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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 1-14094
MEADOWBROOK INSURANCE GROUP, INC.
(Exact name of registrant as specified in its charter)
MICHIGAN 38-2626206
(State of Incorporation) (IRS Employer Identification No.)
26600 TELEGRAPH ROAD, SOUTHFIELD, MICHIGAN 48034
(248) 358-1100
(Address, zip code and telephone of principal executive offices)
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SECURITIES REGISTERED PURSUANT TO SECTION 12(d) OF THE ACT:
NAME OF EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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Common Stock, $.01 per share New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes x No _
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K.
The aggregate market value of the voting stock (common stock, $.01 par value)
held by non-affiliates of the registrant was $150,678,044 on March 20,1998,
based on the closing sales price of the Common Stock on such date.
The aggregate number of shares of the Registrant's Common Stock, $.01 par
value, outstanding on March 20,1998 was 8,660,164
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the registrant's proxy statement for the annual meeting
scheduled for May 18, 1998 are incorporated by reference into Part III of this
report and certain portions of the 1997 Annual Report to Shareholders are
incorporated herein by reference into Part II of this report.
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PART I
ITEM 1. BUSINESS
THE COMPANY
Meadowbrook Insurance Group, Inc. (the "Company") is a Michigan corporation
which was originally incorporated in 1985 under the name Star Holding Company.
In November 1995, the Company changed its name and acquired Meadowbrook, Inc.
("Meadowbrook"). Meadowbrook was founded in 1955 as the Meadowbrook Insurance
Agency and was subsequently incorporated in 1965.
The Company serves as a holding company for not only Meadowbrook but also for
Star Insurance Company ("Star"), Savers Property and Casualty Insurance
Company ("Savers") and American Indemnity Insurance Company Ltd. ("American
Indemnity"). Star was formed in 1985 as a subsidiary of Star Holding Company.
Star then acquired Savers in 1990, and the Company acquired American Indemnity
in 1994.
The Company acquired Association Self Insurance Services, Inc. ("ASI") of
Montgomery, Alabama in November of 1996. The acquisition was not material to
the Company's results of operations. ASI is a full service risk-management
operation focused on pools and funds whose services include claims, loss
control, managed care, and policy issuance. ASI's operations were consolidated
with the Company's existing operations in Montgomery, Alabama.
In July of 1997, the Company acquired Crest Financial Services ("Crest"), a
California based holding company which holds 100% of Williamsburg National
Insurance Company ("Williamsburg"), an insurance carrier, and Crest Financial
Services, a risk management service company. Crest provides these services
primarily to the trucking industry within California. The acquisition was not
material to the Company's results of operation.
INDUSTRY SEGMENTS
Since 1976, the Company has been developing and managing alternative market
risk management programs for defined client groups and their members. The
alternative market, which developed as a result of historical volatility in
the cost and availability of traditional commercial insurance coverages,
includes a wide range of approaches to financing and managing risk exposures,
such as captives and rent-a-captives, risk retention and risk purchasing
groups, governmental pools and trusts and self-insurance plans. According to
an industry report made in 1994, the alternative market accounts for an
estimated $61 billion, or 33%, of the estimated $186 billion of United States
property and casualty premium written; and according to industry sources is
expected to reach an estimated $85 billion, or 38%, of the estimated $225
billion of United States property and casualty premium written in the year
2000. The Company believes that the alternative market has continued to expand
even during the current soft market as a result of the desire of many insureds
to exercise greater control over the risk management process and to obtain
customized risk management services.
GENERAL
The Company provides alternative risk management programs and services
primarily to industry, public entities, and trade/professional groups.
Revenues are generated from four principal sources: fees from program
management services, commissions earned on insurance placed by a subsidiary
with other carriers, earned insurance premiums, and investment income. The
subsidiaries of the Company that provide these services are Star, Savers,
Crest and its wholly owned insurer Williamsburg, American Indemnity, ASI, and
Meadowbrook, the risk management company.
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Through these subsidiaries the Company develops programs, which are customized
packages of services or coverages marketed to the group's members. The programs
are categorized by the level of risk assumed by the Company either as managed
programs, risk-sharing programs, or fully-insured programs.
The Company's capabilities in the provision of both services and insurance
coverages provide flexibility for the consideration and implementation of a
variety of alternative market solutions. Services provided and insurance lines
of business include:
SERVICES LINES OF BUSINESS
- Risk Analysis and Identification - Workers' Compensation
- Feasibility Studies - Commercial Multi-Peril
- Program and Product Design - General Liability
- Sales, Marketing and Public Relations -- Errors and Omissions
- Consultation, Education and Training -- Automobile
- Captive Formation -- Owners, Landlord and
- Captive Management (Onshore and Offshore) Tenant
- Employment Practices
Liability
- Rent-a-Captive - Professional Liability
- Underwriting/Risk Selection -- Legal
- Policy Issuance -- Medical Malpractice
- Reinsurance Brokerage -- Real Estate Appraisers
- Claims Handling and Administration -- Accountants
- Litigation Management -- Pharmacists
- Accounting and Financial Statement Preparation - Inland Marine
- Regulatory Compliance -- Cargo
- Actuarial and Loss Reserve Analysis -- Watercraft
- Loss Prevention and Control - Product Liability
- Legal and Audit Support - Excess Reinsurance
- Information Technology and Processing - Commercial Property
DESCRIPTION OF SERVICES AND CAPABILITIES
PROGRAM DESIGN. Prior to implementing a new program, the Company reviews a
significant amount of data, including: financial projections for the
contemplated program; historical loss experience; actuarial studies of the
underlying risks; the creditworthiness of the potential client; and the
availability of reinsurance. A senior management team and associates
representing each of the risk-management disciplines within the Company work
together to design, market and implement new programs. While the Company does
not generate substantial fees for program design services, these services are an
integral part of the Company's program management services.
FORMATION AND MANAGEMENT OF RISK-BEARING ENTITIES. The Company generates fees by
forming and managing risk-bearing entities for clients and agents. The Company
currently manages over twenty-nine captives and holds a minority interest in ten
of these captives. The offshore captives are managed by the Company's
subsidiaries in Bermuda and Barbados.
RISK SELECTION. The Company performs underwriting services for its clients, its
clients' captives and certain individual accounts. Compensation for underwriting
services generally is included in the Company's management fees. The Company's
underwriting personnel help develop the proper criteria for selecting risks,
while actuarial and reinsurance personnel evaluate and recommend the appropriate
levels of risk retention. The program is then tailored according to the
requirements of each client.
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REINSURANCE BROKERAGE. The Company earns fees by placing excess reinsurance
for its programs. The Company's two reinsurance brokerage subsidiaries,
Meadowbrook Intermediaries, Inc. and Meadowbrook International, Ltd., place
reinsurance (as well as insurance coverage with high deductibles) for
insurance companies, captives and self-insured programs managed by the
Company. Reinsurance is also placed for clients that do not have other
business relationships with the Company.
LOSS CONTROL AND PREVENTION. The Company earns fees for loss control services
which are designed to help clients prevent or limit certain loss events.
Through an evaluation of the client's workplace environment, the Company's
loss control specialists assist the client in planning and implementing a loss
prevention program and, in certain cases, provide educational and training
programs for the client.
CLAIMS HANDLING AND ADMINISTRATION. The Company is experienced in handling and
managing claims for workers' compensation and most other casualty lines,
property and general liability. It handles all claims functions for most of
the programs managed by the Company. The Company's involvement in claims
handling and administration provides feedback to program managers in assessing
the client's risk environment and the overall structure of the program.
SALES AND MARKETING. The Company markets its programs and services to
associations, groups, local, regional and national insurance agents and
insurance consultants. Once a program has been developed for a particular
association or group, the Company generally then markets the program to
members of the association or group. Sales and marketing efforts include
personal contact, direct mail, telemarketing, advertising, internet based
marketing (www.meadowbrookinsgrp.com), and attendance at seminars and trade
and industry conventions.
CUSTOMERS, MARKETING AND DISTRIBUTION
FEE BASED OPERATIONS:
AGENCY. The Company earns commissions through the operation of a retail
property and casualty insurance agency. Formed in 1955 as Meadowbrook's
original business, the insurance agency places principally commercial
insurance, as well as personal property, casualty, life and accident and
health insurance, with more than 25 insurance carriers. The agency has grown
to be one of the largest agencies in Michigan. In addition, with the 1997
acquisition of Crest, the Company added two California based subsidiaries: a
licensed insurance agent, and a licensed general agent and excess and surplus
lines broker.
In total, the Company's agency operations generated commissions of $7.6
million, $4.8 million and $4.8 million for the years ended December 31, 1997,
1996 and 1995, respectively. In addition to its independent retail agency
activities, the Company's insurance agency also earns revenue by serving as
agent for several of the Company's programs, including two of its ten largest
programs.
MANAGED PROGRAMS. In a managed program, the Company, through Meadowbrook,
earns commission and fee revenue by providing management and other services to
a client's risk-bearing entity, but generally does not share in the operating
results of such programs. The Company believes that its managed programs
provide a stable source of revenue as well as opportunities for revenue growth
without a proportionate increase in expenses. Revenue growth may occur through
the sale of existing managed program products to additional members of the
sponsoring client group, the expansion of coverages and services provided to
existing programs and the creation of programs for new client groups (such as
additional municipal associations) with needs that are similar to existing
client groups.
Meadowbrook specializes in providing managed programs to public entity
associations, and currently manages public entity pools and other captive
insurance entities, which provide insurance coverage for over 2500
participants, including city, county, township and village
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governments in five states. Over the years, Meadowbrook has been able to expand
the services offered under existing programs as well as to increase the number
of participants in these managed programs.
Managed program services for which Meadowbrook receives commissions and fees
include: program design and development; underwriting; reinsurance brokerage;
policy administration; loss prevention and control services (including the
provision of specialized law enforcement training); claims and litigation
management; information processing and accounting functions; and general
management oversight of the program on behalf of the sponsoring client group.
Fees and commissions received by the Company under its managed programs are
generally either in a fixed amount or based on a percentage of premium serviced.
In addition to municipal associations, Meadowbrook also manages mutual insurance
companies, offshore captives and other insurance entities including the
Company's insurance subsidiaries Star, Savers and Williamsburg.
In total, Meadowbrook employs 585 associates.
INSURANCE OPERATIONS:
The Company's major insurance subsidiaries, Star, Savers and Williamsburg,
collectively the "Insurance operations", issue insurance policies for both
risk-sharing and fully-insured programs. These companies are complemented by
American Indemnity, which offers clients a rent-a-captive vehicle for
risk-sharing programs. The insurance operations are managed by Meadowbrook and
have no employees.
The Insurance operations are authorized to write business, on either an admitted
or surplus lines basis, in fifty states. Through both risk-sharing and fully
insured programs, the Insurance operations primarily offer workers'
compensation, commercial multiple peril, inland marine and other liability. The
Insurance operations also provide policy issuance services for surety bonds and
transfer the risk to Connecticut Surety (see Surety Bonds below). For the year
ended December 31, 1997, workers' compensation line of business accounted for
44.8% and 48.1% of gross written premiums and net earned premiums, respectively.
