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MEADOWBROOK INSURANCE GROUP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) For the Periods ended September 30, 2014 and 2013 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; a failure of additional capital to be available or only available on unfavorable terms; our geographic concentration and the business and economic conditions, 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; 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, the lowering of the outlook of this ratings from "stable" to "negative", A.M. Best's downgrade of our issuer credit rating and any other future action by A.M. Best with respect to such ratings; increased risks or reduction in the level of our underwriting commitments due to market conditions; a failure of our reinsurers to pay losses in a timely fashion, or at all; interest rate changes; continued difficult conditions in the global capital markets and the economy generally; market and credit risks affecting our investment portfolio; liquidity requirements forcing us to sell our investments; a failure to introduce new products or services to keep pace with advances in technology; the new federal financial regulatory reform; our holding company structure and regulatory constraints restricting dividends or other distributions by our Insurance Company Subsidiaries; minimum capital and surplus requirements imposed on our Insurance Company Subsidiaries; acquisitions and integration of acquired businesses resulting in operating difficulties, which may prevent us from achieving the expected benefits; our reliance upon producers, which subjects us to their credit risk; loss of one of our core selected producers; our dependence on the continued services and performance of our senior management and other key personnel; our reliance on our information technology and telecommunications systems; managing technology initiatives and obtaining the efficiencies anticipated with technology implementation; a failure in our internal controls; the cyclical nature of the property and casualty insurance industry; severe weather conditions and other catastrophes; the effects of litigation, including the previously disclosed arbitration and class action litigation or any similar litigation which may be filed in the future; state regulation; and assessments imposed upon our Insurance Company Subsidiaries to provide funds for failing insurance companies. 32 -------------------------------------------------------------------------------- Table of Contents For additional information with respect to certain of these and other factors, refer to the Item 1A of Part I to our Annual Report on Form 10-K for the year ended December 31, 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, which also owns and operates insurance agencies and an insurance administration services company. We recognize revenue related to the services and coverages within the following categories: net earned premiums, management administrative fees, claims fees, commission revenue, net investment income, and net realized gains (losses). 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 homogeneous risks that have similar characteristics 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 agency operations, we also generate commission revenue, which represents 2.5% of our total consolidated revenues. Our agencies are located in Michigan, California, Massachusetts, and Florida and produce commercial, personal lines, life and accident and health insurance which are placed primarily with unaffiliated insurance carriers. Although our agencies are a minimal source of business for our Insurance Company Subsidiaries, the agency operations remain a core strategy enabling us to balance our sources of revenue and better understand the needs of independent agents within our own insurance carrier operations. 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 insurance brokers. 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. 33 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies 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 periodically on an on-going basis based on a variety of factors. There can be no assurance, however, that 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. The accounting estimates and related risks described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, as filed with the United States Securities and Exchange Commission on March 5, 2014, are those that we consider to be our critical accounting estimates. For the three and nine months ended September 30, 2014, there have been no material changes in regard to any of our critical accounting estimates. Non-GAAP Financial Measures Statutory Surplus Statutory surplus is a non-GAAP measure with the most directly comparable financial GAAP measure being shareholders' equity. The following is a reconciliation of statutory surplus to shareholders' equity: Meadowbrook Insurance Group, Inc. Consolidated Statutory Surplus to GAAP Shareholders' Equity For Period Ending: September 30, 2014 (in thousands) Statutory Consolidated Surplus $ 494,758 Statutory to GAAP differences: Deferred policy acquisition costs 65,128 Other 5,535 Total Statutory to GAAP differences 70,663 Total Non-Regulated Entities (1) (117,317 ) GAAP Consolidated Shareholders' Equity $ 448,104 (1) Total includes $80,930 of debentures and $152,373 of debt 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, respectively. Net operating income and net operating