methods that we use to project ultimate losses for both long-tail and short-tail exposures include, but are not limited to, the following: · Paid Development Method · Incurred Development Method · Paid Bornhuetter-Ferguson Method · Reported Bornhuetter-Ferguson Method · Initial Expected Loss Method · Paid Roll-forward Method · Incurred Roll-forward Method All of these methods are consistently applied to every reserve category where they are applicable and they create indications for each accident year. We use judgment selecting the best estimate from within these estimates or adjusted estimates. As such, no one method or group of methods is strictly used for any line of business or reserve category within a line of business. The individual selections by year are our best judgments based on the strengths and weaknesses of the method, indications, the inherent variability in the data and the specific modifications to selections for data characteristics. 29 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
A brief description of the methods and some discussion of their inherent strengths, weaknesses and uses are as follows:
Paid Development Method. This method uses historical, cumulative paid losses by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment environment, and to the extent necessary supplemented by analyses of the development of broader industry data. Selection of the paid loss pattern requires analysis of several factors including the impact of inflation on claims costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, the impact of large claim payments and other factors. Claim cost inflation itself requires evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors. Because this method assumes that losses are paid at a consistent rate, changes in any of these factors can impact the results. Since the method does not rely on case reserves, it is not directly influenced by changes in the adequacy of case reserves. Incurred Development Method. This method uses historical, cumulative reported loss dollars by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment and case reserving environment, and to the extent necessary supplemented by analyses of the development of broader industry data. Since the method uses more data (case reserves in addition to paid losses) than the paid development method, the incurred development patterns may be less variable than paid patterns. However, selection of the incurred loss pattern requires analysis of all of the factors listed in the description of the paid development method. In addition, the inclusion of case reserves can lead to distortions if changes in case reserving practices have taken place and the use of case incurred losses may not eliminate the issues associated with estimating the incurred loss pattern subsequent to the most mature point available. Paid Bornhuetter-Ferguson Method. This is a method that assigns partial weight to initial expected losses for each accident year and partial weight to observed paid losses. The weights assigned to the initial expected losses decrease as the accident year matures. The method assumes that only future losses will develop at the expected loss ratio level. The percent of paid loss to ultimate loss implied from the paid development method is used to determine what percentage of ultimate loss is yet to be paid. The use of the pattern from the paid development method requires consideration of all factors listed in the description of the paid development method. The estimate of losses yet to be paid is added to current paid losses to estimate the ultimate loss for each year. This method will react very slowly if actual ultimate loss ratios are different from expectations due to changes not accounted for by the expected loss ratio calculation. Reported Bornhuetter-Ferguson Method. This is a method that assigns partial weight to the initial expected losses and partial weight to observed reported loss dollars (paid losses plus case reserves). The weights assigned to the initial expected losses decrease as the accident year matures. The use of case incurred losses instead of paid losses can result in development patterns that are less variable than paid patterns. However, the inclusion of case reserves can lead to distortions if changes in case reserving have taken place, and the method requires analysis of all the factors that need to be reviewed for the expected loss ratio and incurred development methods. Initial Expected Loss Method. This method is used directly, and as an input to the Bornhuetter-Ferguson methods. Initial expected losses for an accident year are based on adjusting prior accident year projections to the current accident year levels using underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments specific to the line of business. This method may be useful if loss development patterns are inconsistent, losses emerge very slowly, or there is relatively little loss history from which to estimate future losses. The selection of the expected loss ratio requires analysis of loss ratios from earlier accident years or pricing studies and analysis of inflationary trends, frequency trends, rate changes, underwriting changes, and other applicable factors. 30 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued Paid Roll-forward Method. This method adjusts prior estimates of ultimate losses based on the actual paid loss emergence in the quarter compared to the expected emergence. It is useful in determining reserves that avoid overreacting to ordinary fluctuations in the development patterns. Incurred Roll-forward Method. This method adjusts prior estimates of ultimate losses based on the actual case incurred loss emergence in the quarter compared to the expected emergence. It may also be useful in determining reserves that avoid overreacting to ordinary fluctuations in the development patterns and generally reacts faster than the paid roll-forward method. Claims for short-tail lines of business settle more quickly than long-tail lines of business, and in general, loss development factors for short-tail lines are smaller than long-tail lines. For long-tail lines, we tend to rely on initial expected loss methods throughout the current accident year then move to development factor based methods for older accident years. Development methods on short-tail lines are generally reliable in the third and fourth quarter of the initial accident year and recorded loss ratios reflect a blend of the development and forecast methods. Short-tail lines represent 3% of our total reserves atDecember 31, 2011 . The reserve categories where the above methods are not applicable are few. The largest of these is our workers' compensation residual market reserve category, where we utilize detailed reserve analyses performed by the industry statistical agencyNCCI in making our estimates. We adjust these estimates for timing differences in the reporting of the data. The other reserve categories that deviate from the above methods are smaller; as a group constituting approximately one percent of the total reserves. Each of the methods listed above requires the selection and application of parameters and assumptions. For all but the initial expected loss method, the key assumptions are the patterns with which our aggregate claims data will be paid or will emerge over time ("development patterns"). These patterns incorporate inherent assumptions of claims cost inflation rates and trends in the frequency of claims, both overall and by severity of claim. These are affected by underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments which are explicit key assumptions underlying the initial expected loss method. Each of these key assumptions is discussed in the following paragraphs. To analyze the development patterns, we compile, to the extent available, long-term and short-term historical data for our insurance subsidiaries, organized in a manner which provides an indication of the historical development patterns. To the extent that the historical data may provide insufficient information about future patterns-whether due to environmental changes such as legislation or due to the small volume or short history of data for some segments of our business-benchmarks based on industry data, and forecasts made by industry rating bureaus regarding the effect of legislative benefit changes on such patterns, may be used to supplement, adjust, or replace patterns based on our insurance companies' historical data. Actuarial judgment is required in selecting the patterns to apply to each segment of data being analyzed, and our views regarding current and future claim patterns are among the factors that enter into our establishment of the reserve for losses and LAE at each balance sheet date. When short-term averages or external rate bureau analyses indicate the claims patterns are changing from historical company or industry patterns, the new or forecasted information typically is factored into the methodologies. When new claims emergence or payment patterns have appeared in the actual data repeatedly over multiple evaluations, those new patterns are given greater weight in the selection process. Because some claims are paid over many years, the selection of claim emergence and payment patterns involves judgmentally estimating the manner in which recently occurring claims will develop for many years and at times, decades in the future. When it is likely the actual development will occur in the distant future, the potential for actual development to differ substantially from historical patterns or current projections is increased. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. In particular, the development factor based methods all have as a key assumption that the development of losses in the future will follow a pattern similar to those measured by past experience and as adjusted either explicitly or by actuarial judgment. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple and varied factors. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the years endedDecember 31, 2011 and 2010. 31 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Variability of Claim Reserve Estimates
