News Column

MEADOWBROOK INSURANCE GROUP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 8, 2014

For the Periods ended June 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. 31 -------------------------------------------------------------------------------- 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 2.6% 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. 32 -------------------------------------------------------------------------------- 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 six months ended June 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: June 30, 2014 (in thousands) Statutory Consolidated Surplus $ 507,700 Statutory to GAAP differences: Deferred policy acquisition costs 64,629 Other 8,145 Total Statutory to GAAP differences 72,774 Total Non-Regulated Entities (1) (133,947 ) GAAP Consolidated Shareholders' Equity $ 446,527



(1) Total includes $80,930 of debentures and $158,481 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: 33



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Table of Contents

For the Three Months Ended June 30, For the Six Months Ended June 30, 2014 2013 2014 2013 (In thousands, except share and per (In thousands, except share and per share data) share data) Net operating income (loss) $ 3,649 $



(115,090 ) $ 12,039$ (108,213 ) Net realized gains, net of tax

2,115 2,032 4,081 2,237 Net income (loss) $ 5,764 $



(113,058 ) $ 16,120$ (105,976 )

Diluted earnings (losses) per common share: Net operating income (loss) $ 0.07 $ (2.31 ) $ 0.24 $ (2.17 ) Net income (loss) $ 0.12 $ (2.27 ) $ 0.32 $ (2.13 ) Diluted weighted average common shares outstanding 50,091,984 49,887,200 50,034,349 49,855,716 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. 34 -------------------------------------------------------------------------------- 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 Six Months Ended June 30, Ended June 30, 2014 2013 2014 2013 Accident year combined ratio 103.0 % 100.9 % 101.7 % 99.9 % Increase (decrease) in net ultimate loss estimates on prior year loss reserves 0.0 % 15.1 % (0.2 %) 8.7 % GAAP combined ratio 103.0 % 116.0 % 101.5 % 108.6 % 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 JUNE, 2014 AND 2013

Executive Overview

Our GAAP combined ratio improved by 13.0 percentage points to 103.0% in the second quarter 2014 from 116.0% for the comparable quarter 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 and the deleveraging impact of the anticipated reduction in earned premium associated with the Company's efforts to terminate unprofitable business. Net operating income, a non-GAAP measure the Company defines as net income excluding after-tax realized gains and losses, was $3.6 million or $0.07 per diluted share, for the second quarter 2014 compared to net operating loss of $115.1 million, or $2.31 per diluted share, for the second quarter 2013. The second quarter 2014 results include pre-tax favorable prior year loss reserve development of $0.1 million, or less than 0.1 percentage points of the loss and LAE ratio. The second quarter 2013 results included pre-tax unfavorable prior year loss reserve development of $26.5 million, or 15.1 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 66.8% for the second quarter of 2014 compared to 67.6% for the comparable quarter in 2013, an improvement of 0.8 percentage points. 35 -------------------------------------------------------------------------------- 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 66.4% for the three months ended June 30, 2014 and 2013. Second quarter 2014 results benefited from lower earned premium on terminated business (i.e., in run-off) in conjunction with the 2012 capital enhancement initiatives, which added 2.2 points to the 2013 accident year loss and LAE ratio and had only a 0.4 percentage point impact on 2014. Rate increases earned in excess of loss ratio trends during the second quarter 2014 also improved the accident year loss and LAE ratio by 4.5 points. These improvements to 2014 accident year results were offset by a slightly higher level of short tail lines claim activity in the second quarter 2014 and a higher and more conservative loss and LAE ratio selection for the 2014 accident year. This selection reflects a more conservative expected loss ratio within the standard actuarial methods and consideration of the inherent risks associated with a less mature accident year. Gross written premium decreased $55.4 million, or 23.7%, to $178.7 million for the three months ended June 30, 2014, compared to $234.1 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 6.2% written rate increase.