Star, Savers, and Williamsburg are domiciled in Michigan, Missouri, and
California, respectively.
During 1997, A.M.Best affirmed an A-, A-, and B++ for Star, Savers, and
Williamsburg, respectively. A.M. Best ratings are based upon factors of concern
to policyholders and are not directed toward the protection of investors. No
assurances can be given that in the future A.M. Best will not reduce or withdraw
the ratings of the Company's insurance subsidiaries.
CLIENT RISK-SHARING. In a client risk-sharing program, the Company participates
in the operating results of the program, and the client group also shares in
such results through a captive, a rent-a-captive or a retrospectively-rated
program. In many instances, a captive owned by a client reinsures a portion of
the risk on a quota-share basis. In addition to premium revenue and investment
income from its participation in the operating results of the program, the
Company may also be compensated through the receipt of ceding commissions and
other fees for policy issuance services and acquisition costs, captive
management services, reinsurance brokerage, loss prevention services and claims
handling and administration services. For financial reporting purposes, ceding
commissions are treated as a reduction in underwriting expenses.
The Company's experience has been that the number of claims and the cost of
losses tend to be lower in risk-sharing programs than with traditional forms of
insurance. The Company believes that client risk-sharing motivates insureds to
focus on loss prevention and control measures and to establish and adhere to
stricter underwriting guidelines. As a result of its experience with
risk-
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sharing programs, the Insurance operations have sustained a ten year average
combined ratio of 95.3% and have outperformed the industry by an average of 12
points.
The Company assists the sponsoring group in forming a captive, which is
capitalized by contributions from members of the sponsoring group in exchange
for shares of the captive. The captive is generally managed for a fee by an
offshore subsidiary of the Company. The Company works with the client to
determine the amount of risk exposure that will be assumed by the captive, which
varies depending on the captive's capitalization, the line of business, the
amount to be retained by the Company and the amount to be reinsured by excess
reinsurers. The Company then issues an insurance policy and receives premium
from the insured. Pursuant to the quota-share reinsurance agreement with the
captive, the Company generally transfers (cedes) a portion of the retained risk
to the captive and pays to the captive its share of the net premium (after
deducting ceding commissions, policy issuance fees, the cost of excess
reinsurance, taxes and other fees and expenses). The Company generally seeks to
cede approximately 50% of its loss exposures, but in some cases cedes as little
as 20% or as much as 80% of its loss exposures. The Company secures obligations
due from captives through the use of funds withheld trusts and letters of
credit. Through its reinsurance intermediary subsidiaries, the Company obtains
excess-of-loss reinsurance, subject to agreed upon limits and retention levels.
The Company generally administers all claims handling functions, and the captive
provides funds to the Company for the payment of the captive's proportionate
share of paid claims and claims expenses. The captive realizes investment income
from its capital, unearned premium and loss reserves, and shares in the
underwriting results.
The Company also offers its clients "rent-a-captive" risk-sharing programs.
These programs allow a client to retain a significant portion of its own loss
exposure without the administrative costs and capital commitment required to
establish and operate its own captive.
In another variation on client risk-sharing, the Company establishes
retrospectively-rated programs for individual accounts. In such a program, the
Company works with the client to develop the appropriate self-insured retention
and loss fund amount and then helps arrange for excess of loss reinsurance. The
client reimburses the Company for all claims payments within the client's
retention. The Company generally earns a management fee (which includes claims
and loss control fees). In most of these programs, the Company also participates
in the operating results of the reinsurance coverage and earns a ceding
commission.
AGENT RISK-SHARING. The Company also writes program business on a risk-sharing
basis with agents or brokers. The Company believes that agent risk-sharing has
grown as a result of market volatility and lack of coverage availability in the
traditional market. Risk-sharing is achieved either through an agent-owned
captive, rent-a-captive or through a contingent commission structure tied to
operating results. The Company believes that certain agents and brokers view
risk-sharing as a means to recapture lost profit margins on commissions that
have been reduced due to premium reductions in the soft market and to establish
a long-term relationship with an insurer.
The agent may own a captive or purchase an interest in a rent-a-captive which
acts as a reinsurer on business produced. In some cases, the captive's
shareholders may include key producers, subproducers and insureds. In other
circumstances, the agent accepts a lower up-front commission in exchange for a
multi-year contingent commission based on operating results. The Company
believes that multi-year commission structures motivate the agent to produce
business with better risk characteristics and higher profit potential.
FULLY-INSURED PROGRAMS. In a fully-insured program, the Company earns premium
revenue by providing insurance coverage without a risk-sharing mechanism. The
Company may provide fully-insured programs when it perceives opportunities for
the development of risk-sharing programs in the future.
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SURETY BONDS. The Company formed a surety bond business unit in late 1993 and
began issuing surety bonds for contractors and licensees in 1994. The Company
earned premium revenue on surety bonds issued through general agents
throughout the United States, including a wholly-owned subsidiary of the
Company. General agents were paid commissions and, in some cases, profit
sharing bonuses based upon loss ratios. The general agents had limited
underwriting authority. In marketing payment and performance surety bonds to
clients, the Company generally considered the net worth and working capital
ratios and the client's experience, expertise, financial statements and
historical track record. In certain instances, the Company required collateral
before issuing a surety bond. The form of collateral varied depending upon an
assessment of the risk factors associated with the surety bond. Generally,
collateral consisted of escrowed cash, letters of credit or investment
securities, all of which was held through the term of the bond.
In December 1996, the Company entered into a five-year joint underwriting
agreement with Connecticut Surety Corporation. The agreement provides for the
transfer of the underwriting risk on the majority of the Company's existing
surety bond business. In addition, Star will continue to write new surety
business, utilizing its capital and licenses, and Connecticut Surety will
manage the operations and assume the risk. This arrangement substantially
reduces the Company's underwriting risk exposure while creating a five-year
fee arrangement. This enables the Company to refocus its efforts on its core
business, alternative risk management.
DEPENDENCE ON KEY PROGRAMS
The Company provides alternative risk management programs and services to
certain large client groups and associations and then markets them to their
individual members. In 1997, 1996, and 1995 the Company's top four programs,
excluding the surety bond business, accounted for 46%, 37% and 34%,
respectively, of the Company's total net earned premiums on an actual basis.
The loss or cancellation of any of the Company's significant programs by the
relevant client groups, or the general availability of commercial market
coverage to members of such groups on more favorable terms than provided under
the Company's programs, could have an adverse effect on the Company's results
of operations.
RESERVES
The information required by this item is incorporated by reference to pages
23, 36, 37, and 41 of the Company's 1997 Annual Report to Shareholders.
Reserves are computed by the Company based on actuarial principles and
procedures applicable to the lines of business written by the Company. These
reserve calculations are reviewed regularly by management and the Company
engages independent actuaries on an annual basis to express an opinion as to
the adequacy of statutory reserves established by management. These opinions
are filed with the various jurisdictions in which the Company is licensed.
Provisions for inflation are implicitly considered in the reserving process.
For GAAP and statutory purposes, the Company's reserves are carried at the
total estimate for ultimate expected loss without any discount to reflect the
time value of money.
Significant periods of time often elapse between the occurrence of an insured
loss, the reporting of the loss to the Company, and the Company's payment of
that loss. To recognize liabilities for unpaid losses, the Company establishes
reserves as balance sheet liabilities representing estimates of amounts needed
to pay reported and unreported losses and loss adjustment expenses ("LAE").
The following table shows the development of reserves for unpaid losses and
LAE from 1988 through 1997 for the Company's current insurance subsidiaries.
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Due to the Company's adoption of SFAS 113, the bottom portion of the table shows
the impact of reinsurance for the years 1992 through 1997, reconciling the net
reserves shown in the upper portion of the table to gross reserves.
ANALYSIS OF LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT
YEARS ENDED DECEMBER 31,
(Dollars in thousands)
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
-------- ------- -------- -------- -------- -------- ------- -------- -------- ---------
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Reserves for losses
and LAE at end
of period.......... $6,311 $6,262 $9,293 $13,964 $23,545 $35,744 $47,149 $64,668 $65,775 $60,786
Cumulative paid as of:
1 year later....... 2,512 1,737 2,877 4,326 5,420 11,172 15,792 25,659 31,626
2 years later...... 3,484 3,284 4,796 6,309 10,052 19,298 26,227 42,969
3 years later...... 4,178 4,508 5,117 7,652 13,554 23,571 33,227
4 years later...... 5,103 4,195 5,971 8,954 15,598 26,700
5 years later...... 4,625 4,594 6,568 9,564 16,574
6 years later...... 4,822 4.970 6,786 10,360
7 years later...... 5,126 5,154 7,123
8 years later...... 5,257 5,425
9 years later...... 5,378
Reserves re-estimated
as of end of year:
1 year later....... 5,466 8,204 9,939 14,693 22,609 35,354 46,738 65,058 67,010
2 years later...... 7,228 7,488 9,800 14,361 21,661 33,524 45,578 65,312
3 years later...... 6,010 7,296 9,396 12,853 20,909 33,308 45,255
4 years later...... 6,374 6,683 8,758 12,649 20,623 33,685
5 years later...... 5,961 6,299 8,600 12,525 19,639
6 years later...... 5,825 6,293 8,371 12,186
7 years later...... 5,850 6,128 7,970
8 years later...... 5,798 5,866
9 years later...... 5,623
Cumulative redundancy
(deficiency):
Dollars.......... $ 688 $ 396 $1,323 $ 1,778 $ 3,906 $ 2,059 $ 1,894 $ (694) $(1,235)
Percentage....... 10.90% 6.32% 14.24% 12.73% 16.59% 5.76% 4.02% -1.00% -1.88%
Net reserves......... $23,545 $35,744 $47,149 $64,668 $65,746 $60,786
Ceded reserves....... 20,399 14,707 17,844 22,318 26,644 38,193
Gross reserves....... 43,944 50,451 64,993 86,986 92,390 98,979
------ ------ ------ ------ ------ ------
Net re-estimated..... 19,639 33,685 45,255 65,312 67,010 --
Ceded re-estimated... 22,442 16,004 21,478 28,560 28,795 --
Gross re-estimated... 42,081 49,689 66,733 93,618 95,805 --
------ -------- -------- ------ --------------
Gross cumulative
redundancy
(deficiency) ..... $ 1,863 $ 962 $(1,740) $(6,632) $(3,415) --
- -----------------------------------------------------------------------------------------------------------------
</TABLE>
Loss and LAE reserves have historically developed redundancies on a net basis
apart from the most recent two years. The cumulative deficiencies of $644,000
and $1,235,000 in 1995 and 1996, respectively, reflect adverse development on
the surety bond program, partially offset by favorable development in the
residual market pools. The residual market pools in many states have declined
resulting in reductions in pool premiums and losses. Gross deficiencies of
$6,632,000 and $3,415,000 in 1995 and 1996, respectively, also reflect adverse
development on the surety bond program. Payments on both a gross and net basis
have typically been about one third of respective prior year-end reserves.