income per share are intended as supplemental information and are not meant to replace net income or 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 (loss) to net income (loss), as well as net operating income (loss) per share to net income (loss) per share: 34-------------------------------------------------------------------------------- Table of Contents For the Three Months Ended September 30, For the Nine Months Ended September 30, 2014 2013 2014 2013 (In thousands,except share and per share data) (In thousands, except share and per share data) Net operating income (loss) $ 3,034 $ 5,077 $ 15,073 $ (103,136 ) Net realized gains, net of tax 1,933 439 6,014 2,676 Net income (loss) $ 4,967 $ 5,516 $ 21,087 $ (100,460 ) Diluted earnings (losses) per common share: Net operating income (loss) $ 0.06 $ 0.10 $ 0.30 $ (2.07 ) Net income (loss) $ 0.09 $ 0.11 $ 0.42 $ (2.01 ) Diluted weighted average common shares outstanding 50,092,755 49,933,540 50,054,031 49,866,326 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 loss or profitability of our business. 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. Combined Ratio The combined loss and expense ratio (or combined ratio), expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty insurance business. The combined ratio is a statutory (non-GAAP) accounting measurement, which represents the sum of (i) the ratio of losses and loss expenses to premiums earned (loss ratio), plus (ii) the ratio of underwriting expenses to premiums written (expense ratio). The combined ratios above have been modified to reflect GAAP accounting, as we evaluate the performance of our underwriting operations using the GAAP combined ratio. Specifically, the GAAP combined ratio is the sum of the loss ratio, plus the ratio of GAAP underwriting expenses (which include the change in deferred policy acquisition costs) to premiums earned (expense ratio). When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable. 35 -------------------------------------------------------------------------------- Table of Contents The accident year combined ratio is a non-GAAP measure that excludes changes in net ultimate loss estimates from prior accident year loss reserves. The accident year combined ratio provides us with an assessment of the specific policy year's profitability (which matches policy pricing with related losses) and assists us in our evaluation of product pricing levels and quality of business written. We use accident year combined ratio as one component to assess the Company's current year performance and as a measure to evaluate, and if necessary, adjust current year pricing and underwriting. The following is a reconciliation of the accident year combined ratio to the GAAP combined ratio: For the Three Months For the Nine Months Ended September 30, Ended September 30, 2014 2013 2014 2013 Accident year combined ratio 103.7 % 99.2 % 102.3 % 99.7 % Increase (decrease) in net ultimate loss estimates on prior year loss reserves (0.2 %) 3.8 % (0.2 %) 7.0 % GAAP combined ratio 103.5 % 103.0 % 102.1 % 106.7 % We believe the accident year combined ratio 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 combined ratio and GAAP combined ratio separately when reviewing and evaluating our performance. RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013 Executive Overview The Company reported net income of $5.0 million, or $0.09 per diluted share, for the third quarter of 2014 compared to net income of $5.5 million, or $0.11 per diluted share, for the same period of 2013. Net operating income, a non-GAAP measure the Company defines as net income excluding after-tax realized gains and losses, was $3.0 million or $0.06 per diluted share, for the third quarter 2014 compared to net operating income of $5.1 million, or $0.10 per diluted share, for the third quarter 2013. Our GAAP combined ratio increased by 0.5 percentage points to 103.5% in the third quarter 2014 from 103.0% for the comparable quarter in 2013. Current year losses and LAE have improved, however, the cost of using an unaffiliated "A" rated insurance company for policy issuance and the deleveraging impact of the anticipated reduction in earned premium associated with the Company's efforts to terminate unprofitable business have caused a slight increase in the combined ratio compared to the prior year. The third quarter 2014 results include pre-tax favorable prior year loss reserve development of $0.2 million, or 0.2 percentage points of the loss and LAE ratio. The third quarter 2013 results included pre-tax unfavorable prior year loss reserve development of $6.9 million, or 3.8 percentage points of the loss and LAE ratio. Our accident year loss and LAE ratio, a non-GAAP measure that excludes changes in net ultimate loss estimates from prior year loss reserves, was 66.1% for the third quarter of 2014 compared to 69.2% for the comparable quarter in 2013, an improvement of 3.1 percentage points. 