Results of Operations

Net income for the three months ended June 30, 2014, was $5.8 million, or $0.12 per dilutive share, compared to a net loss of $113.1 million, or $2.27 per dilutive share, for the comparable period of 2013. Net operating income, a non-GAAP measure, was $3.6 million or $0.07 per diluted share, for the second quarter 2014 compared to net operating loss of $115.1 million, or $2.31 per diluted share, for the second quarter 2013. Total diluted weighted average shares outstanding for the three months ended June 30, 2014 was 50,091,984 compared to 49,887,200 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 three months ended June 30, 2014 decreased $11.1 million, or 5.6%, to $187.9 million, from $199.0 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. 36 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the components of revenues (in thousands): For the Three Months Ended June 30, 2014 2013 Revenue: Net earned premiums $ 164,124 $ 175,781

Management administrative fees 3,301

2,791 Claims fees 1,631 1,674 Commission revenue 4,410 4,074 Net investment income 11,209 11,768 Net realized gains 3,253 2,869 Total revenue $ 187,928 $ 198,957 Net earned premiums decreased $11.7 million, or 6.7%, to $164.1 million for the three months ended June 30, 2014, from $175.8 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 10.3% earned rate increase, which exceeded our estimated loss trend of 1.8%. Net commission and fee revenue increased $0.8 million, or 9.4%, to $9.3 million for the three months ended June 30, 2014, from $8.5 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; and therefore, the related commission revenue is 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. Net realized gains increased $0.4 million, or 13.8%, to $3.3 million for the three months ended June 30, 2014, from $2.9 million for the comparable period in 2013. Expenses Expenses decreased $149.0 million from $330.6 million for the three months ended June 30, 2013 to $181.6 million for the three months ended June 30, 2014. The decrease primarily is attributed to the $115.4 million goodwill impairment and $26.5 million unfavorable development on prior years which was recorded during the second quarter of 2013. 37 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the components of expenses (in thousands): For the Three Months Ended June 30, 2014 2013 Expense: Net losses and loss adjustment expenses $ 109,660 $



145,371

Policy acquisition and other underwriting expenses 59,358

58,450

General selling & administrative expenses 6,752 5,901 General corporate expenses 1,415 760 Amortization expense 961 1,038 Goodwill impairment expense - 115,397 Interest expense 3,472 3,653 Total expenses $ 181,618$ 330,570 Net loss and loss adjustment expenses ("LAE") decreased $35.7 million, to $109.7 million for the three months ended June 30, 2014, from $145.4 million for the same period in 2013. Our loss and LAE ratio was 66.8% for the three months ended June 30, 2014 and 82.7% for the three months ended June 30, 2013; an improvement of 15.9 percentage points. The loss and LAE ratio for the second quarter of 2014 includes pre-tax favorable prior year loss reserve development of $0.1 million, or less than 0.1 percentage points of the loss and LAE ratio. The second quarter 2013 results included pre-tax unfavorable prior year loss reserve development of $26.5 million, or 15.1 percentage points of the loss and LAE ratio. The accident year loss and LAE ratio was 66.8% for the three months ended June 30, 2014 down from 67.6% in the comparable period in 2013; an improvement of 0.8 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 $0.9 million, to $59.4 million for the three months ended June 30, 2014 from $58.5 million for the same period in 2013. Our expense ratio increased 2.9% to 36.2% for the second quarter 2014 from 33.3% for the second quarter 2013. This increase primarily reflects the cost associated with the use of an unaffiliated "A" rated insurance company for policy issuance and the deleveraging fixed costs in relation to the decrease in earned premium noted above. The increase also reflects a shift in the mix of business in 2014. The federal effective rate on operating income was 1.4% for the second quarter of 2014 compared to 16.4% 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 second quarter 2014 results included pre-tax net operating income of $3.1 million compared to a pre-tax net operating loss of $134.5 million for the second quarter 2013. The lower tax rate in 2014 reflects net investment income pre-tax profit (which is taxed at a lower rate due to tax exempt municipal bonds 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 net operating loss. 38 -------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE, 2014 AND 2013