By its nature, the estimate of ultimate losses and LAE is subject to variability due to differences between our assumptions and actual events in the future. Although many factors influence the actual cost of claims and our corresponding reserve estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors known to impact the cost of claims cannot be measured directly, such as the impact on claim costs due to economic inflation, coverage interpretations and jury determinations. In most instances, we rely on our historical experience or industry information to estimate the values for the variables that are explicitly used in our reserve analyses. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of the future effects of these factors. Where we have reason to expect a change in the effect of one of these factors, we perform analyses to perform the necessary adjustments. One implicit assumption underlying development patterns is that the claims inflation trends will continue into the future similar to their past patterns. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, our actuarial department derives expected payment patterns separately for each major line of business. These patterns were applied to theDecember 31, 2011 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. General inflation trends have been fairly stable over the past several years but there have been fluctuations of one to two percent over the past ten years and therefore we used a one percent annual inflation variance factor. The effect differed by line of business but overall was a four percent change in reserve adequacy or approximately$22.6 million effect on after tax net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. An explicit assumption used in the analysis is the set of initial expected loss ratios ("IELRs") used in the current accident year reserve projections and in some of the prior accident year ultimate loss indications. To estimate the sensitivity of the estimated ultimate loss to a change in IELRs, the actuarial department recasted the loss reserve indications using a set of IELRs all one percent higher than the final IELRs. The overall impact of a one percent change in IELRS would be a corresponding one percent change in reserve adequacy or a$4.9 million effect on after tax net income. Often the loss ratios by line of business will vary from the IELR in different directions causing them to partially offset each other. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid. The other factors having influence upon the loss and LAE reserve levels are too numerous and interdependent to efficiently model and test for sensitivity. Likewise, the development factors by reserve category and age are too numerous to model and test for sensitivity. Instead, ranges are estimated by reserve category considering past history, fluctuations in the development patterns, emerging issues, trends and other factors. The ranges are compiled and the total range is estimated considering the sensitivity to all of the underlying factors together. The resulting range is our best estimate of the expected ongoing variability in the loss reserves. Our range of loss and LAE reserves table shows that presently we estimate them as going from favorable development of 10.4% to unfavorable of 10.8%. The range was evaluated based on the ultimate loss estimates from the actuarial methods described above. 32
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued Pre-tax Impact on Earnings from a Variance in Future Loss
Payments and Case Reserves as of December 31, 2011 (in thousands) Minimum Maximum Line of Business Reserve Range Reserve Range Workers' Compensation $ (22,762 ) -6.4 % $ 25,174 7.0 % Residual Markets (1,239 ) -7.0 % 529 3.0 % Commercial Multiple Peril / General Liability (59,088 ) -16.7 % 60,473 17.1 % Commercial Automobile (6,498 ) -5.5 % 7,214 6.1 % Other (2,024 ) -6.3 % 1,719 5.3 % Total $ (91,611 ) -10.4 % $ 95,109 10.8 %
The sensitivity around our workers' compensation reserves primarily reflects the size and the maturity of the underlying book of business. Our workers' compensation reserves represent 43% of our total reserves at
The sensitivity around our commercial multiple peril / general liability reserves primarily reflects the longer duration of reserves relating to our liability excess program, which started in 2003, and construction defect exposure, which together represent approximately 39% of the
The sensitivity around our commercial automobile reserves primarily reflects the speed of reporting of the underlying losses, as well as the maturity of the case law surrounding automobile liability. The sensitivity around the other lines of business primarily reflects the size of the underlying book of business. Our other reserves represent 4% of total reserves atDecember 31, 2011 . A large portion of these reserves represent professional liability programs which tend to be claims-made and reinsured at lower limits, therefore reducing the volatility that is inherent in a smaller book of business. Another large portion represents property claims, which have a shorter reporting and payout pattern than liability and workers' compensation claims. All of our reserves are sensitive to changes in the underlying claim payment and case reserving practices, as well as the other sources of variations mentioned above. Reinsurance Recoverables Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR losses and LAE. Such recoverables, by necessity, are based upon estimates. Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded. Instead of being netted against the appropriate liabilities, ceded unearned premiums and reinsurance recoverables on paid and unpaid losses and LAE are reported separately as assets in our consolidated balance sheets. Reinsurance recoverable balances are also subject to credit risk associated with the particular reinsurer. In our selection of reinsurers, we continually evaluate their financial stability. While we believe our reinsurance recoverables are collectible, the ultimate recoverable may be greater or less than the amount accrued. AtDecember 31, 2011 and 2010, reinsurance recoverables on paid and unpaid losses were$325.8 million and$294.2 million , respectively. In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients' captive, rent-a-captive, large deductible programs, indemnification agreements, or on the portion of risk either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. We collateralize balances due from our risk-sharing partners through funds withheld trusts or stand-by letters of credit issued by highly rated banks. We have historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which may be in dispute. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. AtDecember 31, 2011 , we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of our risk-sharing partners to meet their obligations. 33 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Legal Contingencies
We 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, we vigorously defend 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 at issue, errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, we have established provisions against these items, which are believed to be adequate in light of current information and legal advice. 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 estimable; an accrual is provided for the costs to resolve these claims in our consolidated accompanying financial statements. Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income. We, with the assistance of outside counsel, adjust such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, we do not expect the outcome of the claims, lawsuits and proceedings to which we are subject to, either individually, or in the aggregate, will have a material adverse effect on our financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters.