However, in 1997, net payments were 48% of 1996 reserves due to two novations
conducted in 1997 as well as the run-off of the surety bond business. In
addition, gross payments in 1993 were 46.1% of 1992 year-end gross reserves,
due to the settlement of the large claim on an agent risk-sharing program
covering a type of risk that is no longer insured by the Company. Net payments
in 1993 were only 23.0% of 1992 year-end net reserves, due to the commutation
of a reinsurance treaty with a captive in which the recapture of $4.5 million
in loss and loss adjustment reserves was recorded as a reduction in net paid
losses. Excluding the effects of these two items, 1993 payments would have
represented 33.8% and 37.1% of 1992 year-end reserves on a gross and net basis,
respectively.
INVESTMENTS
The information required by this item is incorporated by reference to pages 22,
35, and 38-41 of the Company's 1997 Annual Report to Shareholders.
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COMPETITION AND PRICING
The Company competes both with other providers of alternative risk management
programs and services and with traditional providers of commercial insurance
coverages. Both the alternative risk management and the traditional property and
casualty insurance markets are highly competitive. The Company's alternative
risk management programs and services compete with products and services offered
by insurance companies, other providers of alternative risk management services
(including certain domestic and foreign insurers and reinsurers and insurance
brokers) as well as with self-insurance plans, captives managed by others, and a
variety of other risk-financing vehicles and mechanisms. These competitive
products are offered by other companies that may have greater financial
resources than the Company.
The market for alternative risk management products and services is
significantly influenced by market conditions affecting the traditional property
and casualty insurance industry. Insurance market conditions historically have
been subject to significant variability due to premium rate competition, natural
disasters and other catastrophic events, judicial trends, changes in the
investment and interest rate environment, regulation and general economic
conditions. Pricing is a primary means of competition in the commercial
insurance market. Competition is also based on the availability and quality of
products, quality and speed of service (including claims service), financial
strength, ratings, distribution systems and technical expertise. The primary
basis for competition among alternative risk management providers varies with
the financial and insurance needs and resources of each potential insured.
Principal factors that are considered by insureds include: an analysis of the
net present-value (after tax) of the cost of financing the insured's expected
level of losses, the amount of excess coverage provided in the event losses
exceed expected levels, cash flow and tax planning considerations and the
expected quality and consistency of the services to be provided. The Company
believes that it is able to compete based on its experience, the quality of its
products and services and its program-oriented approach. However, its ability to
successfully compete is dependent upon a number of factors, many of which,
including market and competitive conditions, are outside of the Company's
control.
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REGULATION
REGULATION IN GENERAL
The Company's insurance subsidiaries are subject to regulation by government
agencies in the states in which they do business. The nature and extent of such
regulation vary from jurisdiction to jurisdiction, but typically involve prior
approval of the acquisition of control of an insurance company or of any company
controlling an insurance company, regulation of certain transactions entered
into by an insurance company with any of its affiliates, approval of premium
rates, forms and policies used for many lines of insurance, standards of
solvency and minimum amounts of capital and surplus which must be maintained,
establishment of reserves required to be maintained for unearned premium, losses
and loss expense or for other purposes, limitations on types and amounts of
investments, restrictions on the size of risks which may be insured by a single
company, licensing of insurers and agents, deposits of securities for the
benefit of policyholders, and the filing of periodic reports with respect to
financial condition and other matters. In addition, state regulatory examiners
perform periodic examinations of insurance companies. Such regulation is
generally intended for the protection of policyholders rather than security
holders.
In addition to the regulatory oversight of the Company's insurance subsidiaries,
the Company is also subject to regulation under the Michigan, Missouri and
California Insurance Holding Company System Regulatory Acts (the "Holding
Company Acts"). The Holding Company Acts contain certain reporting requirements
including those requiring the Company, as the ultimate parent company, to file
information relating to its capital structure, ownership, and financial
condition and general business operations of its insurance subsidiaries. The
Holding Company Acts contain special reporting and prior approval requirements
with respect to transactions among affiliates.
Insurance companies are also affected by a variety of state and federal
legislative and regulatory measures and judicial decisions that define and
extend the risks and benefits for which insurance is sought and provided. These
include redefinitions of risk exposure in areas such as product liability,
environmental damage and workers' compensation. In addition, individual state
insurance departments may prevent premium rates for some classes of insureds
from reflecting the level of risk assumed by the insurer for those classes. Such
developments may adversely affect the profitability of various lines of
insurance. In some cases, these adverse effects on profitability can be
minimized through re-pricing, if permitted by applicable regulations, of
coverages or limitations or cessation of the affected business.
The Company's reinsurance intermediaries are subject to regulation as
reinsurance intermediaries. Under applicable regulations, the intermediary is
responsible as a fiduciary for funds received for the account of the parties to
the reinsurance transaction and is required to hold such funds in appropriate
bank accounts subject to restrictions on withdrawals and prohibitions on
commingling.
INSURANCE REGULATION CONCERNING CHANGE OR ACQUISITION OF CONTROL
Star, Savers and Williamsburg are domestic property and casualty insurance
companies organized, respectively, under the insurance laws (the "Insurance
Codes") of Michigan, Missouri and California. The Insurance Codes provide that
the acquisition or change of "control" of a domestic insurer or of any person
that controls a domestic insurer cannot be consummated without the prior
approval of the relevant insurance regulatory authority. A person seeking to
acquire control, directly or indirectly, of a domestic insurance company or of
any person controlling a domestic insurance company must generally file with the
relevant insurance regulatory authority an application for change of control
containing certain information required by statute and published regulations and
provide a copy of such to the domestic insurer. In all three states, control is
generally presumed to exist if any person, directly or indirectly, owns,
controls, holds
9
<PAGE> 11
with the power to vote or holds proxies representing 10% or more of the voting
securities of any other person.
In addition, many state insurance regulatory laws contain provisions that
require pre-notification to state agencies of a change in control of a
non-domestic admitted insurance company in that state. While such
pre-notification statutes do not authorize the state agency to disapprove the
change of control, such statutes do authorize issuance of a cease and desist
order with respect to the non-domestic admitted insurer if certain conditions
exist such as undue market concentration.
Any future transactions that would constitute a change in control of the
Company would also generally require prior approval by the Insurance
Departments of Michigan, Missouri and California and would require
pre-acquisition notification in those states which have adopted
pre-acquisition notification provisions and in which the insurers are
admitted. Such requirements may deter, delay or prevent certain transactions
that could be advantageous to the stockholders of the Company.
RESTRICTIONS ON DIVIDENDS AND RISK-BASED CAPITAL
The information required by this item is incorporated by reference to pages
25-27 and 44 of the Company's 1997 Annual Report to Shareholders.
EFFECT OF FEDERAL LEGISLATION
Although the federal government does not directly regulate the business of
insurance, federal initiatives often affect the insurance business in a
variety of ways. Current and proposed federal measures which may significantly
affect the insurance business include federal government participation in
asbestos and other product liability claims, pension regulation (ERISA),
examination of the taxation of insurers and reinsurers minimum levels of
liability insurance and automobile safety regulations.
NAIC-IRIS RATIOS
The NAIC's Insurance Regulatory Information System ("IRIS") was developed by a
committee of state insurance regulators and is primarily intended to assist
state insurance departments in executing their statutory mandates to oversee
the financial condition of insurance companies operating in their respective
states. IRIS identifies 11 industry ratios and specifies "usual values" for
each ratio. Departure from the usual values on four or more ratios generally
leads to inquiries from individual state insurance commissioners.
In 1997, Star had one ratio which varied from the "usual value" range as
follows:
For Star:
RATIO USUAL RANGE STAR VALUE
----------------------- ----------- ----------
Agents' balances / under 40 43
Surplus................
Star's "agents' balance to surplus ratio" was affected by increased gross
premium writings in the fourth quarter. In particular, two portfolio
transfers (novations) occurred in late 1997 and will be collected and
remitted to reinsurers in early 1998. Eliminating the effect of these
portfolio transfers, the agents' balance would have been 30, which puts Star
within the usual range.
10
<PAGE> 12
ITEM 2. PROPERTIES
The Company currently leases its corporate offices in Southfield, Michigan from
26600 Development Associates Limited Partnership. In 1996, the Company paid rent
in the amount of approximately $1,060,000. The term of the lease for the offices
in Southfield expires on September 30, 2004. The Company, through its
subsidiaries, is also a party to various leases for locations in which such
subsidiaries have offices. The Company does not consider any of these leases to
be material.
ITEM 3. LEGAL PROCEEDINGS
On June 26, 1995, two shareholders of a former agent of Star initiated legal
proceedings against, among others, Star and Meadowbrook. The plaintiffs have
requested injunctive relief, compensatory damages, punitive and exemplary
damages, and attorney's fees in an unspecified amount. The Nevada Insurance
Department revoked the license of the first plaintiff and denied further
licensing of the second plaintiff. The Company is vigorously defending itself
and has filed counterclaims against the plaintiffs. While the Company believes
that it has meritorious defenses and counterclaims in this lawsuit, there can be
no assurance that the Company's results of operations and financial condition
will not be materially adversely affected by this lawsuit. The ultimate outcome
of the lawsuit cannot be determined at this time, and the Company is unable to
estimate the range of possible loss, if any.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
The information required by this item is incorporated by reference to page 51 of
the Company's 1997 Annual Report to Shareholders.
ITEM 6. SELECTED FINANCIAL DATA
The information required by this item is incorporated by reference to page 28 of
the Company's 1997 Annual Report to Shareholders.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The information required by this item is incorporated by reference to pages
19-27 of the Company's 1997 Annual Report to Shareholders.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is incorporated by reference to pages
30-34 of the Company's 1997 Annual Report to Shareholders.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
11
<PAGE> 13
Not Applicable
PART III
Certain information required by Part III is omitted from this Report in that the
Registrant has filed a definitive proxy statement pursuant to Regulation 14A
(the "Proxy Statement") not later than 120 days after the end of the fiscal year
covered by this report and certain information included therein is incorporated
herein by reference. Only those sections of the Proxy Statement that
specifically address the items set forth herein are incorporated by reference.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is included under the caption "Directors
and Executive Officers" of the Company's Proxy Statement relating to the Annual
Meeting of Shareholders to be held on May 18, 1998, which is hereby incorporated
by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is included under the captions "Executive
Compensation", "Report of Compensation Committee on Executive Compensation" and
"Stock Performance Graph" of the Company's Proxy Statement relating to the
Annual Meeting of Shareholders to be held on May 18, 1998, which are hereby
incorporated by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
The information required by this item is included under the caption "Security
Ownership of Certain Beneficial Owners and Management" of the Company's Proxy
Statement relating to the Annual Meeting of Shareholders to be held on May 18,
1998, which is hereby incorporated by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
12
<PAGE> 14
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K
(A) The following documents are filed as part of this Report:
1. Financial Statements: The following Consolidated Financial Statements of
Meadowbrook Insurance Group, Inc., the accompanying Notes to Consolidated
Financial Statements and Report of Coopers & Lybrand L.L.P., Independent
Accountants, have been incorporated herein by reference in their entirety, from
pages 29-49 of the 1997 Annual Report to Shareholders:
Report of Coopers & Lybrand L.L.P., Independent Accountants
Consolidated Balance Sheet - December 31, 1997 and 1996
Consolidated Statement of Income - Fiscal Years Ended December 31, 1997, 1996
and 1995
Consolidated Statement of Shareholders' Equity - Fiscal Years Ended December 31,
1997, 1996 and 1995
Consolidated Statement of Cash Flows - Fiscal Years Ended December 31, 1997,
1996 and 1995
Notes to Consolidated Financial Statements
2. Report of Independent Accountants on Financial Statement
Schedule Listed Under 14(a)3 of this Form 10-K (attached on pg. 17)
3. Financial Statement Schedule
Schedule II Condensed Financial Information of Registrant (attached on
pg. 18-20)
Schedules not listed above have been omitted because they are not applicable or
are not required or the information required to be set forth therein is included
in the Consolidated Financial Statements and Notes thereto.