36 -------------------------------------------------------------------------------- Table of Contents Excluding the impact of the previously terminated multi-line quota share reinsurance treaty with Swiss Re America Corporation ("Swiss Re Treaty"), the accident year loss and LAE ratio was 66.1% for the three months ended September 30, 2014 and 64.8% for the three months ended September 30, 2013. On a quarter-to-date basis, the accident year loss and LAE ratio can fluctuate from quarter to quarter as the ratio is evaluated on an accident year inception to date basis and adjusted quarterly. In third quarter of 2013, the accident year loss and LAE ratio on a quarter-to-date basis was 64.8% and on a year-to-date basis was 65.7%. As of December 31, 2013, the 2013 accident year loss and LAE ratio on a year-to-date basis was 66.5%.The year-to-date 2014 accident year loss and LAE ratio of 65.0% shows an improvement over such 66.5%. Gross written premium decreased $59.0 million, or 23.0%, to $198.0 million for the three months ended September 30, 2014, compared to $257.0 million in the same period in 2013. The decline in premium, as expected, is attributable to the termination of, or the reduction of premium in certain programs for which pricing and/or underwriting risk did not meet the Company's targets. This decline was offset by an overall 6.8% written rate increase. Results of Operations Net income for the three months ended September 30, 2014, was $5.0 million, or $0.09 per dilutive share, compared to net income of $5.5 million, or $0.11 per dilutive share, for the comparable period of 2013. Net operating income, a non-GAAP measure, was $3.0 million or $0.06 per diluted share, for the third quarter 2014 compared to net operating income of $5.1 million, or $0.10 per diluted share, for the third quarter 2013. Total diluted weighted average shares outstanding for the three months ended September 30, 2014 was 50,092,755 compared to 49,933,540 for the comparable period in 2013. This increase reflects the impact of shares issued under our Long Term Incentive Plan and the annual non-restricted stock awards issued to the members of the Board of Directors. Refer to Note 6 - Restricted and Non-Restricted Stock Awards of the Notes to the Consolidated Financial Statements, for additional information specific to the impact of our Long Term Incentive Plan. Revenues Revenues for the three months ended September 30, 2014 decreased $16.1 million, or 7.9%, to $187.8 million, from $203.9 million for the comparable period in 2013. This decrease primarily reflects the planned reduction within our net earned premiums, partially offset by an increase in net commissions and fees and net realized gains. 37 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the components of revenues (in thousands): For the Three Months Ended September 30, 2014 2013 Revenue: Net earned premiums $ 161,749 $ 181,056 Management administrative fees 6,054 5,270 Claims fees 1,721 1,736 Commission revenue 4,185 3,452 Net investment income 11,087 11,695 Net realized gains 2,973 675 Total revenue $ 187,769 $ 203,884 Net earned premiums decreased $19.3 million, or 10.7%, to $161.7 million for the three months ended September 30, 2014, from $181.1 million in the comparable period in 2013. This expected decrease was primarily the result of the termination of, or reduction in certain programs in which pricing and underwriting did not meet our underwriting standards and was offset by an overall 9.7% earned rate increase, which exceeded our estimated loss trend of 1.8%, and the decrease in the ceded earned premiums related to the previously terminated Swiss Re Treaty. Net commission and fee revenue increased $1.5 million, or 14.4%, to $12.0 million for the three months ended September 30, 2014, from $10.5 million for the comparable period in 2013. This increase was the net result of increased agency commission revenue attributable to a recently acquired agency and a decrease in managed fee revenues from the Massachusetts and Minnesota self-insured groups' business which was driven by competitive market conditions. Net realized gains increased $2.3 million, to $3.0 million for the three months ended September 30, 2014, from $0.7 million for the comparable period in 2013. The increase was primarily due to the rebalancing of the high dividend equity program, which contributed $2.3 million in the third quarter 2014 compared to $0.7 million in the third quarter 2013. Expenses Expenses decreased $15.8 million from $199.1 million for the three months ended September 30, 2013 to $183.3 million for the three months ended September 30, 2014. The decrease primarily is attributed to higher losses incurred during the third quarter of 2013. 38 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the components of expenses (in thousands): For the Three Months Ended September 30, 2014 2013 Expense: Net losses and loss adjustment expenses $ 106,658 $ 132,247 Policy acquisition and other underwriting expenses 60,816 54,228 General selling & administrative expenses 9,949 7,026 General corporate expenses 1,372 1,025 Amortization expense 1,011 1,037 Interest expense 3,506 3,581 Total expenses $ 183,312 $ 199,144 Net loss and loss adjustment expenses ("LAE") decreased $25.6 million, to $106.7 million for the three months ended September 30, 2014, from $132.2 million for the same period in 2013. Our loss and LAE ratio was 65.9% for the three months ended September 30, 2014 and 73.0% for the three months ended September 30, 2013; an improvement of 7.1 percentage points. The loss and LAE ratio for the third quarter of 2014 includes pre-tax favorable prior year loss reserve development of $0.2 million, or 0.2 percentage points of the loss and LAE ratio. The third quarter 2013 results included pre-tax unfavorable prior year loss reserve development of $6.9 million, or 3.8 percentage points of the loss and LAE ratio. The accident year loss and LAE ratio was 66.1% for the three months ended September 30, 2014 down from 69.2% in the comparable period in 2013; an improvement of 3.1 percentage