Non-GAAP Financial Measures
Net Operating Income and Net Operating Income Per Share
Net operating income and net operating income per share are non-GAAP measures that represent net income excluding net realized gains or loss, net of tax. The most directly comparable financial GAAP measures to net operating income and net operating income per share are net income and net income per share. Net operating income and net operating income per share are intended as supplemental information and are not meant to replace net income nor net income per share. Net operating income and net operating income per share should be read in conjunction with the GAAP financial results. The following is a reconciliation of net operating income to net income, as well as net operating income per share to net income per share: For the Years
Ended December 31,
2011 2010 2009 (In thousands, except share and per share data) Operating income, net of tax $ 40,912 $ 58,216 $ 53,515 Net realized gains (losses), net of tax 2,699 1,505 (865 ) Net income $ 43,611 $
59,721
Diluted earnings per common share: Net operating income $ 0.78 $ 1.07 $ 0.93 Net income $ 0.83 $ 1.10 $ 0.92 Diluted weighted average common shares outstanding 52,404,377 54,289,131 57,413,391 We use net operating income and net operating income per share as components to assess our performance and as measures to evaluate the results of our business. We believe these measures provide investors with valuable information relating to our ongoing performance that may be obscured by the net effect of realized gains and losses as a result of our market risk sensitive instruments, which primarily relate to fixed income securities that are available for sale and not held for trading purposes. Realized gains and losses may vary significantly between periods and are generally driven by external economic developments, such as capital market conditions. Accordingly, net operating income excludes the effect of items that tend to be highly variable from period to period and highlights the results from our ongoing business operations and the underlying profitability of our business. Therefore, we believe that it is useful for investors to evaluate net operating income and net operating income per share, along with net income and net income per share when reviewing and evaluating our performance. 34
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Accident Year Loss Ratio
The accident year loss ratio is a non-GAAP measure and represents our net loss and LAE ratio adjusted for any adverse or favorable development on prior year reserves. The most directly comparable financial GAAP measure to the accident year loss ratio is the net loss and LAE ratio. The accident year loss ratio is intended as supplemental information and is not meant to replace the net loss and LAE ratio. The accident year loss ratio should be read in conjunction with the GAAP financial results. The following is a reconciliation of the accident year loss ratio to the net loss and LAE ratio, which is the most directly comparable GAAP measure: For the Years Ended December 31, 2011 2010 2009 Accident year loss ratio 65.3 % 65.3 % 66.0 % Adverse (favorable) development on prior years 1.0 % -4.7 % -5.3 % Net loss & LAE ratio 66.3 % 60.6 % 60.7 % We use the accident year loss ratio as one component to assess our current year performance and as a measure to evaluate, and if necessary, adjust our pricing and underwriting. Our net loss and LAE ratio is based on calendar year information. Adjusting this ratio to an accident year loss ratio allows us to evaluate information based on the current year activity. We believe this measure provides investors with valuable information for comparison to historical trends and current industry estimates. We also believe that it is useful for investors to evaluate the accident year loss ratio and net loss and LAE ratio separately when reviewing and evaluating our performance.
Results of Operations
Executive Overview
Our results for the year endedDecember 31, 2011 , include the positive impact from continued selective growth, coupled with our adherence to strict corporate underwriting guidelines and a focus on current accident year price adequacy. Our generally accepted accounting principles ("GAAP") combined ratio was 99.7% for the year endedDecember 31, 2011 , compared to 95.0% in 2010. Our accident year combined ratio was 98.7% for the year endedDecember 31, 2011 , compared to 99.7% in 2010. The year-to-date 2011 results were impacted by higher than expected or 'normal level' storm losses that occurred during 2011, which added 1.2 percentage points to both the GAAP and accident year combined ratios. Net operating income, a non-GAAP measure, decreased$17.3 million , from$58.2 million , or$1.07 per diluted share for the year endedDecember 31, 2010 , to$40.9 million , or$0.78 per diluted share for the year endedDecember 31, 2011 . The 2011 results include losses of$5.9 million after-tax, due to higher than expected or 'normal level' of storm activity in 2011. Development on prior year reserves reduced net operating income by$4.8 million in 2011, compared to an increase in net operating income by$20.2 million in 2010. Excluding the impact of the higher than normal level storm losses and development on prior year loss reserves, 2011 net operating income on an accident year basis increased to$51.6 million , compared to$38.0 million in 2010. Gross written premium increased$102.1 million , or 12.7%, to$904 million in 2011, compared to$801.9 million in 2010. The 2011 results reflect the conversion of an existing fee-based program into an insured program where we now assumes the underwriting risk. Excluding the impact of the conversion of the existing fee-based program, gross written premium increased$68.0 million , or 8.7% as compared to the prior year. This increase primarily reflects the maturation of existing programs, rate increases that have been achieved and new business initiatives that were implemented during the past twelve months designed to develop specialty niche expertise in a range of areas. These increases were partially offset by reductions in certain programs where pricing or underwriting did not meet the Company's targets. 35 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Results of Operations 2011 compared to 2010:
Net income for the year endedDecember 31, 2011 , was$43.6 million , or$0.83 per dilutive share, compared to net income of$59.7 million , or$1.10 per dilutive share, for the comparable period of 2010. Net operating income, a non-GAAP measure, decreased$17.3 million , or 29.7%, to$40.9 million , or$0.78 per diluted share, compared to net operating income of$58.2 million , or$1.07 per diluted share in 2010. Total diluted weighted average shares outstanding for the year endedDecember 31, 2011 , were 52,404,377, compared to 54,289,131for the comparable period in 2010. This decrease reflects the impact of our Share Repurchase Plan (the "Plan") in which we repurchased 2.2 million shares during 2011.
Revenues - 2011 compared to 2010
Revenues for the year ended
The following table sets forth the components of revenues (in thousands):
For the Years Ended December 31, 2011 2010 Revenue: Net earned premiums $ 747,635 $ 659,840 Management administrative fees 12,814 16,240 Claims fees 6,251 6,806 Commission revenue 13,050 11,193 Net investment income 54,522 54,173 Net realized gains 2,949 1,817 Total revenue $ 837,221 $ 750,069 Net earned premiums increased$87.8 million , or 13.3%, to$747.6 million for the year endedDecember 31, 2011 , from$659.8 million in the comparable period in 2010. This increase primarily reflects the maturation of existing programs, the conversion of the existing fee-based program into an insured program, rate increases that have been achieved and new business initiatives that were implemented during the past twelve months designed to develop specialty niche expertise in a range of areas. Management fees decreased$3.4 million , or 21%, to$12.8 million for the year endedDecember 31, 2011 , from$16.2 million for the comparable period in 2010. As previously discussed, this decrease was primarily driven by the conversion of an existing fee-based program into an insured program where we earn premium revenue as opposed to fees revenue. Commission revenue increased$1.9 million , or 17%, to$13.1 million for the year endedDecember 31, 2011 , from$11.2 million for the comparable period in 2010. This increase primarily reflectsMichigan agency business that was added in the current year. Net realized gains increased by$1.1 million , to a$2.9 million gain for the year endedDecember 31, 2011 , from a$1.8 million gain for the comparable period in 2010. The increase in realized gains relates to our efforts to generate capital gains as a result of our tax strategy to utilize the benefit from our capital tax loss carry-forward.