4. Exhibits The Exhibits listed on the accompanying Index to Exhibits
immediately following the financial statement schedule are filed as part of, or
incorporated by reference into, this Form 10-K.
13
<PAGE> 15
INDEX TO EXHIBITS
Exhibit
No. Description Filing Basis
- ------- ----------- ------------
3.1 Articles of Incorporation of the Company, including
Certificate of Amendment to the Articles of
Incorporation. *
3.2 Bylaws of the Company. *
10.1 Employment Agreement between the Company and
James R. Parry, Sr. ("Parry") dated January 1, 1993. *
Exhibit
No. Description Filing Basis
- ------- ----------- ------------
10.2 Management Services Agreement among the Company,
Star, Savers and Meadowbrook dated January 1, 1993. *
10.3 Meadowbrook Insurance Group, Inc. 1995 Stock Option Plan. *
10.4 Lease between Meadowbrook and 26600 Development
Associates Limited Partnership, with fourth amendment to
lease dated March 21, 1995. *
10.5 Fifth and sixth Amendments to Lease between Meadowbrook
and 26600 Development Associates Limited Partnership
dated August 7, 1995 and May 13, 1996. *
10.6 Meadowbrook, Inc. 401(k) Profit Sharing Plan Trust,
amended and restated December 31, 1994. *
10.7 Employment Agreement, Covenant Not to Compete and
Restricted Stock Agreement dated as of August 1, 1995
between Meadowbrook and Robert A. Engle. *
10.8 Employment Agreement, Covenant Not to Compete and
Restricted Stock Agreement dated as of August 1, 1995
between Meadowbrook and Robert A. Engle, Amendment. *
10.9 Stock Purchase Agreement dated August 1, 1995 among the
Company , Robert A. Engle, Trustee of the Robert A. Engle
Revocable Trust dated November 24, 1993, Merton J. Segal
and certain other employees of the Company. *
10.10 Stock Purchase Agreement dated August 1, 1995 among the
Company , Robert A. Engle, Trustee of the Robert A. Engle
Revocable Trust dated November 24, 1993, Merton J. Segal
and certain other employees of the Company, Amendment. *
11 Statement re computation of per share earnings. Pg. 21
13 1997 Annual Report to Shareholders. Pg. 22-75
21 List of Subsidiaries. Pg. 76
14
<PAGE> 16
23 Consent of Independent Accountants Pg. 77
24 Power of attorney. Pg. 78
27 Financial Data Schedule. Pg. 79
28.1 Star Insurance Company's 1997 Schedule P. Pg. 80 - 131 **
28.2 Savers Property & Casualty Insurance Company's 1997
Schedule P. Pg. 132 - 187**
28.3 Williamsburg National Insurance Company's 1997
Schedule P. Pg. 188 - 244**
(*) Incorporated by reference to Form S-1 Registration
Statement (No. 33-2626206) of Meadowbrook
Insurance Group, Inc. declared effective November 20, 1995.
(**) Submitted in paper format under separate cover; see Form SE filing.
(B) REPORTS ON FORM 8-K
No reports on Form 8-K were filed by the Registrant during the year ended
December 31, 1997.
15
<PAGE> 17
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the Registrant has duly caused this Report to be signed
on its behalf by the undersigned, thereunto duly authorized, in Southfield,
Michigan, on March 26, 1998.
MEADOWBROOK INSURANCE GROUP, INC.
By: **
------------------------------------
Merton J. Segal
Chairman and Chief Executive Officer
(Principal Executive Officer)
By:/s/ Daniel G. Gibson
------------------------------------------
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
Dated: March 26, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacity and on the dates indicated.
Signature Title Date
- --------- ----- ----
** Chairman, Chief Executive Officer and March 26, 1998
- ---------------------- Director (Principal Executive Officer)
Merton J. Segal
** Vice Chairman and Director March 26, 1998
- ----------------------
Warren D. Gardner
/s/ Robert S. Cubbin Office of the President, Secretary March 26, 1998
- ---------------------- and Director
Robert S. Cubbin
** Office of the President, Treasurer March 26, 1998
- ---------------------- and Director
Joseph C. Henry
** Office of the President, March 26, 1998
- ---------------------- Chief Marketing Officer and Director
James R. Parry, Sr.
** Director March 26, 1998
- ----------------------
Bruce E. Thal
** Director March 26, 1998
- ----------------------
Hugh W. Greenberg
** By: /s/ Robert S. Cubbin
----------------------
Robert S. Cubbin, Attorney-in-fact
16
<PAGE> 18
[LETTERHEAD OF COOPERS & LYBRAND]
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
Meadowbrook Insurance Group, Inc.
We have audited the consolidated financial statements of Meadowbrook Insurance
Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and for each of
the three years in the period ended December 31, 1997, which financial
statements are included on pages 30 through 49 of the 1997 Annual Report to
Shareholders of Meadowbrook Insurance Group, Inc. and Incorporated by reference
herein. We have also audited the financial statement schedule listed under
Item 14(A)3 of this Form 10-K. These financial statements and financial
statement schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Meadowbrook
Insurance Group, Inc. and Subsidiaries as of December 31, 1997 and 1996, and the
consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles. In addition, in our opinion, the
financial statement schedule referred to above, when considered in relation to
the basic financial statements taken as a whole, presents fairly, in all
material respects, the information required to be included therein.
COOPERS & LYBRAND LLP
Detroit, Michigan
March 19, 1998
17
<PAGE> 19
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
INCOME STATEMENT
For the years ended December 31,
-------
<TABLE>
<CAPTION>
1997 1996 1995
----------- ----------- -----------
<S> <C> <C> <C>
Revenue: $ 23,970 $ 275,740 $ 129,376
Operating expenses:
Interest expense 370,875 -- 316,175
Other expenses 488,274 350,849 109,770
----------- ----------- -----------
Total Operating Expenses 859,149 350,849 425,945
----------- ----------- -----------
Loss before federal income taxes (835,179) (75,109) (296,569)
Federal income tax benefit (293,955) (41,940) (100,834)
----------- ----------- -----------
Net loss before subsidiary equity (541,224) (33,169) (195,735)
earnings ----------- ----------- -----------
Subsidiary equity earnings 13,583,680 8,739,193 7,415,605
----------- ----------- -----------
Net Income $13,042,456 $ 8,706,024 $ 7,219,870
=========== =========== ===========
</TABLE>
18
<PAGE> 20
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
BALANCE SHEET
As of December 31, 1997 and 1996
-------
<TABLE>
<CAPTION>
1997 1996
------------- -------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 64,996 $ 1,056,424
Investment in subsidiaries 114,837,287 91,772,990
Receivables from subsidiaries 6,894,567 6,975,678
Intangible assets 3,073,693
Other assets 521,303 639,376
------------- -------------
Total Assets $ 125,391,846 $ 100,444,468
============= =============
LIABILITIES
Other liabilities $ 305,933 $ 243,634
Line of credit 9,639,507 --
------------- -------------
Total Liabilities 9,945,440 243,634
SHAREHOLDERS' EQUITY
Common Stock 86,602 86,493
Additional paid in capital 72,650,671 72,873,396
Retained earnings 39,730,884 27,381,111
Unrealized appreciation (depreciation) on
available for sale securities 2,978,249 (140,166)
------------- -------------
Total Shareholders' Equity 115,446,406 100,200,834
------------- -------------
Total Liabilities and Shareholders' Equity $ 125,391,846 $ 100,444,468
============= =============
</TABLE>
19
<PAGE> 21
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
MEADOWBROOK INSURANCE GROUP, INC.
PARENT COMPANY ONLY
STATEMENT OF CASH FLOWS
For the years ended December 31,
-------
<TABLE>
<CAPTION>
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Net cash provided by (used in)
operating activities: $ 445,015 $ (6,145,849) $ (718,847)
------------ ------------ ------------
Cash Flow from Investing Activities:
Investment in subsidiaries (9,513,711) -- (32,504,672)
------------ ------------ ------------
Net cash used in
investing activities: (9,513,711) -- (32,504,672)
------------ ------------ ------------
Cash Flows from Financing Activities:
Proceeds from borrowings 11,139,507 -- --
Principal payments on borrowings (2,146,940) -- (3,500,000)
Additional expenses from IPO -- (221,018) --
Dividends paid on common stock (692,683) (517,797) --
Retirement of common stock (222,616) (470,370) (27,655)
Issuance of common stock -- 318,739 44,242,503
------------ ------------ ------------
Net cash (used in) provided by
financing activities: 8,077,268 (890,446) 40,714,848
------------ ------------ ------------
Increase/(decrease) in cash and
cash equivalents (991,428) (7,036,295) 7,491,329
Cash and cash equivalents,
beginning of year 1,056,424 8,092,719 601,390
------------ ------------ ------------
Cash and cash equivalents
end of year $ 64,996 $ 1,056,424 $ 8,092,719
============ ============ ============
</TABLE>
20
<PAGE> 1
EXHIBIT 11
MEADOWBROOK INSURANCE GROUP, INC. AND SUBSIDIARIES
COMPUTATION OF PER SHARE EARNINGS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Basic:
Weighted average shares outstanding 8,657,677 8,630,150 4,970,626
Diluted:
Weighted average shares outstanding 8,657,677 8,630,150 4,970,626
Common stock equivalents 519,077 554,122 494,310
----------- ----------- -----------
9,176,754 9,184,272 5,464,936
=========== =========== ===========
Income before extraordinary item and
preferred dividend requirement $13,042,456 $ 8,706,024 $ 7,219,870
Preferred dividend requirement -- -- --
----------- ----------- -----------
Income applicable to common shareholders
and before extraordinary item $13,042,456 $ 8,706,024 $ 7,219,870
Extraordinary item -- -- --
----------- ----------- -----------
Net income applicable to common
shareholders $13,042,456 $ 8,706,024 $ 7,219,870
=========== =========== ===========
Earnings per share:
Basic -
Net income before extraordinary item $ 1.51 $ 1.01 $ 1.45
Extraordinary item -- -- --
Net income 1.51 1.01 1.45
Diluted -
Net income before extraordinary item 1.42 .95 1.32
Extraordinary item -- -- --
Net income 1.42 .95 1.32
</TABLE>
21
<PAGE> 1
EXHIBIT 13
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
Meadowbrook Insurance Group, Inc. (the "Company") provides alternative risk
management programs and services primarily to industry, public entities, and
trade/professional groups. Revenues are generated from four principal sources:
fees from program management services, commissions earned on insurance placed by
a subsidiary with other carriers, earned insurance premiums, and investment
income. The subsidiaries of the Company that provide these services are Star
Insurance Company ("Star"), Savers Property and Casualty Insurance Company
("Savers"), Crest Financial Corporation ("Crest") and its wholly owned insurer
Williamsburg National Insurance Company ("Williamsburg"), American Indemnity
Insurance Company, Ltd. ("American Indemnity"), Association Self Insurance
Services, Inc. ("ASI") and Meadowbrook, Inc. ("Meadowbrook"), the risk
management company.