points. Additional discussion of our quarterly reserve activity is described below within the Other Items ~ Reserves section. Policy acquisition and other underwriting expenses increased $6.6 million, to $60.8 million for the three months ended September 30, 2014 from $54.2 million for the same period in 2013. Our expense ratio increased 7.6% to 37.6% for the third quarter 2014 from 30.0% for the third quarter 2013. Excluding the quota share agreement, the expense ratio was 37.6% in 2014 and 33.4% in 2013. The third quarter 2013 results include a $1.1 million expense, or 0.6 percentage points, due to a reallocation of corporate overhead costs from our fee-for-service operations to insurance company operations. The reallocation reflected a shift of corporate resources used to support capital and operating enhancements. There was a corresponding decrease to general, selling & administrative expenses in the third quarter of 2013 and, therefore, the reallocation had no impact on net income. The increase in the 2014 expense ratio reflects the cost associated with the use of an unaffiliated "A" rated insurance company for policy issuance, which added 1.9 percentage points; a shift in the mix of business toward business that has a higher average commission rate; a reduction in ceding commissions related to a planned reduction in a program; an increase in reinsurance costs relating to a reinstatement premium on an isolated program; and the deleveraging impact of the anticipated reduction in earned premium associated with the Company's efforts to terminate unprofitable business. General, selling and administrative expenses increased $2.9 million, to $9.9 million for the three months ended September 30, 2014, from $7.0 million for the same period in 2013. As discussed above, the third quarter 2013 results include a $1.1 million reduction in expense due to a reallocation of corporate overhead costs from our fee-for-service operations to insurance company operations. The general, selling and administrative expenses, as a percent of net commission and fee revenue, are comparable for the three months ended September 30, 2014 and 2013 after the 2013 expenses are adjusted upwards for the $1.l million reallocation adjustment. 39 -------------------------------------------------------------------------------- Table of Contents Federal income tax expense for the three months ended September 30, 2014 was $0.4 million, or 9.2% of income before taxes, compared to a tax expense of $0.3 million or 6.9% of income before taxes for the same period in 2013. These rates include adjustments to an annual operating effective tax rate. The higher rate in 2014 reflects a higher proportion of taxable income derived from capital gains compared to 2013. Income tax expense on capital gains and the change in our valuation allowance on deferred tax assets was $1.0 million and $0.2 million for the periods ended September 30, 2014 and 2013, respectively. RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER, 2014 AND 2013 Executive Overview The Company reported net income of $21.1 million, or $0.42 per diluted share, for the nine months ended September 30, 2014 compared to net loss of $100.5 million, or $2.01 per diluted share, for the same period of 2013. Net operating income, a non-GAAP measure the Company defines as net income excluding after-tax realized gains and losses, was $15.1 million or $0.30 per diluted share, for the nine months ended September 30, 2014 compared to net operating loss of $103.1 million, or $2.07 per diluted share, for nine months ended September 30, 2013. The 2013 results included a $101.6 million, or $2.04 per share, non-cash charge for goodwill impairment. Our GAAP combined ratio improved by 4.6 percentage points to 102.1% for the nine months ended September 30, 2014 from 106.7% for the comparable period in 2013. This improvement reflects the continued stabilization of reserves, improved current accident year loss experience and earned rate increases in excess of loss ratio trends. These improvements were partially offset by the costs of using an unaffiliated "A" rated insurance company for policy issuance, the deleveraging impact of the anticipated reduction in earned premium associated with the Company's efforts to terminate unprofitable business and a shift in the mix of business. The results for the nine months ended September 30, 2014 include pre-tax favorable prior year loss reserve development of $1.0 million, or 0.2 percentage points of the loss and LAE ratio. The results for the nine months ended September 30, 2013 included pre-tax unfavorable prior year loss reserve development of $37.0 million, or 7.0 percentage points of the loss and LAE ratio. Our accident year loss and LAE ratio, a non-GAAP measure that excludes changes in net ultimate loss estimates from prior year loss reserves, was 65.6% for the nine months ended September 30, 2014 compared to 68.7% for the comparable period in 2013, an improvement of 3.1 percentage points. 