Expenses - 2011 compared to 2010
Expenses increased
36 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
The following table sets forth the components of expenses (in thousands):
For the Years EndedDecember 31, 2011 2010
Expense:
Net losses and loss adjustment expenses $ 495,351 $
399,650
Policy acquisition and other underwriting expenses 249,644 227,031 General selling & administrative expenses
24,775 22,494 General corporate expenses 400 5,668 Amortization expense 4,973 4,966 Interest expense 8,347 9,458 Total expenses $ 783,490 $ 669,267 Relating to the components of our combined ratio, it is important to note the impact of the issuance of a one-time replacement policy for one of our self-insured clients for which we purchased a reinsurance policy from a third party re-insurer, which transferred 100% of the risk. This transaction had no impact on the combined ratio or underwriting income, but did result in a 0.4% percentage point increase during the year on our loss and LAE ratio and a corresponding 0.4% percentage point decrease on the expense ratio. Net loss and loss adjustment expenses ("LAE") increased$95.7 million , to$495.4 million for the year endedDecember 31, 2011 , from$399.7 million for the same period in 2010. Our loss and LAE ratio was 66.3% for the year endedDecember 31, 2011 and 60.6% for the year endedDecember 31, 2010 . The accident year loss and LAE ratio was 65.3% for the both years endedDecember 31, 2011 and 2010. The 2011 accident year loss and LAE ratio includes 1.2 percentage points of higher than an expected or 'normal level' of storm loss activity. The higher than normal level of storm losses was partially offset by improved underwriting results as rate increases and underwriting actions begin to take effect. Excluding the higher than normal level of storm activity the 2011 accident year loss and LAE ratio improved to 64.1%, compared to 65.3% in the prior year. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section. Policy acquisition and other underwriting expenses increased$22.6 million , to$249.6 million for the year endedDecember 31, 2011 , from$227.0 million for the same period in 2010. Our expense ratio decreased one percentage point to 33.4% for the year endedDecember 31, 2011 , from 34.4% for the same period in 2010. This improvement reflects a reduction in variable compensation and a reduction in commission rates due to mix of business. General, selling and administrative costs increased$2.3 million , to$24.8 million for the year endedDecember 31, 2011 , from$22.5 million for the same period in 2010. This increase relates primarily to investments in new sales initiatives to stimulate net commission and fee revenue growth, as well as a shift in certain overhead expenses from direct insurance operations to corporate overhead. These items were partially offset by a reduction in performance based variable compensation in 2011 as compared to 2010. General corporate expenses decreased$5.3 million , to$0.4 million for the year endedDecember 31, 2011 , from$5.7 million for the same period in 2010. The decrease is due to a reduction in the performance based variable compensation accrual in the current year, as compared to accruing a provision for variable compensation in 2010. Interest expense for the year endedDecember 31, 2011 , decreased$1.2 million , to$8.3 million , from$9.5 million for the comparable period in 2010. Interest expense is primarily attributable to our debentures, which are described within the Liquidity and Capital Resources section of Management's Discussion and Analysis, as well as our term loan. The overall decrease reflects the decline in the average outstanding balance on our term loan to$30.8 million for the period endedDecember 31, 2011 from$43.8 million for same period in 2010. Federal income tax expense for the year endedDecember 31, 2011 was$11.8 million , or 22.3% of income before taxes, compared to$22.9 million , or 28.7% of income before taxes for the same period in 2010. Income tax expense on net capital gains and the change in our valuation allowance on deferred tax assets, was$0.3 million and$0.4 million for the years endedDecember 31, 2011 and 2010, respectively. Excluding the tax impact of net capital gains and the change in or valuation allowance, the effective income tax rate would have been 23.1% and 28.8% for the years endedDecember 31, 2011 and 2010, respectively. The lower rate reflects a larger portion of taxable income coming from net investment income rather than fee based and underwriting income, which includes a portion of tax exempt investments. 37 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Results of Operations 2010 compared to 2009:
Net income for the year endedDecember 31, 2010 , was$59.7 million , or$1.10 per dilutive share, compared to net income of$52.7 million , or$0.92 per dilutive share, for the comparable period of 2009. Net operating income, a non-GAAP measure, increased$4.7 million , or 8.8%, to$58.2 million , compared to net operating income of$53.5 million in 2009; this equates to an increase in operating income per share of 15.1% to$1.07 per dilutive share, compared to$0.93 per dilutive share in 2009, on lower weighted average shares outstanding. Total weighted average shares outstanding for the year endedDecember 31, 2010 , were 54,289,131, compared to 57,413,391 for the comparable period in 2009. This decrease reflects the impact of our Share Repurchase Plan (the "Plan") in which we repurchased 2.5 million shares during 2010. We currently have approximately 2.5 million more shares within the Plan authorized for repurchase.
Revenues - 2010 compared to 2009
Revenues for the year ended
The following table sets forth the components of revenues (in thousands):
For the Years Ended December 31, 2010 2009 Revenue: Net earned premiums $ 659,840 $ 539,602 Management administrative fees 16,240 19,697 Claims fees 6,806 7,427 Commission revenue 11,193 10,757 Net investment income 54,173 50,366 Net realized gains (losses) 1,817 (225 ) Total revenue $ 750,069 $ 627,624 Net earned premiums increased$120.2 million , or 22.3%, to$659.8 million for the year endedDecember 31, 2010 , from$539.6 million in the comparable period in 2009. This increase was primarily the result of growth within our existing programs and the new business we began writing in 2009. Management fees decreased$3.5 million , or 17.6%, to$16.2 million for the year endedDecember 31, 2010 , from$19.7 million for the comparable period in 2009. This decrease primarily reflects the impact of a program we previously managed that decided to perform its own policy administration services, the conversion of an existing program into an insured program within the Company's underwriting subsidiary during 2010, as well as a decrease in fees for self-insured programs, caused by a decrease in premium volume from continued competition, economic conditions, and higher unemployment. Claim fees decreased$0.6 million , or 8.4%, to$6.8 million for the year endedDecember 31, 2010 , from$7.4 million for the comparable period in 2009. This decrease is primarily due to the previously mentioned program above is now administering their claims in house and an anticipated decrease resulting from the termination of one unprofitable program. Net investment income increased$3.8 million , or 7.6%, to$54.2 million for the year endedDecember 31, 2010 , from$50.4 million in 2009. This increase primarily reflects the increase in average invested assets from$1.1 billion in 2009 to$1.3 billion in 2010. The increase in our average investment balance is because of growth in underwriting profits, growth in investment income, and a slight lengthening of our loss and LAE reserve duration. The average investment yield forDecember 31, 2010 was 4.3% compared to 4.4% in 2009. The current pre-tax book yield was 4.2% compared to 4.4% in 2009. The current after-tax book yield was 3.1% compared to 3.4% in 2009. The effective duration of the investment portfolio was 5.0 years atDecember 31, 2010 and 5.1 years atDecember 30, 2009 . Net realized gains (losses) improved by$2.0 million , to a$1.8 million gain for the year endedDecember 31, 2010 , from a($0.2) million loss for the comparable period in 2009. The loss in 2009 reflected both the realized losses on the sale of securities sold during the prior year and other-than-temporary impairments pertaining to certain corporate bonds, asset-backed and mortgage-backed securities, compared to the realized gains on the sale of securities sold in 2010. 38
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Expenses - 2010 compared to 2009
In 2010, we completed an in-depth cost allocation study and made refinements to our process to track these costs on a functional basis. The purpose of the study was to align our internal expenses with those activities for which individuals perform, such as claims administration or otherwise referred to as unallocated loss adjustment expense, underwriting and related policy administration, or general, selling and administrative costs associated with the production and management of our net commission, fee revenue, and general corporate expenses. Upon completion of the study, we have the information to better define our inter-company fees and to treat these fees as an inter-company cost reimbursement for financial reporting purposes. This enabled us to align the consolidated results with the underlying nature or function of internal expenses in the current year. Previously, we used estimations based on an overall cost study that focused on inter-company fees in total and the reasonableness of the split between claims administration and policy acquisition costs. Furthermore, during the first quarter of 2010, we made certain reclassifications to the expense classifications on the Consolidated Statement of Income. These reclassifications were made to enable the user of the financial statements to calculate the GAAP combined ratio directly from the Consolidated Statement of Income. As a result, the Consolidated Statement of Income for the year endedDecember 31, 2009 , has been reclassified to conform to this revised presentation, see Note 1 ~ Summary of Significant Accounting Policies for reclassification table. These reclassifications do not change total expenses or consolidated net income as originally reported for the year endedDecember 31, 2009 . Please refer to Form 8-K filed onMay 3, 2010 for further detail. For the year endedDecember 31, 2010 , this refinement resulted in a 1.7 percentage point increase in the expense ratio, a 1.0 percentage point decrease in the loss and LAE ratio and a decrease of$4.9 million in general, selling and administrative costs.