Through these subsidiaries the Company develops programs, which are customized
packages of services or coverages marketed to the group's members. The programs
are categorized by the level of risk assumed by the Company. In managed
programs, the Company usually assumes no insurance risk and generates fee
revenue through program management services. In risk-sharing programs, the
Company participates with the client or producing agent in the operating results
of the programs through a captive, retrospectively-rated program, or a
contingent commission. In fully-insured programs, the Company provides
traditional insurance without a risk-sharing mechanism and derives revenue
exclusively from earned premiums and investment income. Fully-insured programs
are developed only in response to a specific market opportunity and generally
when the Company believes there is potential to develop a long-term risk-sharing
partnership in the future.
The Company's major insurance subsidiaries, Star, Savers and Williamsburg, issue
insurance policies for both risk-sharing and fully-insured programs. These
companies are complimented by American Indemnity, which offers clients a
rent-a-captive vehicle for risk-sharing programs.
Managed programs and agency activities are provided through Meadowbrook, the
Company's risk management subsidiary. Meadowbrook was acquired by the Company in
November of 1995. Prior to its acquisition, it was an affiliated company. Fee
and commission revenues are generated through Meadowbrook and Crest Financial
Services primarily from the following sources: retail insurance agency
commissions, program management fees, claims handling and administration fees,
loss prevention and control fees, and reinsurance brokerage commissions.
Management fee revenue is also generated from the following services: program
design and implementation, sales and marketing to members of a client group,
captive formation and management, underwriting/risk selection, accounting and
financial statement preparation, regulatory compliance, actuarial and loss
reserve analysis. In addition to providing services to outside clients,
Meadowbrook also provides services to the Company's insurance subsidiaries which
include the management of their insurance operations.
The Company acquired ASI of Montgomery, Alabama in November of 1996. The
acquisition was not material to the Company's results of operations. ASI is a
full service risk-management operation focused on pools and funds whose services
include claims, loss control, managed care, and policy issuance. ASI's
operations were consolidated with the Company's existing operations in
Montgomery, Alabama.
In December of 1996, the Company entered into a five-year joint underwriting
agreement with Connecticut Surety Corporation. The agreement provides for the
transfer of the underwriting risk on the majority of the Company's existing
surety bond business. In addition, Star will continue to write new surety
business, utilizing its capital and licenses, and Connecticut Surety will manage
the operations and assume the risk. This arrangement substantially reduces the
Company's underwriting risk exposure while creating a five year fee arrangement.
This enables the Company to refocus its efforts on its core business,
alternative risk management.
19
<PAGE> 2
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
In July of 1997, the Company acquired Crest, a California based holding company
which owns 100% of Williamsburg, an insurance carrier, and Crest Financial
Services, a risk management service company. Crest provides these services
primarily to the trucking industry within California.
Management's discussion and analysis is presented on an actual and pro forma
basis for the year ended December 31, 1995. The data presented on an actual
basis, for 1995, reflects consolidated operations with Meadowbrook only for the
brief period from the date of acquisition (November 20, 1995) through year-end.
The pro forma financial information for 1995 is based on a consolidation of
operations, assuming that Meadowbrook had been a wholly-owned subsidiary for the
entire year ended December 31, 1995.
RESULTS OF OPERATIONS
<TABLE>
<CAPTION>
PRO
ACTUAL FORMA CHANGE 97 VS. 96 CHANGE 96 VS. 95
---------------------------------------------------------------------------
(In thousands, except %'s) 1997 1996 1995 $ % $ %
---------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Total revenues $101,125 $109,189 $103,349 $ (8,064) (7.4%) $ 5,840 5.7%
Total expenses 83,739 98,321 90,179 (14,582) (14.8%) 8,142 9.0%
---------------------------------------------------------------------------
Income before taxes 17,386 10,868 13,170 6,518 60.0% (2,302) (17.5%)
Income taxes 4,343 2,162 3,495 2,181 100.9% (1,333) (38.1%)
---------------------------------------------------------------------------
Net Income $ 13,043 $ 8,706 $ 9,675 $ 4,337 49.8% $ (969) (10.0%)
---------------------------------------------------------------------------
<CAPTION>
PRO
ACTUAL FORMA CHANGE 97 VS. 96 CHANGE 96 VS. 95
---------------------------------------------------------------------------
(In thousands, except %'s) 1997 1996 1995 $ % $ %
---------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Total revenues $101,125 $109,189 $ 89,974 $ (8,064) (7.4%) $ 19,215 21.4%
Total expenses 83,739 98,321 80,486 (14,582) (14.8%) 17,835 22.2%
---------------------------------------------------------------------------
Income before taxes 17,386 10,868 9,488 6,518 60.0% 1,380 14.5%
Income taxes 4,343 2,162 2,268 2,181 100.9% (106) (4.7%)
---------------------------------------------------------------------------
Net Income $ 13,043 $ 8,706 $ 7,220 $ 4,337 49.8% $ 1,486 20.6%
---------------------------------------------------------------------------
</TABLE>
Net income in 1997 increased $4.3 million, or 49.8%, from $8.7 million in 1996
to $13.0 million in 1997. The increase in net income primarily reflects overall
growth from our fee-based risk management operations as well as profitable
underwriting results from our core program business. Total revenues decreased
$8.1 million, or 7.4%, while total expenses decreased $14.6 million, or 14.8%.
The decrease in expenses primarily relates to an increase in ceding commissions
of $7.3 million, or 49.3%, decrease in overall acquisition costs of $5.8
million, or 49.0%, associated with the transfer of the surety bond program, as
well as overall savings in administrative costs.
Net income in 1996 decreased $1.0 million, or 10.0%, from the pro forma net
income of $9.7 million in 1995. Net earned premiums increased $1.8 million, or
2.2%, over the prior year. Net investment income increased by $2.4 million, or
41.8%, in 1996 due to a full year's earnings on invested proceeds from the
Company's initial public offering. Salaries and employee benefits increased by
$5.0 million in 1996 as a result of additional new full-time employees. Other
operating expenses increased $4.2 million due to investments in new programs.
20
<PAGE> 3
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
REVENUE
<TABLE>
<CAPTION>
PRO
ACTUAL FORMA CHANGE 97 VS. 96 CHANGE 96 VS. 95
------------------------------------------------------------------------
(In thousands, except %'s) 1997 1996 1995 $ % $ %
------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Net earned premium $ 68,493 $ 84,547 $ 82,698 $(16,054) (19.0%) $ 1,849 2.2%
Net commissions & fees 24,360 16,566 14,955 7,794 47.0% 1,611 10.8%
Investment & misc. income 8,272 8,076 5,696 196 2.4% 2,380 41.8%
------------------------------------------------------------------------
Total Revenue $101,125 $109,189 $103,349 $ (8,064) (7.4%) $ 5,840 5.7%
------------------------------------------------------------------------
<CAPTION>
PRO
ACTUAL FORMA CHANGE 97 VS. 96 CHANGE 96 VS. 95
------------------------------------------------------------------------
(In thousands, except %'s) 1997 1996 1995 $ % $ %
------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Net earned premium $ 68,493 $ 84,547 $ 82,698 $(16,054) (19.0)% $ 1,849 2.2%
Net commissions & fees 24,360 16,566 1,886 7,794 47.0% 14,680 778%
Investment & misc. income 8,272 8,076 5,390 196 2.4% 2,686 49.8%
------------------------------------------------------------------------
Total Revenue $101,125 $109,189 $ 89,974 $ (8,064) (7.4%) $ 19,215 21.4%
------------------------------------------------------------------------
<CAPTION>
The Company's written and earned premium were as follows:
YEARS ENDED DECEMBER CHANGE 97 VS. 96 CHANGE 96 VS. 95
---------------------------------------------------------------------------
(In thousands, except %'s) 1997 1996 1995 $ % $ %
---------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Gross written premium $146,739 $115,580 $123,119 $ 31,159 27.0% $ (7,539) (6.1%)
Net written premium 74,965 72,758 93,638 2,207 3.0% (20,880) (22.3%)
Net earned premium 68,493 84,547 82,698 (16,054) (19.0%) 1,849 2.2%
</TABLE>
Gross written premium increased by $31.2 million, or 27.0%, to $146.7 million in
1997 from $115.6 million in 1996. The increase reflects growth in existing
business of $13.2 million and new programs totaling $31.1 million. This growth
was somewhat offset by the discontinuation of other programs in prior years. The
growth in existing business reflects a full year of premium writings in programs
initiated in 1996, assumed business, and expansion into additional states. The
increase in new business reflects the addition of twelve new programs in 1996,
and $3.7 million from premiums produced by Williamsburg.
Net written premium increased by $2.2 million, or 3.0%, to $75.0 million in 1997
from $72.8 million in 1996. The disproportionate growth between gross written
and net written resulted from higher participation by risk sharing clients, new
policy issuance services, and the transfer of the surety bond program in
December 1996.
Net earned premiums decreased by $16.1 million, or 19.0%, to $68.5 million in
1997 from $84.5 million in 1996. This decrease reflects the impact of the
discontinuation of the surety bond program in December 1996 and offset by growth
in our core program business.
Gross written premium decreased by $7.5 million, or 6.1%, to $115.6 million in
1996 from $123.1 million in 1995. This decrease reflects favorable claims
experience in three of our retrospectively rated (retro) programs, changes in
residual market program assessments, and discontinued and downsized programs
which the Company deemed unprofitable. These factors were offset by growth in
our core program business from both new programs and cross-selling products in
existing programs.
Net written premium decreased by $20.9 million, or 22.3%, to $72.8 million in
1996 from
21
<PAGE> 4
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
$93.6 million in 1995. The disproportionate growth between gross written and net
written resulted from higher participation by risk sharing clients as well as
the transfer of the unearned premium on the Surety Bond business to Connecticut
Surety which decreased net written premiums by $11.9 million.