Executive Overview

Our GAAP combined ratio improved by 7.1 percentage points to 101.5% for the six months ended June 30, 2014 from 108.6% 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 the one-time expenses associated with the first quarter 2014 restructuring. Net operating income, a non-GAAP measure the Company defines as net income excluding after-tax realized gains and losses, was $12.0 million or $0.24 per diluted share, for the six months ended June 30, 2014 compared to net operating loss of $108.2 million, or $2.17 per diluted share, for six months ended June 30, 2013. The results for the six months ended June 30, 2014 include favorable prior year loss reserve development of $0.8 million, or less than 0.2 percentage points of the loss and LAE ratio. The results for the six months ended June 30, 2013 included pre-tax unfavorable prior year loss reserve development of $30.1 million, or 8.7 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 65.4% for the six months ended June 30, 2014 compared to 68.4% for the comparable period in 2013, an improvement of 3.0 percentage points. 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 64.5% for the six months ended June 30, 2014 and 66.2% for the six months ended June 30, 2013. The 2014 results benefited from the decrease in premium from business terminated in conjunction with the 2012 capital enhancement initiatives, which added 2.5 points to the 2013 accident year loss and LAE ratio and had only a 0.3 percentage point impact on 2014. Rate increases earned in excess of loss ratio trends during 2014 also benefited the current accident year loss and LAE ratio by 4.5 points. These improvements to the 2014 accident year loss ratio were offset by a higher level of short tail lines claim activity in the second quarter 2014 and a higher and more conservative accident loss and LAE ratio selection for the 2014 accident year. This selection reflects a more conservative expected loss ratio within the standard actuarial methods and consideration of the inherent risks associated with a less mature accident year. Gross written premium decreased $121.4 million, or 24.2%, to $380.4 million for the six months ended June 30, 2014, compared to $501.8 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 6.2% written rate increase. 39 -------------------------------------------------------------------------------- Table of Contents Results of Operations Net income for the six months ended June 30, 2014, was $16.1 million, or $0.32 per dilutive share, compared to a net loss of $106.0 million, or $2.13 per dilutive share, for the comparable period of 2013. Net operating income, a non-GAAP measure, was $12.0 million or $0.24 per diluted share, for the six months ended June 30, 2014 compared to net operating loss of $108.2 million, or $2.17 per diluted share, for the comparable period in 2013. Total diluted weighted average shares outstanding for the six months ended June 30, 2014 was 50,034,349 compared to 49,855,716 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 six months ended June 30, 2014 decreased $13.8 million, or 3.5%, to $376.8 million, from $390.6 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 Six Months Ended June 30, 2014 2013 Revenue: Net earned premiums $ 326,662$ 346,369

Management administrative fees 8,439

6,158 Claims fees 3,298 3,416 Commission revenue 9,652 8,599

Net investment income 22,470

22,908 Net realized gains 6,279 3,185 Total revenue $ 376,800$ 390,635 Net earned premiums decreased $19.7 million, or 5.7%, to $326.7 million for the six months ended June 30, 2014, from $346.4 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 10.3% earned rate increase, which exceeded our estimated loss trend of 1.8%. Net commission and fee revenue increased $3.2 million, or 17.6%, to $21.4 million for the six months ended June 30, 2014, from $18.2 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; and therefore, the related commission revenue is 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. 40 -------------------------------------------------------------------------------- Table of Contents Net realized gains increased $3.1 million to $6.3 million for the six months ended June 30, 2014, from $3.2 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 $155.2 million from $513.8 million for the six months ended June 30, 2013 to $358.6 million for the six months ended June 30, 2014. The decrease primarily is attributed to the $115.4 million goodwill impairment and $30.1 million of unfavorable development on prior years that was recorded during the six months ended June 30, 2013.