Expenses increased
The following table sets forth the components of expenses (in thousands):
For the Years EndedDecember 31, 2010 2009
Expense:
Net losses and loss adjustment expenses $ 399,650 $
327,426
Policy acquisition and other underwriting expenses 227,031 175,134 General selling & administrative expenses
22,494 29,601 General corporate expenses 5,668 5,977 Amortization expense 4,966 5,781 Interest expense 9,458 10,596 Total expenses $ 669,267 $ 554,515 Net loss and loss adjustment expenses ("LAE") increased$72.3 million , to$399.7 million for the year endedDecember 31, 2010 , from$327.4 million for the same period in 2009. Our loss and LAE ratio was 60.6% for the year endedDecember 31, 2010 and 60.7% for the year endedDecember 31, 2009 . The accident year loss and LAE ratio was 65.3% for the year endedDecember 31, 2010 down from 66.0% in the comparable period in 2009. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section. Policy acquisition and other underwriting expenses increased$51.9 million , to$227.0 million for the year endedDecember 31, 2010 , from$175.1 million for the same period in 2009. Our expense ratio increased 1.9 percentage points to 34.4% for the year endedDecember 31, 2010 , from 32.5% for the same period in 2009. This increase reflects the reclassification impact described above as well as an increase in external cost, primarily net commission expense, relating to new business added in the second half of 2009 for which the agent performs certain policy issuance functions. General, selling and administrative costs decreased$7.1 million , to$22.5 million for the year endedDecember 31, 2010 , from$29.6 million for the same period in 2009. This decrease reflects the reclassification impact described above as well as our ability to further leverage fixed costs. 39 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued General corporate expenses decreased$0.3 million , to$5.7 million for the year endedDecember 31, 2010 , from$6.0 million for the same period in 2009. The decrease is driven primarily by certain non-recurring legal expenses that were incurred in 2009. Amortization expense decreased$0.8 million to$5.0 million for the year endedDecember 31, 2010 , from$5.8 million for the same period in 2009. This decrease reflects a decrease in the amortization relating to the USSU acquisition completed in 2007. Interest expense for the year endedDecember 31, 2010 , decreased$1.1 million , to$9.5 million , from$10.6 million for the comparable period in 2009. Interest expense is primarily attributable to our debentures, which are described within the Liquidity and Capital Resources section of Management's Discussion and Analysis, as well as our term loan. The overall decrease reflects the decline in the average outstanding balance on our term loan to$43.8 million for the period endedDecember 31, 2010 from$55.1 million for same period in 2009. The decrease also reflects interest rate swaps that were entered into during the current year that replaced expiring swaps and had a lower fixed interest rate. Federal income tax expense for the year endedDecember 31, 2010 was$22.9 million , or 28.7% of income before taxes, compared to$20.9 million , or 28.8% of income before taxes for the same period in 2009. Income tax expense on capital gains (losses) and the change in our valuation allowance for other than temporary impairments and loss carryforwards from prior years where there are not any realized gains to offset the realized capital losses, was$426,000 and$640,000 for the years endedDecember 31, 2010 and 2009, respectively. Excluding the tax impact of realized gains (losses), the effective income tax rate would have been 28.8% and 27.8% for the years endedDecember 31, 2010 and 2009, respectively. The current year rate increase reflects a$477,000 adjustment to our current tax expense relating to a return to provision analysis completed on the closing tax return ofProCentury . Excluding this adjustment, the effective tax rate on net operating income, a non-GAAP measure, for the year endedDecember 31, 2010 would have been 28.2% compared to 27.8% for the same period in 2009. The increase in our effective tax rate is primarily due to a shift in new purchases in our investment portfolio away from tax exempt municipal bonds. Tax exempt income as a percentage of total taxable income has therefore declined, resulting in an increased effective tax rate.