40 -------------------------------------------------------------------------------- Table of Contents Excluding the impact of the Swiss Re Treaty, the accident year loss and LAE ratio was 65.0% for the nine months ended September 30, 2014 and 65.7% for the nine months ended September 30, 2013. Gross written premium decreased $180.3 million, or 23.8%, to $578.5 million for the nine months ended September 30, 2014, compared to $758.8 million in the same period in 2013. This decrease is attributable to the termination of, or the reduction of premium in certain programs for which pricing and/or underwriting risk did not meet the Company's targets and was offset by an overall year to date 6.8% written rate increase. Results of Operations Net income for the nine months ended September 30, 2014, was $21.1 million, or $0.42 per dilutive share, compared to a net loss of $100.5 million, or $2.01 per dilutive share, for the comparable period of 2013. Net operating income, a non-GAAP measure, was $15.1 million or $0.30 per diluted share, for the nine months ended September 30, 2014 compared to net operating loss of $103.1 million, or $2.07 per diluted share, for the comparable period in 2013. Total diluted weighted average shares outstanding for the nine months ended September 30, 2014 was 50,054,031 compared to 49,866,326 for the comparable period in 2013. This increase reflects the impact of shares issued under our Long Term Incentive Plan. Refer to Note 8 ~ Earnings Per Share of the Notes to the Consolidated Financial Statements, for additional information specific to the impact of our Long Term Incentive Plan. Revenues Revenues for the nine months ended September 30, 2014 decreased $29.9 million, or 5.0%, to $564.6 million, from $594.5 million for the comparable period in 2013. This decrease primarily reflects the expected reduction within our net earned premiums, partially offset by an increase in net commissions and fees and net realized gains. The following table sets forth the components of revenues (in thousands): For the Nine Months Ended September 30, 2014 2013 Revenue: Net earned premiums $ 488,411 $ 527,425 Management administrative fees 14,492 11,411 Claims fees 5,020 5,152 Commission revenue 13,837 12,068 Net investment income 33,557 34,603 Net realized gains 9,252 3,860 Total revenue $ 564,569 $ 594,519 41-------------------------------------------------------------------------------- Table of Contents Net earned premiums decreased $39.0 million, or 7.4%, to $488.4 million for the nine months ended September 30, 2014, from $527.4 million in the comparable period in 2013. This expected decrease was primarily the result of the termination of, or reduction in, certain programs in which pricing and underwriting did not meet our underwriting standards and was offset by an overall 9.7% earned rate increase, which exceeded our estimated loss trend of 1.8%, and the decrease in the ceded earned premiums related to the previously terminated Swiss Re Treaty. Net commission and fee revenue increased $4.7 million, or 16.5%, to $33.3 million for the nine months ended September 30, 2014, from $28.6 million for the comparable period in 2013. This increase was driven primarily by commission revenue generated from our subsidiary US Specialty Underwriters ("USSU") that is no longer considered intercompany revenue, as the applicable polices are now written by SNIC and reinsured by our Insurance Company Subsidiaries. Therefore, beginning in the third quarter of 2013, the related commission revenue was no longer eliminated in consolidation. This increase did not impact our consolidated financial results, as there is a corresponding increase in the expenses from net commission and fee operations. The remainder of the increase in commission and fee revenue was the net result of increased agency commission revenue attributable to a recently acquired agency and a decrease in managed fee revenues from the Massachusetts and Minnesota self-insured groups' business which was driven by competitive market conditions. Net realized gains increased $5.4 million to $9.3 million for the nine months ended September 30, 2014, from $3.9 million for the comparable period in 2013 primarily due to the rebalancing of the equity portfolio in accordance with the Company's investment policy. Expenses Expenses decreased $171.0 million from $712.9 million for the nine months ended September 30, 2013 to $541.9 million for the nine months ended September 30, 2014. The decrease primarily is attributed to the $115.4 million goodwill impairment and $37.0 million of unfavorable development on prior years that was recorded during the nine months ended September 30, 2013. 42 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the components of expenses (in thousands): For the Nine Months Ended September 30, 2014 2013 Expense: Net losses and loss adjustment expenses $ 319,508 $ 399,434 Policy acquisition and other underwriting expenses 179,373 163,283 General selling & administrative expenses 25,196 18,950 General corporate expenses 4,420 3,301 Amortization expense 2,959 3,146 Goodwill impairment expense - 115,397 Interest expense 10,440 9,431 Total expenses $ 541,896 $ 712,942 Net loss and loss adjustment expenses ("LAE") decreased $79.9 million, to $319.5 million for the nine months ended September 30, 2014, from $399.4 million for the same period in 2013. Our loss and LAE ratio was 65.4% for the nine months ended September 30, 2014 and 75.7% for the nine months ended September 30, 2013; an improvement of 10.3 percentage points. The loss and LAE ratio for the nine months ended 2014 includes pre-tax favorable prior year loss reserve development of $1.0 million, or 0.2 percentage points of the loss and LAE ratio. The results for the nine months ended September 30, 2013 included pre-tax unfavorable prior year loss reserve development of $37.0 million, or 7.0 percentage points of the loss and LAE ratio. The accident year loss and LAE ratio was 65.6% for the nine months ended September 30, 2014 down from 68.7% in the comparable