The following table sets forth the components of expenses (in thousands):

For the Three Months Ended June 30, 2014 2013 Expense: Net losses and loss adjustment expenses $ 212,850 $



267,187

Policy acquisition and other underwriting expenses 118,557

109,055

General selling & administrative expenses 15,247 11,924 General corporate expenses 3,048 2,276 Amortization expense 1,948 2,109 Goodwill impairment expense - 115,397 Interest expense 6,934 5,850 Total expenses $ 358,584$ 513,798 Net loss and loss adjustment expenses ("LAE") decreased $54.2 million, to $212.9 million for the six months ended June 30, 2014, from $267.1 million for the same period in 2013. Our loss and LAE ratio was 65.2% for the six months ended June 30, 2014 and 77.1% for the six months ended June 30, 2013; an improvement of 11.9 percentage points. The loss and LAE ratio for the six months ended 2014 includes pre-tax favorable prior year loss reserve development of $0.8 million, or 0.2 percentage points of the loss and LAE ratio. The results for the six months ended June 30, 2013 included pre-tax unfavorable prior year loss reserve development of $30.1 million, or 8.7 percentage points of the loss and LAE ratio. The accident year loss and LAE ratio was 65.4% for the six months ended June 30, 2014 down from 68.4% in the comparable period in 2013; an improvement of 3.0 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 $9.5 million, to $118.6 million for the six months ended June 30, 2014 from $109.1 million for the same period in 2013. Our expense ratio increased 4.8% to 36.3% for the six months ended June 30, 2014 from 31.5% for the comparable period in 2013. This increase primarily reflects the cost associated with the use of an unaffiliated "A" rated insurance company for policy issuance and deleveraging fixed costs in relation to the decrease in earned premium noted above. In addition, one-time restructuring charges added 0.5 percentage points, with the remainder of the difference relating to a shift in the mix of business in 2014 as compared to prior year and the impact of the elimination of the Swiss Re quota share agreement. 41 -------------------------------------------------------------------------------- Table of Contents The federal effective rate on operating income was 14.8% for the six months ended June 30, 2014 compared to 4.8% for the comparable 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 six months ended June 30, 2014 included pre-tax net operating income of $11.9 million compared to a pre-tax net operating loss of $126.4 million for the six months ended June 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 municipal bonds 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 $1.1 million, or $0.02 per dilutive share, for the six months ended June 30, 2014, compared to $1.0 million, or $0.02 per dilutive share, for the comparable period of 2013. We received dividends from MFH for the six months ended June 30, 2014 and 2013, of $2.5 million and $1.4 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 June 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 $0.8 million, or $0.02 per dilutive share and $0.6 million, or $0.01 per dilutive share, for the six months ended June 30, 2014 and 2013, respectively. 42 -------------------------------------------------------------------------------- Table of Contents Reserves The reserve stability for the six months ended June 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 developed favorably in the quarter, led by the California-dominated business segments for which substantial rate and underwriting improvements have been enacted over the last few years. 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 reserve indications show additional improvement beyond the 2013 accident year. Reserves on terminated business remained stable in the quarter. At June 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 $969.7 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 Maximum Reserve Reserve Selected Line of Business Range Range Reserves Workers' Compensation $ 435,753$ 507,042$ 471,365 Residual Markets 23,376 25,890 25,136



Commercial Multiple Peril / General Liability 381,910 526,826

454,284 Commercial Automobile 98,969 116,181 107,608 Other 29,718 33,568 31,593 Total Net Reserves $ 969,726$ 1,209,507$ 1,089,986 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 six months ended June 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. 43 -------------------------------------------------------------------------------- Table of Contents For the six months ended June 30, 2014, we reported a decrease in net ultimate loss estimates for accident years 2013 and prior of $0.8 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 December 31, Total at June 30, Line of Business 2013 Current Year Prior Years Incurred Current Year Prior Years Total Paid 2014 Workers' Compensation $ 477,413$ 95,650$ (8,283 )$ 87,367$ 8,931$ 84,484$ 93,415$ 471,365 Residual Markets 22,577 7,442 (1,005 ) 6,437 959 2,919 3,878 25,136 Commercial Multiple Peril / General Liability 459,950 56,838 7,065 63,903 2,243 67,326 69,569 454,284 Commercial Automobile 118,375 26,730 885 27,615 6,603 31,779 38,382 107,608 Other 32,775 26,953 575 27,528 11,842 16,868 28,710 31,593 Net Reserves 1,111,090 $ 213,613$ (763 )$ 212,850$ 30,578$ 203,376$ 233,954 1,089,986 Reinsurance Recoverable 505,431 525,149 Consolidated $ 1,616,521$ 1,615,135