Other Items - Results of Operations
Equity earnings of affiliated, net of tax
InJuly 2009 , our subsidiary, Star, purchased a 28.5% ownership interest in an affiliate, MFH, for$14.8 million in cash. We are not required to consolidate this investment as we are not the primary beneficiary of the business nor do we control the entity's operations. Our ownership interest is significant, but is less than a majority ownership and, therefore, we are accounting for this investment under the equity method of accounting. Star will recognize 28.5% of the profits and losses as a result of this equity interest ownership. We recognized equity earnings, net of tax, from MFH of$2.4 million , or$0.5 per dilutive share, for the year endedDecember 31, 2011 , compared to$2.3 million , or$0.04 per dilutive share, for the comparable period of 2010, and$0.9 million , or$0.02 per dilutive share, for the comparable period of 2009. We received dividends from MFH in 2011, 2010 and 2009, for$3.4 million ,$1.0 million and$0.4 million , respectively. 40 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued Reserves AtDecember 31, 2011 , our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was$879.1 million . We established a reasonable range of reserves of approximately$787.5 million to $974.2 million . This range was established primarily by considering the various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business (in thousands): Minimum Maximum Reserve Reserve Selected Line of Business Range Range Reserves Workers' Compensation $ 335,369 $ 383,305 $ 358,131 Residual Markets 16,443 18,211 17,682
Commercial Multiple Peril / General Liability 294,223 413,784
353,311 Commercial Automobile 111,096 124,808 117,594 Other 30,351 34,094 32,375 Total Net Reserves $ 787,482 $ 974,202 $ 879,093 Reserves are reviewed and established by our internal actuaries for adequacy and peer reviewed by our third-party actuaries. When reviewing reserves, we analyze historical data and estimate the impact of numerous factors such as (1) per claim information; (2) industry and our historical loss experience; (3) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (4) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple factors. The key assumptions used in our selection of ultimate reserves included the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the twelve months endedDecember 31, 2011 , and the year endedDecember 31, 2010 . For the twelve months endedDecember 31, 2011 , we reported an increase in net ultimate loss estimates for accident years 2010 and prior of$7.3 million , or 0.9% of$784.2 million of beginning net loss and LAE reserves atDecember 31, 2010 . The change in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2011 that differed from the projected activity. There were no significant changes in the key assumptions utilized in the analysis and calculations of our reserves during 2010 and for the twelve months endedDecember 31, 2011 . The major components of this change in ultimates are as follows (in thousands): 41 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued Incurred Losses Paid Losses Reserves at Reserves at December 31, Current Prior
Total Current Prior Total December 31, Line of Business 2010 Year Years Incurred Year Years Paid 2011 Workers' Compensation $ 285,069 $ 209,144 $ 9,229 $ 218,373 $ 40,637 $ 104,674 $ 145,311 $ 358,131 Residual Markets 18,963 3,257 (1,414 ) 1,843 1,008 2,116 3,124 17,682 Commercial Multiple Peril / General Liability 330,850 121,069 (5,077 ) 115,992 11,020 82,511 93,531 353,311 Commercial Automobile 112,388 85,566 5,344 90,910 32,321 53,383 85,704 117,594 Other 36,932 69,004 (771 ) 68,233 45,561 27,229 72,790 32,375 Net Reserves 784,202 $ 488,040 $ 7,311 $ 495,351 $ 130,547 $ 269,913 $ 400,460 879,093 Reinsurance Recoverable 280,854 315,884 Consolidated $ 1,065,056 $ 1,194,977 Total Development Re-estimated as a Reserves at Percentage of Reserves at December 31, 2011 Prior Year Line of Business December 31, 2010 on Prior Years Reserves Workers' Compensation $ 285,069 $ 294,298 3.2 % Commercial Multiple Peril / General Liability 330,850 325,773 -1.5 % Commercial Automobile 112,388 117,732 4.8 % Other 36,932 36,161 -2.1 % Sub-total 765,239 773,964 1.1 % Residual Markets 18,963 17,549 -7.5 % Total Net Reserves $ 784,202 $ 791,513 0.9 %
Workers' Compensation Excluding Residual Markets
The projected net ultimate loss estimate for the workers' compensation line of business excluding residual markets increased$9.2 million , or 3.2% of net workers' compensation reserves. This net overall increase reflects increases of$8.7 million ,$3.8 million , and$1.1 million for accident years 2010, 2009, and 2003, respectively. This increase in the net ultimate loss estimate for these accident years was due to greater than expected claim emergence. The 2009 and 2010 accident years' emergence was from two countrywide programs, aNew England program, threeCalifornia programs, and aNevada program. Accident year 2003 emergence came from a single claim reserve increase. These increases were partially offset by decreases of$1.0 million ,$2.0 million ,$533,000 and$763,000 for accident years 2008, 2007, 2006, and 2005 respectively. The decrease in the net ultimate loss estimates for these accident years was due to less than expected claim emergence in two countrywide programs and aFlorida program. The change in ultimate loss estimates for all other accident years was insignificant.
Commercial Multiple Peril / General Liability
The commercial multiple peril line and general liability line of business had a decrease in net ultimate loss estimates of$5.1 million , or 1.5% of net commercial multiple peril and general liability reserves. The net decrease reflects decreases of$7.0 million ,$3.1 million ,$681,000 ,$2.1 million ,$665,000 , and$873,000 in the ultimate loss estimates for accident years 2010, 2009, 2008, 2007, 2002, and 1996 respectively. The decreases in the net ultimate loss estimates for these accident years were due to better than expected claim emergence in several general liability programs and an excess liability program. The decreases were offset by increases of$841,000 ,$4.2 million ,$2.4 million ,$686,000 ,$522,000 and$852,000 for accident years 2006, 2005, 2004, 2003, 2000, and 1997, respectively. These increases in the net ultimate loss estimates for these accident years was due to greater than expected claim emergence in an excess liability program and a contractors program. The change in ultimate loss estimates for all other accident years was insignificant. 42 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Commercial Automobile
The projected net ultimate loss estimate for the commercial automobile line of business increased$5.3 million , or 4.8% of net commercial automobile reserves. This net overall increase reflects increases in the net ultimate loss estimate of$2.7 million ,$2.4 million and$646,000 for accident years 2010, 2009, and 2007, respectively. This increase in the net ultimate loss estimates for this accident year was due to greater than expected claim emergence in a garage program, aCalifornia program, an excess program, and a transportation program. This increase was partially offset by a decrease of$630,000 for accident year 2005. The decrease in the net ultimate loss estimates for this accident year was due to less than expected claim emergence spread across several programs. The change in ultimate loss estimates for all other accident years was insignificant. Other The projected net ultimate loss estimate for the other lines of business decreased$771,000 , or 2.1% of net reserves. This net decrease reflects decreases of$450,000 ,$445,000 , and$459,000 in accident years 2009, 2008, and 2006, respectively. This decrease is primarily due to better than expected case reserve development during the calendar year in two professional liability programs and a general liability program. The change in ultimate loss estimates for all other accident years was insignificant.
Residual Markets
The workers' compensation residual market line of business had a decrease in net ultimate loss estimate of$1.4 million , or 7.5% of net reserves. This decrease reflects a reduction of$1.3 million in accident year 2009. We record loss reserves as reported by theNational Council on Compensation Insurance ("NCCI"), plus a provision for the reserves incurred but not yet analyzed and reported to us due to a two quarter lag in reporting. These changes reflect a difference between our estimate of the lag incurred but not reported and the amounts reported by theNCCI in the year. The change in ultimate loss estimates for all other accident years was insignificant.