period in 2013; an improvement of 3.1 percentage points. Additional discussion of our quarterly reserve activity is described below within the Other Items ~ Reserves section. Policy acquisition and other underwriting expenses increased $16.0 million, to $179.3 million for the nine months ended September 30, 2014 from $163.3 million for the same period in 2013. Our expense ratio increased 5.7% to 36.7% for the nine months ended September 30, 2014 from 31.0% for the comparable period in 2013. Excluding the impact of the quota share surplus relief treaty, the year to date expense ratio was 37.0% for 2014 compared to 32.7% for 2013. This increase primarily reflects the cost associated with the use of an unaffiliated "A" rated insurance company for policy issuance which added 2.0 percentage points; a shift in the mix of business which includes business with a higher average commission rate; an increase in reinsurance premium relating to a reinstatement premium on an isolated program; deleveraging impact of the anticipated reduction in earned premium associated with the Company's efforts to terminate unprofitable business; and a one-time restructuring charge which added 0.3 percentage points. General, selling and administrative expenses increased $6.2 million, to $25.2 million for the nine months ended September 30, 2014 from $19.0 million for the same period in 2013. As discussed above, the increase was driven by the USSU commission expense, which is no longer considered intercompany revenue, and by increased agency commission revenue attributable to a recently acquired agency. The increase attributed to the USSU commission expense did not impact our consolidated financial results, as there is a corresponding increase in the commission revenues. The general, selling and administrative expenses, as a percent of net commission and fee revenue, are comparable for the nine months ended September 30, 2014 and 2013 after the year-to-date USSU expenses are eliminated in both years. 43 -------------------------------------------------------------------------------- Table of Contents Federal income tax expense for the nine months ended September 30, 2014 was $4.3 million, or 19.0% of income before taxes, compared to a tax benefit of $15.7 million or 13.2% of loss before taxes for the same period in 2013. These rates include adjustments to an annual operating effective tax rate. The expected annual operating tax rate primarily excludes discrete charges related to the arbitration allowance and the goodwill impairment charge taken during the second quarter of 2013. The results for the nine months ended September 30, 2014 included pre-tax net operating income of $13.2 million compared to a pre-tax net operating loss of $122.6 million for the nine months ended September 30, 2013. The higher tax rate in 2014 reflects net investment income pre-tax profit (which is taxed at a lower rate due to tax exempt income) being partially offset by a pre-tax loss from corporate expenses and underwriting results. The 2013 rate primarily reflects a tax benefit due to the pre-tax operating loss. Other Items Equity earnings of affiliated, net of tax In July 2009, our subsidiary, Star, purchased a 28.5% ownership interest in an affiliate, Midwest Financial Holdings, LLC ("MFH"), for $14.8 million in cash. We are not required to consolidate this investment because 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 recognizes 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 $1.8 million, or $0.04 per dilutive share, for the nine months ended September 30, 2014, compared to $2.0 million, or $0.04 per dilutive share, for the comparable period of 2013. We received dividends from MFH for the nine months ended September 30, 2014 and 2013, of $3.2 million and $2.0 million, respectively. In November 2012, our subsidiary, Century Surety Company, committed to a $10.0 million strategic equity investment in Aquiline Financial Services Fund II L.P. As of September 30, 2014, approximately $6.6 million of the commitment had been satisfied with $3.4 million of unfunded commitment remaining. Our ownership interest is approximately 1.3% of the fund, which we are accounting for under the equity method of accounting. Century Surety Company will recognize 1.3% of the Fund's profits and losses as a result of this equity interest ownership. We recognized equity earnings, net of tax, from the Aquiline Financial Services Fund II L.P. of $1.0 million, or $0.02 per dilutive share and $0.5 million, or $0.01 per dilutive share, for the nine months ended September 30, 2014 and 2013, respectively. Reserves The reserve stability for the nine months ended September 30, 2014 was the result of underwriting and pricing improvements that we have implemented to date, as well as our prior efforts to stabilize key segments of the Company's loss reserves. Workers' compensation reserves have developed favorably during the year, led by the California-dominated business segments for which substantial rate and underwriting improvements have been enacted over the last few years. This favorable development was partially offset by increases in the commercial multi-peril/general liability segment related primarily to the 2009 - 2012 accident years. For all prior accident years combined, the reserves were stable for the year with $1.0 million of favorable development. 