Net earned premium increased by $1.8 million, or 2.2%, to $84.5 million in 1996
from $82.7 in 1995, due principally to growth in existing and new programs, and
premiums from the Surety Bond program. Offsetting these increases were the
decreases in earned premium corresponding to the retrospectively-rated programs,
residual markets, and discontinued programs.
Net Commissions and Fees. Net commissions and fees for Meadowbrook increased by
$7.8 million, or 47.0%, from $16.6 million in 1996 to $24.4 million in 1997. Net
commission and fees, on a pro forma basis, increased by $1.6 million, or 10.8%,
to $16.6 million in 1996 from $15.0 million in 1995. Commissions and fees are
derived from managed programs and the retail insurance agency operations and
consist of the following:
<TABLE>
<CAPTION>
PRO
ACTUAL FORMA
---------------------------------
(In thousands) 1997 1996 1995
---------------------------------
<S> <C> <C> <C>
Management fees $ 6,799 $ 5,822 $ 5,490
Claims fees 8,155 3,720 2,332
Loss control fees 1,168 1,390 1,413
Reinsurance brokerage 560 797 906
Miscellaneous fees and charges 8 23 7
---------------------------------
Total Risk Management Fees 16,690 11,752 10,148
Agency and sales commissions 7,670 4,814 4,807
---------------------------------
Net Commissions and Fees $24,360 $16,566 $14,955
---------------------------------
</TABLE>
Net commissions and fees increased $7.8 million, or 47.0%, during 1997. The
increase in Risk Management fees of $4.9 million primarily reflects additional
management fees of $1.3 million and ASI claims fees of $3.2 million. The
remaining increase resulted from Crest management fees of $0.5 million. The
increase in Agency and sales commissions reflect additional commissions from
Crest Financial of $2.1 million. The remaining increase resulted from growth in
our core programs.
Net commissions and fees increased $1.6 million during 1996. Management fees
increased 6.0%, or $0.3 million, due to fee increases for existing programs and
fees from newly formed captives. Claims fees increased 59.5%, or $1.4 million,
due to the two months of revenue generated from ASI, additional claim handling
services provided to an existing client, and fee increases to existing programs.
Agency and sales commissions were unchanged from the prior year.
Net Investment Income. Net investment income increased $0.2 million in 1997, or
2.4%, to $8.3 million from $8.1 million in 1996 and $2.4 million in 1996, or
41.8%, from 1995, on a pro forma basis. The increase in investment income in
1996 was primarily the result of growth in cash and invested assets related to
$43.8 million in new capital raised through the initial public offering at the
end of November 1995. The pre-tax weighted average yield on invested assets was
5.4% in 1997, and 5.3% in both 1996 and 1995. The Company's investment
philosophy is one of maximizing after-tax earnings through significant
investments in tax-exempt bonds. Accordingly, the weighted average yield on
invested assets on an after-tax basis was 4.7% in both 1997 and 1996 and 4.5%
for 1995.
22
<PAGE> 5
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
EXPENSES
Total expenses decreased by $14.6 million, or 14.8%, to $83.7 million in 1997
from $98.3 million in 1996 and increased, on a pro forma basis, by $8.1 million,
or 9.0%, to $98.3 million in 1996 from $90.2 million in 1995. Total expenses on
an actual basis increased $17.8 million, or 22.2%, to $98.3 million in 1996 from
$80.5 million in 1995. The expenses are as follows:
<TABLE>
<CAPTION>
PRO
ACTUAL FORMA ACTUAL
-----------------------------------------------------------------
(In thousands) 1997 1996 1995 1997 1996 1995
-----------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Net Losses & LAE:
Other than surety $ 31,558 $ 32,971 $ 36,089 $ 31,558 $ 32,971 $ 38,231
Surety business 4,585 8,294 5,584 4,585 8,294 5,564
Salaries and benefits 27,416 24,977 20,001 27,416 24,977 2,629
Interest 649 -- 576 649 --
341
Other operating expenses:
Expenses other than surety 20,910 21,962 18,095 20,910 21,962 23,921
Surety bond expenses (1,379) 10,117 9,834 (1,379) 10,117 9,800
-----------------------------------------------------------------
Total expenses $ 83,739 $ 98,321 $ 90,179 $ 83,739 $ 98,321 $ 80,486
-----------------------------------------------------------------
</TABLE>
NET LOSSES AND LOSS ADJUSTMENT EXPENSES (LAE)
Net losses and LAE incurred decreased by $5.1 million, or 12.4%, to $36.1
million in 1997 from $41.3 million in 1996, and decreased on a pro forma basis
by $0.4 million, or 1.0%, to $41.3 million for 1996 from $41.7 million for 1995.
Analysis of losses and LAE utilizing insurance ratios, on an overall and
non-surety basis, are reflected below.
The GAAP loss and LAE ratio was 55.7% and 52.1% in 1997 and 1996, respectively,
a 3.6 point change. On a pro forma basis, as if the Connecticut Surety
reinsurance ceding arrangement on the surety program had occurred at the
beginning of 1996, the GAAP loss and LAE ratio would have been 56.3% in 1996.
This change reflects favorable claims experience primarily in workers
compensation based programs and residual markets. This favorable experience was
somewhat offset by adverse development relating to the run-off of the surety
bond program which added 3.3 points in 1997.
The GAAP loss and LAE was 52.1% and 53.2% in 1996 and 1995, respectively, a one
point improvement. The major reason for the decline in 1996 was the reduction in
residual market participation, due to the shrinking size of the involuntary
pools. The GAAP loss and LAE ratio for non-surety business also improved one
point to 56.4% in 1996 from 57.4% in 1995. The decrease in the GAAP loss and LAE
ratio for non-surety business is also a result of the reduction in the residual
market assessments.
SALARIES AND EMPLOYEE BENEFITS
Salaries and employee benefits increased by $2.4 million, or 9.8%, to $27.4
million in 1997 compared to $25.0 million in 1996. This increase reflects
additional 1997 salary and employee expenses of $3.3 million from Crest and ASI
and somewhat offset by a reduction in surety department salaries due to the
Connecticut Surety arrangement. The average salaries and wages per associate in
1997 remained relatively consistent with 1996.
Salaries and employee benefits increased by $5.0 million, or 24.9%, to $25.0
million in 1996 compared to $20 million in 1995, on a pro forma basis, as a
result of additional new full-time
23
<PAGE> 6
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
employees. A major reason for this was the expansion of the bond operation that
began in mid-1995. Bond salary expense includes an entire twelve months of
expense in 1996 versus only six months in 1995. Marketing and other departments
grew to accommodate pending growth from several large new programs that were
under development during the year. The average salaries and wages per associate
in 1996 remained relatively consistent with 1995.
INTEREST EXPENSE
Interest expense of $649,000 and $576,000 for 1997 and 1995, respectively,
relates to the use of the Company's line of credit. There was no interest
expense recorded during 1996, as all debt was retired with the proceeds of the
initial public offering.
OTHER OPERATING EXPENSES
Other operating expenses from the non-surety business decreased $1.1 million, or
4.8%, to $20.9 million in 1997 from $22.0 million in 1996. This decrease
reflects a $3.3 million increase in ceding commission on risk sharing and
fronted programs, reduction in technology costs incurred in 1996 and overall
savings in administrative costs related to management's efforts to increase
operating efficiencies. These reductions were offset by incremental costs of
$3.1 million incurred by ASI and Crest in 1997.
Other operating expenses from the non-surety business increased $3.9 million, or
21.4%, to $22.0 million in 1996 from $18.1 million in 1995, on a pro forma
basis. This increase reflects 1996 consulting fees incurred in connection with
systems technology studies to assess the capabilities of, and set the future
direction for upgrades to, major operating systems. The remaining increase
reflects investments to build the Company's infrastructure to accommodate the
development of two large programs and other future growth.
Other operating expense from the surety business decreased $11.5 million to
($1.4) million in 1997 from $10.1 million in 1996. This decrease reflects the
run-off of the surety business and the increase in ceding commissions.
Other operating expense from the surety business increased $ 0.3 million to
$10.1 million in 1996 from $9.8 million in 1995, on a pro forma basis. The
increase reflects the amortization of deferred acquisition cost which was mostly
offset by ceding commission associated with the surety bond program transfer.
Other operating expenses, on an actual basis, decreased by $1.6 million in 1996,
or 4.9%, from $33.7 million in 1995. The decrease reflects an unusual charge-off
of an uncollectible premium receivable in 1995. In addition, the 1995 expenses
include management fees paid by the insurance subsidiaries to Meadowbrook prior
to its acquisition in November of 1995.
TAXES
The provision for income taxes on an actual basis was $4.3 million in 1997, $2.2
million in 1996, and $2.3 million in 1995, representing effective tax rates of
25.0%, 19.9%, and 23.9% in 1997, 1996, 1995, respectively. The tax rates were
significantly lower than the 34% corporate rate due to the Company's heavily
tax-exempt investment portfolio.
The increase in the effective tax rate in 1997 reflects the higher proportion of
underwriting and risk management service income in relation to net investment
income.
On a pro forma basis, the tax provision was $3.5 million in 1995, representing
an effective tax
24
<PAGE> 7
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
rate of 26.5%. The higher effective tax rate over the actual rate was due to
increased taxable income generated from Meadowbrook's risk-management
operations.
LIQUIDITY AND CAPITAL RESOURCES
The principal sources of funds for the Company are insurance premiums,
investment income, proceeds from the maturity and sale of invested assets, risk
management fees and agency commissions. Funds are primarily used for the payment
of claims, commissions, salaries and employee benefits, and other operating
expenses. In addition, the Company has a high volume of intercompany
transactions due to the payment of management fees by the insurance subsidiaries
to the risk management subsidiaries. Such fees are subject to regulatory
approval by state insurance departments.
Cash flow (used by) from operations for 1997 was ($1.7) million as compared to
$11.6 million for 1996, and $25.0 million for 1995. The reduced cash from
operations in 1997 and 1996 reflect significant written, but uncollected,
premiums in the fourth quarter of 1997, the transfer of the surety bond program
to Connecticut Surety and the payment of claims associated with the run-off of
the surety bond program. The Company held $20.2 million in cash and cash
equivalents at December 31, 1997.
The Company has one unsecured line of credit totaling $15.0 million, of which
$10.3 was outstanding at December 31, 1997. The line expires on January 1, 2000.
The Company drew on this line of credit to meet cash flow needs, primarily to
consummate the acquisitions of both Crest and ASI and to settle claims on surety
and other discontinued programs. The Company had no debt outstanding during
1996.
The Company raised additional capital through an initial public offering in
November 1995, which generated net proceeds of $43.6 million.