Other-Than-Temporary Impairments (OTTI)
Refer to Note 2 ~ Investments of the Notes to the Consolidated Financial Statements, for additional information specific to OTTI and their fair value and amount of unrealized losses segregated by the time period the investment has been in an unrealized loss position.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of funds are insurance premiums, investment income, proceeds from the maturity and sale of invested assets from our Insurance Company Subsidiaries, and risk management fees and agency commissions from our non-regulated subsidiaries. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, other operating expenses, shareholder dividends, share repurchases, capital expenditures, and debt service. A significant portion of our consolidated assets represents assets of our Insurance Company Subsidiaries that may not be transferable to the holding company in the form of dividends, loans or advances in accordance with state insurance laws. These laws generally specify that dividends can be paid only from unassigned surplus and only to the extent that all dividends in the current twelve months do not exceed the greater of 10% of total statutory surplus as of the end of the prior fiscal year or 100% of the statutory net income for the prior year, less any dividends paid in the prior twelve months. Using these criteria, the available ordinary dividend available to be paid from the Insurance Company Subsidiaries during 2011 is$43.8 million without prior regulatory approval. Of this$43.8 million , ordinary dividends of$22.6 million have been declared and paid as ofDecember 31, 2011 . In addition to ordinary dividends, the Insurance Company Subsidiaries have the capacity to pay$111.9 million of extraordinary dividends in 2011, subject to prior regulatory approval. The Insurance Company Subsidiaries' ability to pay future dividends without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon the Insurance Company Subsidiaries generating net income. Total ordinary dividends paid from our Insurance Company Subsidiaries to our holding company were$22.6 million and$42.0 million as ofDecember 31, 2011 and 2010, respectively. We remain well within our targets as they relate to our premium leverage ratios, even taking into consideration the dividends paid by our Insurance Company Subsidiaries. Our targeted maximum leverage ratios for gross and net written premium to statutory surplus are 2.75 to 1.0 and 2.25 to 1.0, respectively. As ofDecember 31, 2011 , on a trailing twelve month statutory consolidated basis, the gross and net premium leverage ratios were 2.3 to 1.0 and 2.0 to 1.0, respectively. 43 --------------------------------------------------------------------------------
MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued We also generate operating cash flow from non-regulated subsidiaries in the form of commission revenue, outside management fees, and intercompany management fees. These sources of income are used to meet debt service, shareholders' dividends, and other operating expenses of the holding company and non-regulated subsidiaries. Earnings before interest, taxes, depreciation, and amortization from non-regulated subsidiaries were approximately$12.1 million for the year endedDecember 31, 2011 . We have a total revolving credit facility of$35.0 million , which may include up to$15.0 million in letters of credit. As ofDecember 31, 2011 , we had$4.5 million outstanding balance on our revolving credit facility and$0.5 million in letters of credit issued. The undrawn portion of the revolving credit facility is available to finance working capital and for general corporate purposes, including but not limited to, surplus contributions to ourInsurance Company Subsidiaries to support premium growth or strategic acquisitions. Cash flows provided by operations were$138.1 million and$174.5 million for the years endedDecember 31, 2011 and 2010, respectively. The decrease in cash flows from operations is driven primarily by a decrease in cash provided by underwriting activities due to the lag on losses paid relating to the growth in premiums from 2009 to 2010. The reduction in cash provided from underwriting was offset by increases in cash provided from net investment income, net commissions and fees, and the timing of taxes paid. We maintain a strong balance sheet with geographic spread of risks, high quality reinsurance, and a high quality investment portfolio.
Other Items - Liquidity and Capital Resources
Interest Rate Swaps
We have entered into interest rate swap transactions to mitigate our interest rate risk on our 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.
Refer to Note 7 ~ Derivative Instruments for additional information specific to our interest rate swaps.
Credit Facilities
Refer to Note 6 ~ Debt for additional information specific to our credit facilities and debentures.
Investment Portfolio
As of
In general, we believe our overall investment portfolio is conservatively invested. The effective duration of the investment portfolio atDecember 31, 2011 and 2010, was 4.9 years and 5.0 years, respectively. Our current pre-tax book yield is 4.0% compared to 4.2% in 2010. The current after-tax yield is 3.0%, compared to 3.1% in 2010. Approximately 98.9% of our fixed income investment portfolio is investment grade.
Shareholders' Equity
Refer to Note 12 ~ Shareholders' Equity of the Notes to the Consolidated Financial Statements.
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Contractual Obligations and Commitments
The following table is a summary of our contractual obligations and commitments as of
Payments due by period Less than One to three Three to five More than Total one year years years five years Non-regulated companies: Term Loan $ 23,875 $ 15,625 $ 8,250 $ - $ - Lines of Credit (1) 4,500 4,500 - - - Debentures (2): Senior debentures due 2034; issued $13.0 million 13,000 - - - 13,000 Senior debentures due 2034; issued $12.0 million 12,000 - - - 12,000 Junior subordinated debentures due 2035; issued $20.6 million 20,620 - - - 20,620 Junior subordinated debentures due 2033; issued $10.3 million 10,310 - - - 10,310 Junior subordinated debentures due 2032; issued$15.0 million (3) 15,000 - - - 15,000 Junior subordinated debentures due 2033; issued$10.0 million (3) 10,000 - - - 10,000 Total Debt 109,305 20,125 8,250 - 80,930 Interest on Term Loan (4) 1,307 1,102 205 - - Interest on Line of Credit 130 130 - - - Interest on Debentures: Senior debentures due 2034; issued $13.0 million 7,224 1,032 2,064 2,064 2,064 Senior debentures due 2034; issued $12.0 million 5,358 765 1,531 1,531 1,531 Junior subordinated debentures due 2035; issued $20.6 million 8,817 1,260 2,519 2,519 2,519 Junior subordinated debentures due 2033; issued $10.3 million 5,709 816 1,631 1,631 1,631 Junior subordinated debentures due 2032; issued$15.0 million (3) 8,180 1,169 2,337 2,337 2,337 Junior subordinated debentures due 2033; issued$10.3 million (3) 5,516 788 1,576 1,576 1,576 Total Interest Payable 42,241 7,062 11,863 11,658 11,658 Operating lease obligations (5) 10,542 3,889 4,547 1,474 632 Regulated companies: Losses and loss adjustment expenses (6) 1,194,977 295,273 374,265 173,090 352,349 Total $ 1,357,065 $ 326,349 $ 398,925 $ 186,222 $ 445,569
(1) Relates to our revolving line of credit.
(2) Five year call feature associated with debentures, estimated seven year repayment. For a description of our debentures and related interest rate terms, as well as actual rates in accordance with our interest rate swap transactions, refer to Note 6 ~ Debt and Note 7 ~ Derivative Instruments.
(3) Relates to the junior subordinated debentures acquired in conjunction with the
(4) For a description of our term loan and its interest rate terms, as well as actual rates in accordance with our interest rate swap transaction, refer to Note 6 ~ Debt and Note 7 ~ Derivative Instruments.
(5) Consists of rental obligations under real estate leases related to branch offices. In addition, includes amounts related to equipment leases.
(6) The loss and loss adjustment expense payments do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of our gross losses and loss adjustment expenses. In addition, we have anticipated cash receipts on reinsurance recoverables on unpaid losses and loss adjustment expenses of$315.9 million , of which we estimate that these payments to be paid for losses and loss adjustment expenses for the periods less than one year, one to three years, three to five years, and more than five years, to be$58.6 million ,$91.7 million ,$43.9 million , and$121.6 million , respectively, resulting in net losses and loss adjustment expenses of$236.7 million ,$282.6 million ,$129.2 million , and$230.7 million , respectively.