44 -------------------------------------------------------------------------------- Table of Contents The 2013 accident year reserves showed favorable signs as the accident year continues to mature reflecting the effectiveness of rate changes, underwriting improvements and termination of underperforming blocks of business since 2012. The 2014 accident year actuarial reserving method indications for the methods performed show additional improvement beyond the 2013 accident year. At September 30, 2014, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $1.1 billion. We established a reasonable range of reserves of approximately $960.5 million to $1.2 billion. 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 Reserve Maximum Selected Line of Business Range Reserve Range Reserves Workers' Compensation $ 432,175 $ 503,866 $ 468,434 Residual Markets 23,317 25,824 25,073 Commercial Multiple Peril / General Liability 384,194 526,604 454,489 Commercial Automobile 96,510 113,294 104,937 Other 24,281 27,510 25,862 Total Net Reserves $ 960,477 $ 1,197,098 $ 1,078,795 Reserves are reviewed and established by our internal actuaries for adequacy and peer reviewed annually 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 methods remained consistent for the nine months ended September 30, 2014, and the year ended December 31, 2013. We reviewed the key assumptions that underlie the actuarial standard methods and made the appropriate adjustments to reflect the emergence of claim activity. 45 -------------------------------------------------------------------------------- Table of Contents For the nine months ended September 30, 2014, we reported a decrease in net ultimate loss estimates for accident years 2013 and prior of $1.0 million, or 0.1% of $1.1 billion of beginning net loss and LAE reserves at January 1, 2014. The change in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2014 that differed from the projected activity. The major components of this change in ultimates are as follows (in thousands): Incurred Losses Paid Losses Reserves at Reserves at December 31, Total September 30, Line of Business 2013 Current Year Prior Years Incurred Current Year Prior Years Total Paid 2014 Workers' Compensation $ 477,413 $ 151,625 $ (23,675 ) $ 127,950 $ 20,153 $ 116,776 $ 136,929 $ 468,434 Residual Markets 22,577 8,908 (1,166 ) 7,742 1,475 3,771 5,246 25,073 Commercial Multiple Peril / General Liability 459,950 81,677 16,661 98,338 5,501 98,298 103,799 454,489 Commercial Automobile 118,375 39,598 5,431 45,029 11,751 46,716 58,467 104,937 Other 32,775 38,696 1,753 40,449 25,338 22,024 47,362 25,862 Net Reserves 1,111,090 $ 320,504 $ (996 ) $ 319,508 $ 64,218 $ 287,585 $ 351,803 1,078,795 Reinsurance Recoverable 505,431 537,879 Consolidated $ 1,616,521 $ 1,616,674 The following table shows the re-estimated December 31, 2013 held reserves by line as of September 30, 2014 (in thousands): Development Re-estimated as a Reserves for percentage Reserves at December 31, 2013 of prior December 31, at September 30, year Line of Business 2013 2014 reserves Workers' Compensation $ 477,413 $ 453,738 -5.0% Commercial Multiple Peril / General Liability 459,950 476,611 3.6% Commercial Automobile 118,375 123,806 4.6% Other 32,775 34,528 5.3% Sub-total 1,088,513 1,088,683 0.0% Residual Markets 22,577 21,411 -5.2% Total Net Reserves $ 1,111,090 $ 1,110,094 -0.1% 46-------------------------------------------------------------------------------- Table of Contents Workers' Compensation Excluding Residual Markets The net ultimate loss estimates for accident years 2013 and prior in the workers' compensation line of business decreased $23.7 million, or 5.0%. This decrease was led by the California-dominated business segments for which, as noted earlier, substantial rate and underwriting improvements have been enacted over the last few years. Commercial Multiple Peril / General Liability The net ultimate loss estimates for accident years 2013 and prior in the commercial multi-peril/general liability line of business increased $16.7 million, or 3.6%. The increase was driven by a $13.1 million increase related to the 2009-2012 accident years combined. Accident year 2011 has the highest loss & ALAE ratio of that group peaking at 67%. Accident year 2013 is below a 58% loss & ALAE ratio and accident year 2014 is even lower. The improvement in the recent accident year loss ratios reflects the rate increase, underwriting actions, and termination of unprofitable business undertaken since 2012. Commercial Automobile The $5.4 million increase, or 4.6%, in net ultimate loss estimates for the commercial automobile line of business was primarily driven by the 2009-2012 accident years which developed unfavorably by $8.4 million. Of the 2009-2012 unfavorable development, 75% was on terminated business and almost 50% was on a single terminated transportation program. Other The $1.8 million increase, or 5.3%, in net ultimate loss estimates in other lines of business is primarily from an increase in accident year 2012 related to a cancelled surety program. Residual Markets The workers' compensation residual market line of business had a decrease in net ultimate loss estimate of $1.2 million, or 5.2% of net reserves. This decrease reflects a reduction in the net ultimate loss estimates for various accident years. We record loss reserves as reported by the 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 the NCCI in the year. 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. 