As of December 31, 1997 and 1996, the recorded values of the Company's
investment portfolio, including cash and cash equivalents, were $167.3 million
and $156.5 million, respectively. The Company's investment portfolio consists
primarily of tax-exempt fixed income securities of varying maturities. In the
third quarter of 1997, the Company revised its investment policy to account for
its debt securities as available for sale which reflect industry practice. Also,
in the third quarter of 1997, the Company sold securities that had been
classified as held to maturity for the purpose of generating taxable realized
gains to utilize the tax loss carryforwards which expire in 1997 and for other
short-term operating needs. The Company has reclassified the remaining held to
maturity securities to the available for sale category.
Shareholders' equity was $115.4 million, or $13.33 per common share, at December
31, 1997, compared to $100.2 million at December 31, 1996, or $11.58 per common
share. Shareholders' equity reflects the increase of $3.1 million in the fair
values of available-for-sale debt and equity securities. Changes in
shareholders' equity related to the unrealized values of underlying portfolio
investments will continue to be volatile as market prices of debt securities
fluctuate with changes in the interest rate environment.
The insurance subsidiaries are required to maintain certain deposits with
regulatory authorities which totaled $17.6 million at December 31, 1997, and
$16.0 million at December 31, 1996.
REGULATORY ISSUES
Insurance operations are subject to various leverage tests (e.g. premium to
statutory surplus ratios) which are evaluated by regulators and rating agencies.
The Company seeks to maintain a ratio of consolidated gross written premium to
statutory surplus at or below 3 to 1 and a
25
<PAGE> 8
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
ratio at or below 2 to 1 on a net written premium basis. For 1997, premium
leverage ratios were 1.9 to 1 and 1.0 to 1 on a gross and net premium written
basis, respectively.
The National Association of Insurance Commissioners ("NAIC") has adopted a
risk-based capital ("RBC") formula to be applied to all property and casualty
insurance companies. The formula measures required capital and surplus based on
an insurance company's products and investment portfolio and is to be used as a
tool to identify weakly capitalized companies. At December 31, 1996, Star
Insurance Company, the parent insurance company had an RBC ratio that exceeded
applicable risk-based capital requirements. At December 31, 1997, Star's
statutory surplus was $70.0 million; the threshold requiring regulatory
involvement was $9.2 million.
REINSURANCE CONSIDERATIONS
The Company seeks to manage the risk exposure of its insurance subsidiaries and
its clients through the purchase of excess-of-loss and quota share reinsurance.
The Company's reinsurance requirements are analyzed on a specific program basis
to determine the appropriate retention levels and reinsurance coverage limits.
The Company secures this reinsurance based on the availability, cost, and
benefits of various reinsurance alternatives.
Reinsurance does not legally discharge an insurer from its primary liability for
the full amount of risks assumed under insurance policies it issues, but it does
make the assuming reinsurer liable to the insurer to the extent of the
reinsurance ceded. Therefore, the Company is subject to credit risk with respect
to the obligations of its reinsurers. In its selection of reinsurers, the
Company evaluates the financial stability of its prospective reinsurers. To
date, the Company has not experienced any material difficulties in collecting
reinsurance recoverables. No assurance can be given, however, regarding the
future ability of any of the Company's reinsurers to meet their obligations. The
following table sets forth certain information relating to the Company's five
largest reinsurers (other than client captive quota-share reinsurers) as of
December 31, 1997:
<TABLE>
<CAPTION>
Reinsurance Premium Ceded A.M. Best
REINSURER December 31, 1997 Rating
(in thousands)
-----------------------------------------
<S> <C> <C>
Connecticut Surety Company / NAC Re $19,213 * / A+
Swiss Reinsurance Corporation 6,536 A
Employers Reinsurance Corporation 3,733 A++
Lloyds of London Syndicate Number 314 585 A
Lloyds of London Syndicate Number 205 488 A
</TABLE>
* Not rated
In its risk-sharing programs, the Company is also subject to credit risk with
respect to the payment of claims by its clients' captive insurers on the portion
of risk exposure ceded to such captives. The capitalization and credit
worthiness of prospective captive insurers is one of the factors considered by
the Company in entering into and renewing risk-sharing programs. The Company
secures reinsurance balances due from its non-admitted reinsurers through funds
withheld trusts and letters of credit.
DEPENDENCE ON KEY PROGRAMS
The Company provides alternative risk management programs and services to
certain large client groups and associations and then markets them to their
individual members. In 1997, and in 1996, the Company's top four programs,
excluding the surety bond business, accounted for 46% and 37%, respectively, of
the Company's total revenue on an actual basis. The loss
26
<PAGE> 9
Meadowbrook Insurance Group, Inc.
Management's Discussion & Analysis
or cancellation of any of the Company's significant programs by the relevant
client groups, or the general availability of commercial market coverage to
members of such groups on more favorable terms than provided under the Company's
programs, could have an adverse effect on the Company's results of operations.
NEW ACCOUNTING PRONOUNCEMENTS
In June of 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income", and SFAS No. 131, "Disclosure about
Segments of an Enterprise and Related Information." SFAS No. 130 establishes
standards for reporting and display of comprehensive income and its components
(revenues, expenses, gains, and losses) in a full set of general-purpose
financial statements. SFAS No. 131 establishes standards for the way that public
business enterprises report information about operating segments in annual
financial statements. It also requires companies to report selected information
about operating segments in interim financial reports issued to shareholders.
These standards will be adopted January 1, 1998 and are not expected to have a
material effect on the Company's financial statements.
27
<PAGE> 10
Meadowbrook Insurance Group, Inc.
Selected Consolidated Financial Data
FOR THE YEARS ENDED DECEMBER 31,
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
--------------------------------------------------------------
(in thousands, except per share and ratio data)
<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Gross written premium $ 146,739 $ 115,580 $ 123,119 $ 90,625 $ 64,816
Net written premium 74,965 72,758 93,638 57,555 39,452
Net earned premium 68,493 84,547 82,698 49,855 34,336
Net investment income 8,128 8,002 5,325 3,257 2,639
Net realized gain (loss) on investments 134 25 45 (35) (24)
Total revenue 101,125 109,189 89,974 53,155 36,911
Net losses and LAE 36,143 41,265 43,795 30,956 23,297
Policy acquisition and other expenses 20,180 32,079 33,721 16,950 10,527
Income before income taxes 17,386 10,868 9,488 4,867 2,642
Net income 13,043 8,706 7,220 3,702 2,105
Earnings per share - Diluted $1.42 $0.95 $1.32 $0.95 $0.54
Dividends declared per share $0.08 $0.08 -- -- --
BALANCE SHEET DATA:
Total investments and
cash and cash equivalents $ 167,293 $ 156,495 $ 148,977 $ 88,460 $ 58,418
Total assets 328,642 265,035 241,764 158,637 115,568
Loss and LAE reserves 98,979 92,390 86,986 64,993 50,451
Shareholders' equity 115,446 100,201 92,216 44,444 25,493
OTHER DATA:
GAAP ratios (insurance companies only)
Net loss and LAE ratio 55.7% 52.1% 53.2% 62.1% 67.9%
Expense ratio 34.0% 45.0% 41.7% 34.0% 30.7%
---------------------------------------------------------------
Combined ratio 89.7% 97.1% 94.9% 96.1% 98.6%
===============================================================
Statutory combined ratio 90.2% 98.1% 94.2% 96.4% 97.5%
===============================================================
Industry statutory combined ratio 101.6% 105.8% 106.4% 108.5% 106.9%
</TABLE>
28
<PAGE> 11
Meadowbrook Insurance Group, Inc.
Report of Management and Independent Accountants
Management is responsible for the accompanying consolidated financial statements
and all other financial information contained in the Annual Report. The
financial statements have been prepared in conformity with generally accepted
accounting principles and include amounts which of necessity are based on
management's best estimates and informed judgments under existing circumstances.
The Company maintains a system of internal controls designed to provide
reasonable assurance, at appropriate costs, that assets are safeguarded,
transactions are properly authorized and recorded, and that the financial
records provide a reliable basis for the preparation of financial statements
that are free of material misstatement.
The financial statements have been audited by the independent auditors Coopers &
Lybrand L.L.P.. Their role is to render an independent professional opinion on
management's financial statements based upon performance of procedures they deem
appropriate under generally accepted auditing standards. As part of their audit,
they evaluate the Company's internal control structure to the extent they
consider necessary to express their opinion on the consolidated financial
statements.
The Audit Committee of the Board of Directors, composed of directors who are not
officers or employees of the Company, meets periodically with management, the
Company's chief internal auditor, and with its independent auditors to discuss
their evaluation of internal accounting controls and the quality of financial
reporting. Both the independent auditors and the internal auditors have free
access to the Audit Committee to discuss the results of audits.
Merton J. Segal Daniel G. Gibson
Chairman and Vice President and
Chief Executive Officer Chief Financial Officer
TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF MEADOWBROOK INSURANCE
GROUP, INC.:
We have audited the accompanying consolidated balance sheet of Meadowbrook
Insurance Group, Inc. (formerly "Star Holding Company") and Subsidiaries as of
December 31, 1997 and 1996, and the related consolidated statements of income,
shareholders' equity, and cash flows for the three years in the period ended
December 31, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Meadowbrook
Insurance Group, Inc. and Subsidiaries as of December 31, 1997 and 1996 and the
consolidated results of their operations and cash flows for the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principals.
Detroit, Michigan
March 19, 1998
29
<PAGE> 12
Meadowbrook Insurance Group, Inc.
Consolidated Balance Sheet
DECEMBER 31, 1997 AND 1996
<TABLE>
<CAPTION>
ASSETS 1997 1996
Investments:
---------------------------------
<S> <C> <C>
Debt securities held to maturity, at amortized cost $ - $ 120,116,668
(fair value of $122,485,366)
Debt securities available for sale, at fair value 141,465,353 15,955,481
(cost of $137,613,515 and $16,025,804)
Equity securities available for sale, at fair value 5,612,207 1,420,949
(cost of $4,951,545 and $1,562,999)
Cash and cash equivalents 20,214,994 19,002,241
---------------------------------
Total investments and cash and cash equivalents 167,292,554 156,495,339
Accrued investment income 1,766,922 1,811,195
Premiums and agent balances receivable 51,132,125 25,907,407
Reinsurance recoverable on:
Paid losses 9,887,997 6,672,133
Unpaid losses 38,192,571 26,615,052
Prepaid reinsurance premiums 27,231,424 20,271,068
Funds held by or deposited with reinsured companies 63,515 1,042,116
Deferred policy acquisition costs 6,608,500 4,264,795
Deferred federal income taxes 2,880,432 6,623,758
Furniture and equipment, less accumulated depreciation of $5,282,660
and $2,891,725 in 1997 and 1996, respectively 4,831,037 3,587,364
Intangible assets, less accumulated amortization of $736,007
and $312,768 in 1997 and 1996, respectively 9,636,559 5,414,073
Other assets 9,118,608 6,331,041
---------------------------------
Total assets $ 328,642,244 $ 265,035,341
---------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Reserve for losses and loss adjustment expenses $ 98,978,937 $ 92,390,227
Unearned premiums 59,168,204 44,090,675
Payable to insurance companies 10,937,481 4,457,315
Federal income taxes payable 16,184 1,666,772
Accounts payable and accrued expenses 7,909,648 7,823,567
Reinsurance funds held and balances payable 20,107,964 2,909,353
Other liabilities 4,613,241 11,496,598
Lines of credit 11,464,179 -
---------------------------------
Total liabilities 213,195,838 164,834,507
---------------------------------
Commitments and contingencies (note 12)
Shareholders' Equity
Common stock, $0.01 stated value; authorized 20,000,000 shares; 8,660,164
and 8,649,346 shares issued and outstanding in
1997 and 1996, respectively 86,602 86,493
Additional paid-in capital 72,650,671 72,873,396
Retained earnings 39,730,884 27,381,111
Unrealized appreciation (depreciation) on available for sale securities,
net of deferred tax (expense) benefit of $1,534,251 and ($72,207)
in 1997 and 1996,respectively 2,978,249 (140,166)
---------------------------------
Total shareholders' equity 115,446,406 100,200,834
---------------------------------
Total Liabilities and Shareholders' Equity $ 328,642,244 $ 265,035,341
---------------------------------
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
OF THE CONSOLIDATED FINANCIAL STATEMENTS.