The following table shows the re-estimated December 31, 2013 held reserves by line as of June 30, 2014 (in thousands):

Re-estimated Development as a Reserves at Reserves for percentage of December December 31, 2013 prior year Line of Business 31, 2013 at June 30, 2014 reserves Workers' Compensation $ 477,413 $ 469,130 -1.7% Commercial Multiple Peril / General Liability 459,950 467,015 1.5% Commercial Automobile 118,375 119,260 0.7% Other 32,775 33,350 1.8% Sub-total 1,088,513 1,088,755 0.0% Residual Markets 22,577 21,572 -4.5% Total Net Reserves $ 1,111,090$ 1,110,327 -0.1%



Workers' Compensation Excluding Residual Markets

The net ultimate loss estimates for accident years 2013 and prior in the workers' compensation line of business decreased $8.3 million, or 1.7%. 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. 44 -------------------------------------------------------------------------------- Table of Contents 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 $7.1 million, or 1.5%. The increase was driven by the 2009-2012 accident years. Accident year 2011 has the highest loss & ALAE ratio of that group peaking at 65%. 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 $0.9 million increase, or 0.7%, in net ultimate loss estimates for the commercial automobile line of business was primarily driven by the 2009-2012 accident years mostly on business in a terminated transportation program. This was partially offset by modest improvement in the 2013 accident year.



Other

The $0.6 million increase, or 1.6%, in net ultimate loss estimates in other lines of business is primarily from an increase in accident year 2012 related to a surety program.

Residual Markets The workers' compensation residual market line of business had a decrease in net ultimate loss estimate of $1.0 million, or 4.5% 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. 45 -------------------------------------------------------------------------------- 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, no ordinary dividends have been declared and paid as of June 30, 2014. In addition to ordinary dividends, the Insurance Company Subsidiaries have the capacity to pay $140.6 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. There were no ordinary dividends paid from our Insurance Company Subsidiaries to our holding company for the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014, on a trailing twelve month statutory consolidated basis, the gross and net premium leverage ratios were 1.6 to 1.0 and 1.2 to 1.0, respectively. Additionally, pursuant to the Amendment (Note 4 ~ Debt) 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. Earnings before interest, taxes, depreciation, and amortization from non-regulated subsidiaries were approximately $6.1 million for the six months ended June 30, 2014. We have a revolving credit facility of $30.0 million. As of June 30, 2014, we had an outstanding balance of $20.0 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 $9.9 million as of June 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 June 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. 46 -------------------------------------------------------------------------------- Table of Contents Cash used in operations was $6.6 million and $1.5 million for the six months ended June 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 June 30, 2014 and December 31, 2013, the recorded value of our investment portfolio, including cash and cash equivalents, was $1.7 billion and the Company has the ability and intent to hold underwater debt securities to maturity and underwater equity securities for a sufficient period of time to allow for a recovery of the cost of the security in value. In general, we believe our overall investment portfolio is conservatively invested. The effective duration of the investment portfolio at June 30, 2014, is 4.7 years, compared to 5.2 years at June 30, 2013. Our pre-tax book yield, excluding cash and cash equivalents, was 2.9%, compared to 3.3% in 2013. The tax equivalent yield, excluding cash and cash equivalents was 3.6%, compared to 3.8% in 2013. Approximately 99.8% 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.

47 -------------------------------------------------------------------------------- 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 a result of the issuance of the cash convertible notes, as of June 30, 2014, the total debt (including debentures) of the Company and its non-regulated subsidiaries was $209.4 million, and the payments due in more than five years increased to $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 June 30, 2014, there were no other 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.

48



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