We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued
Variable Compensation
Our variable compensation plans have been established as an incentive for performance of our management team, consist of an Annual Bonus Plan ("Bonus Plan") and a Long-Term Incentive Plan ("LTIP"). The Bonus Plan is a discretionary cash bonus plan premised upon a targeted growth in net after-tax earnings on a year over year basis. Each year, the Compensation Committee and our Board of Directors establish a new target based upon prior year performance and the forecasted performance levels anticipated for the following year. The amount of the bonus pool is established by aggregating the individual targets for each participant, which is a percentage of salary. An employee's actual bonus may be plus or minus his or her target based upon the Company and individual's performance At the end of the year, the Compensation Committee and the Board of Directors review our performance in relation to performance targets and then establish the total bonus pool to be utilized to pay cash bonuses to the management team based upon overall corporate and individual participant goals. The LTIP is intended to provide an incentive to management to improve our performance over a three year period, thereby increasing shareholder value. The LTIP is not discretionary and is based upon a target for an average three year return on beginning equity. If the targets are met and all other terms and conditions are satisfied, the LTIP awards are paid. The LTIP is paid 50% in cash and 50% in stock. A participant's percentage is established by the Compensation Committee and the Board of Directors in advance of any new three year LTIP award. The stock component of the LTIP is paid based upon the closing stock price at the beginning of the three year LTIP performance period, in accordance with the terms and conditions of the LTIP. Our Compensation Committee also is authorized to issue restricted stock awards when the Company achieves various financial, operational and strategic goals and objectives. With theProCentury merger our Compensation Committee and Board of Directors determined that our opportunity for successfully integrating theProCentury merger would be heightened and shareholder value increased, if all participants were in the same equity-based plan beginning in 2009. As a result, our Compensation Committee approved the termination of our current 2007-2009 LTIP effectiveDecember 31, 2008 and established a new plan for 2009-2011 based on new performance targets. Based on this amendment, the LTIP participants would receive their award based on a two-year performance period, rather than a three-year period. Therefore, the total award would be approximately two-thirds of the original three-year award. There were no accounting adjustments as a result of the amendment as there were no changes to the underlying plan, only an adjustment to the performance period. All of our plans are administered by the Compensation Committee of the Board of Directors and all awards are reviewed and approved by the Board of Directors at both inception and at distribution.
Refer to Note 11 ~ Variable Compensation for additional information relating to our variable compensation.
Regulatory and Rating Issues TheNational Association of Insurance Commissioners ("NAIC") has adopted a risk-based capital ("RBC") formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company's products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general, an insurance company must submit a calculation of its RBC formula to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company's RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidation proceeding.
At
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued Insurance operations are subject to various leverage tests (e.g., premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. Our targeted maximum leverage ratios for gross and net written premium to statutory surplus are 2.75 to 1.0 and 2.25 to 1.0, respectively. As ofDecember 31, 2011 , on a statutory consolidated basis, the gross and net premium leverage ratios were 2.3 to 1.0 and 2.0 to 1.0, respectively. The NAIC's Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies "usual values" for each ratio. Departure from the "usual values" on four or more ratios, at an individual company, generally leads to inquiries or possible further review from individual state insurance commissioners.
In 2011, our Insurance Company Subsidiaries generated ratios that varied from the "usual value" range. The variations and reasons are set forth below:
Ratio Usual Range Value Company: Star Adjusted Liabilities to Liquid Assets Under 100% 125%(1)
Gross Agents' Balances to Policyholders' Surplus Under 40% 47%(2)
Company: Savers Gross Agents' Balances to Policyholders' Surplus Under 40% 41%(2) Company:Williamsburg Adjusted Liabilities to Liquid Assets Under 100% 105%(1)
Gross Agents' Balances to Policyholders' Surplus Under 40% 55%(2)
(1) Adjusted Liabilities to Liquid Assets on Star and
the usual range primarily as a result of our Intercompany Reinsurance Pooling Agreement. The Adjusted Liabilities include the gross amount of reinsurance payables related to the pool and does not allow an offset to those payables for any reinsurance recoverables related to the pool. In
addition, the reinsurance recoverables are not included in the Liquid Assets
portion of the formula. This causes the ratio results to appear much higher
due to the timing of the settlement of the pool balances. Pool balances
between the entities are settled in the month following the completion of
the pooling. Once the balances are settled, the ratio will be 99% and 87% respectively, which is within the usual range.
(2) The Gross Agents' Balances to Policyholders' Surplus on Star, Savers and
Agreement. The assumed premium receivable increased as a result of growth in
business, thereby increasing the gross agents' balances related to the
pooling agreement. Excluding the intercompany pooling, this ratio would have
been within the usual range for 2011 for all companies.
Reinsurance Considerations
We seek to manage the risk exposure of our Insurance Company Subsidiaries and our clients through the purchase of excess-of-loss and quota share reinsurance. Our reinsurance requirements are analyzed on both a specific program and line of business basis to determine the appropriate retention levels and reinsurance coverage limits. We secure this reinsurance based on the availability, cost, and benefits of various reinsurance alternatives. Reinsurance does not legally discharge an insurer from its primary liability for the full amount of risks assumed under insurance policies it issues, but it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, we are subject to credit risk with respect to the obligations of our reinsurers. In regard to our excess-of-loss reinsurance, we manage our credit risk on reinsurance recoverables by reviewing the financial stability,A.M. Best rating, capitalization, and credit worthiness of prospective or existing reinsurers. We generally do not seek collateral where the reinsurer is rated "A-" or better by A. M. Best, has$500 million or more in surplus, and is admitted in the state ofMichigan . The following table sets forth information relating to our five largest unaffiliated excess-of-loss reinsurers based upon ceded premium as ofDecember 31, 2011 : 47
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MEADOWBROOK INSURANCE GROUP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS - continued Reinsurance Premium Ceded Reinsurance Recoverable A.M. Best Reinsurer December 31, 2011 December 31, 2011 Rating (In thousands) (In thousands) Hannover Rueckversicherung AG $ 11,912 $ 20,639 A Lloyds Syndicate Number 2003 9,500 23,724 A Maiden Reinsurance Company 9,069 27,492 A - Swiss Reinsurance America Corporation 8,952 22,035 A + Munich Reinsurance America 6,300 20,661 A + In regard to our risk-sharing partners (client captive or rent-a-captive quota-share non-admitted reinsurers), we manage credit risk on reinsurance recoverables by reviewing the financial stability, capitalization, and credit worthiness of prospective or existing reinsures or partners. We customarily collateralize reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks. To date, we have not, in the aggregate, experienced material difficulties in collecting reinsurance recoverables.
Off-Balance Sheet Arrangements
As of
Convertible Note
Refer to Note 7 ~ Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements.
Related Party Transactions
Refer to Note 17 ~ Related Party Transaction of the Notes to the Consolidated Financial Statements.
Recent Accounting Standards
Refer to Note 1 ~ Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements.
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