47 -------------------------------------------------------------------------------- Table of Contents 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 ordinary dividend available that can be paid from the Insurance Company Subsidiaries during 2014 is $48.8 million without prior regulatory approval. Of this $48.8 million, $20.0 million of ordinary dividends have been declared and paid as of September 30, 2014. In addition to ordinary dividends, the Insurance Company Subsidiaries have the capacity to pay $147.7 million of extraordinary dividends in 2014, subject to prior regulatory approval. The ability to pay ordinary and extraordinary dividends must be reviewed in relation to the impact on key financial measurement ratios, including Risk Based Capital (RBC) ratios and A.M. Best's Capital Adequacy Ratio. 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 $20.0 million and zero for the nine months ended September 30, 2014 and 2013, respectively. As of September 30, 2014, on a trailing twelve month statutory consolidated basis, the gross and net premium leverage ratios were 1.5 to 1.0 and 1.2 to 1.0, respectively. Pursuant to the Amendment the Company cannot pay quarterly dividends to shareholders in excess of the lesser of $0.02 per share or $1.25 million in the aggregate without the bank's prior approval. 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. For the three months ended September 30, 2014, cash flows generated from operating activities were $9.7 million, compared to $20.4 million for the three months ended September 30, 2013. The decrease in operating cash flows primarily reflects the lower premium volumes in the current year. For the nine months ended September 30, 2014, cash flows used in operating activities were $3.2 million, compared to $18.9 million for the nine months ended September 30, 2013. The decrease in operating cash flows primarily reflects the lower premium volumes in the current year. We have a revolving credit facility of $24.3 million. As of September 30, 2014, we had an outstanding balance of $15.0 million under our revolving credit facility and $0.1 million in letters of credit issued. The undrawn portion of the revolving credit facility, which was $9.1 million as of September 30, 2014, is available to finance working capital and for other general corporate purposes, including but not limited to, surplus contributions to our Insurance Company Subsidiaries to support premium growth or strategic acquisitions. Because of our Insurance Company Subsidiaries' membership in the FHLBI, we have the ability to borrow on a collateralized basis at relatively low borrowing rates, providing a source of liquidity. As of September 30, 2014, we had borrowed $30.0 million from the FHLBI. The proceeds were used to fund purchases of high quality bonds with maturities that match the maturity of the FHLBI credit facility. Due to the low cost of the FHLBI funding, we expect to generate returns in excess of its cost of borrowing under this strategy. We have the ability to increase our borrowing capacity through additional investments in FHLBI and pledging additional securities. As of December 31, 2013, we had $30.0 million of borrowings outstanding from the FHLBI. 48-------------------------------------------------------------------------------- Table of Contents Cash provided by operations was $3.2 million and $18.9 million for the nine months ended September 30, 2014 and 2013, respectively. 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 5 ~ Derivative Instruments of the Notes to the Consolidated Financial Statements, for additional information specific to our interest rate swaps. Credit Facilities, Debentures, and Cash Convertible Senior Notes Refer to Note 4 ~ Debt of the Notes to the Consolidated Financial Statements, for additional information specific to our Credit Facilities, debentures, and the Notes. Investment Portfolio As of September 30, 2014 and December 31, 2013, the recorded value of our investment portfolio, including cash and cash equivalents, was $1.7 billion. The net unrealized gain as of September 30, 2014 and December 31, 2013 was $47.5 million and $21.9 million, respectively. The effective duration of the fixed income investment portfolio at September 30, 2014, is 4.5 years, compared to 5.1 years at September 30, 2013. Our pre-tax book yield, excluding cash and cash equivalents, was 2.9%, compared to 3.1% in 2013. The tax equivalent yield, excluding cash and cash equivalents was 3.6% at September 30, 2014 and 2013. Approximately 99.9% of our fixed income investment portfolio is investment grade. Refer to Note 2 ~ Investments of the Notes to the Consolidated Financial Statements, for additional information specific to our investment portfolio. Shareholders' Equity Refer to Note 7 ~ Shareholders' Equity of the Notes to the Consolidated Financial Statements. 49 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations and Commitments On March 18, 2013, the Company issued $100.0 million of 5.0% cash convertible senior notes, which mature on March 15, 2020. As of September 30, 2014, the total debt (including debentures) of the Company and its non-regulated subsidiaries was $203.3 million, and the payments due in more than five years was $180.9 million. For additional information regarding the cash convertible notes, refer to Note 4 ~ Debt of the Notes to the Consolidated Financial Statements. For the three months ended September 30, 2014, there were no material changes in relation to our contractual obligations and commitments, outside of the ordinary course of our business. Recent Accounting Pronouncements Refer to Note 1 ~ Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements. |