30
<PAGE> 13
Meadowbrook Insurance Group, Inc.
Consolidated Statement of Income
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>
1997 1996 1995
-----------------------------------------------
<S> <C> <C> <C>
REVENUES
Premiums earned
Gross $ 133,313,937 $ 116,924,848 $ 115,248,000
Ceded (64,820,760) (32,378,004) (32,549,722)
-----------------------------------------------
Net earned 68,493,177 84,546,844 82,698,278
Net commissions and fees 24,360,076 16,566,327 1,885,708
Net investment income 8,128,007 8,002,072 5,324,921
Net realized gains on disposition of investments 133,549 25,354 45,082
Miscellaneous income 10,379 48,040 20,158
-----------------------------------------------
Total Revenues 101,125,188 109,188,637 89,974,147
-----------------------------------------------
EXPENSES
Losses and loss adjustment expenses 69,288,709 64,328,606 60,216,035
Reinsurance recoveries (33,145,711) (23,063,948) (16,421,185)
-----------------------------------------------
Net losses and loss adjustment expenses 36,142,998 41,264,658 43,794,850
Salaries and employee benefits 27,416,141 24,976,666 2,629,486
Other operating expenses 19,531,083 32,015,980 33,721,329
Interest on notes payable 649,271 -- 340,952
Policyholder dividends -- 63,378 --
-----------------------------------------------
Total Expenses 83,739,493 98,320,682 80,486,617
-----------------------------------------------
Income before taxes 17,385,695 10,867,955 9,487,530
-----------------------------------------------
Federal income taxes
Current 2,114,554 3,522,801 1,984,677
Deferred expense (benefit) 2,228,685 (1,360,870) 282,983
-----------------------------------------------
Total income taxes 4,343,239 2,161,931 2,267,660
-----------------------------------------------
Net income $ 13,042,456 $ 8,706,024 $ 7,219,870
===============================================
Earnings Per Share
Basic $1.51 $1.01 $1.45
Diluted $1.42 $0.95 $1.32
Weighted average number of common shares
Basic 8,657,677 8,630,150 4,970,626
Diluted 9,176,754 9,184,272 5,464,936
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
OF THE CONSOLIDATED FINANCIAL STATEMENTS.
31
<PAGE> 14
Meadowbrook Insurance Group, Inc.
Consolidated Statement of Shareholders' Equity
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>
UNREALIZED
(DEPRECIATION)
APPRECIATION
CLASS A ADDITIONAL ON AVAILABLE TOTAL
COMMON COMMON PAID-IN FOR SALE RETAINED SHAREHOLDERS'
STOCK STOCK CAPITAL SECURITIES EARNINGS EQUITY
----------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balances, January 1, 1995 $ 41,135 $ 3,712 $ 32,431,039 $ (181,253) $ 12,149,248 $ 44,443,881
Share exchange 3,712 (3,712) -- -- -- --
Purchase and retirement of
2,425 shares of common stock (24) -- (27,631) -- -- (27,655)
Issuance of 2,419,118 shares
of common stock to purchase
subsidiary 24,191 -- 3,313,120 -- -- 3,337,311
Issuance of 2,331,811 shares
of common stock 23,318 -- 44,219,185 -- -- 44,242,503
Unrealized appreciation on
available for sale securities -- -- -- 73,450 -- 73,450
Retirement of 613,171 shares
of common stock (6,132) -- (7,067,062) -- -- (7,073,194)
Net income -- -- -- -- 7,219,870 7,219,870
----------------------------------------------------------------------------------
Balances, December 31, 1995 86,200 -- 72,868,651 (107,803) 19,369,118 92,216,166
Unrealized depreciation on
available for sale securities -- -- -- (32,363) -- (32,363)
Dividends declared at $0.08 per share -- -- -- -- (690,784) (690,784)
Issuance of 45,608 shares
of common stock 455 -- 318,284 -- -- 318,739
Retirement of 16,178 shares
of common stock (162) -- (466,961) -- (3,247) (470,370)
Tax benefit of stock option exercises -- -- 374,440 -- -- 374,440
Initial public offering
- - additional expenses -- -- (221,018) -- -- (221,018)
Net income -- -- -- -- 8,706,024 8,706,024
----------------------------------------------------------------------------------
Balances, December 31, 1996 86,493 -- 72,873,396 (140,166) 27,381,111 100,200,834
Unrealized appreciation
on available for sale securities -- -- -- 3,118,415 -- 3,118,415
Dividends declared at $0.08 per share -- -- -- -- (692,683) (692,683)
Issuance of 35,409 shares
of common stock 354 -- 241,022 -- -- 241,376
Retirement of 24,591 shares
of common stock (245) -- (574,363) -- -- (574,608)
Tax benefit of stock
option exercises -- -- 110,616 -- -- 110,616
Net income -- -- -- -- 13,042,456 13,042,456
----------------------------------------------------------------------------------
Balances, December 31, 1997 $ 86,602 $ -- $ 72,650,671 $ 2,978,249 $ 39,730,884 $115,446,406
==================================================================================
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
OF THE CONSOLIDATED FINANCIAL STATEMENTS.
32
<PAGE> 15
Meadowbrook Insurance Group, Inc.
Consolidated Statement of Cash Flows
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>
1997 1996 1995
--------------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 13,042,456 $ 8,706,024 $ 7,219,870
--------------------------------------------
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization of intangible assets 423,239 152,968 108,887
Depreciation of furniture and equipment 2,390,935 1,359,752 140,817
Net accretion of discount on bonds (191,050) (232,278) (178,093)
Gain on sale of investments (493,545) (25,354) (45,082)
Deferred income tax (benefit) expense 2,228,685 (1,360,870) 282,983
Changes in operating assets and liabilities:
Decrease (increase) in:
Accrued investment income 44,273 (428,248) (555,370)
Premiums and agent balances receivable (22,723,438) 4,027,680 (250,351)
Reinsurance recoverable on
paid and unpaid losses (14,793,383) (7,704,557) (5,143,566)
Prepaid reinsurance premiums (6,960,356) (10,444,335) 3,068,355
Funds held by or deposited with
reinsured companies 1,014,096 (381,202) (1,264)
Deferred policy acquisition costs (1,866,365) 4,799,194 (4,373,099)
Other assets (14,459) 3,154,437 (1,119,594)
Increase (decrease) in:
Losses and loss adjustment expenses 5,036,469 5,404,613 21,992,912
Unearned premiums 12,955,672 (302,298) 7,875,927
Federal income taxes payable (1,590,553) 1,345,900 612,955
Accounts payable and accrued expenses 24,808 348,059 350,668
Insurance company payable 2,382,159 (925,815) (1,924,372)
Reinsurance funds held and
balances payable 17,091,314 (1,311,180) (1,612,779)
Due to affiliates -- -- (1,116,388)
Other liabilities (9,733,948) 5,403,118 (286,374)
--------------------------------------------
Total adjustments (14,775,447) 2,879,584 17,827,172
--------------------------------------------
Net cash provided by operating activities (1,732,991) 11,585,608 25,047,042
--------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of equity securities available for sale (3,866,284) (63,953) (40,447)
Purchase of debt securities available for sale (25,927,260) (17,276,583) --
Purchase of debt securities held to maturity -- (26,419,086) (45,299,301)
Proceeds from sale of equity
securities available for sale 460,691 723,058 98,225
Proceeds from sale of debt
securities available for sale 28,367,199 1,185,731 --
Proceeds from maturity of
securities held to maturity 4,611,894 11,661,884 7,901,310
Capital expenditures (3,427,740) (2,523,979) (445,183)
Proceeds from sale of furniture and equipment -- -- 65,945
Purchase of subsidiary (7,821,636) (886,570) --
--------------------------------------------
Net cash used in investing activities (7,603,136) (33,599,498) (37,719,451)
--------------------------------------------
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
OF THE CONSOLIDATED FINANCIAL STATEMENTS.
33
<PAGE> 16
Meadowbrook Insurance Group, Inc.
Consolidated Statement of Cash Flows
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>
1997 1996 1995
--------------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from lines of credit $ 30,410,119 $ -- $ --
Payments on lines of credit (18,945,940) -- (8,654,672)
Use of initial public offering proceeds (221,018) --
Dividends paid on common stock (692,683) (517,797) --
Retirement of common stock (222,616) (470,370) (27,655)
Issuance of common stock 318,739 44,242,503
--------------------------------------------
Net cash (used in) provided by financing activities 10,548,880 (890,446) 35,560,176
--------------------------------------------
Increase (decrease) in cash and cash equivalents 1,212,753 (22,904,336) 22,887,767
Cash and cash equivalents, beginning of year 19,002,241 41,906,577 19,018,810
--------------------------------------------
Cash and cash equivalents, end of year $ 20,214,994 $ 19,002,241 $ 41,906,577
============================================
SUPPLEMENTAL DISCLOSURE OF
CASH FLOW INFORMATION:
Interest paid $ 644,403 $ 21,638 $ 262,916
Income taxes paid, net of refund $ 3,705,108 $ 2,089,225 $ 1,377,251
SUPPLEMENTAL DISCLOSURE OF
NONCASH INVESTING AND FINANCING ACTIVITIES:
Common stock issued for net
noncash assets of acquired subsidiary $ -- $ -- $ 3,337,311
Dividend and retirement of common stock
in connection with the acquisition of subsidiary $ -- $ -- $ 7,073,194
Tax benefit from stock option exercises $ 110,616 $ 374,440 $ --
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
OF THE CONSOLIDATED FINANCIAL STATEMENTS.
34
<PAGE> 17
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF FINANCIAL PRESENTATION
The accompanying consolidated financial statements have been prepared in
conformity with generally accepted accounting principles ("GAAP"), which differ
from statutory accounting practices prescribed or permitted for insurance
companies by regulatory authorities. Prescribed statutory accounting practices
include a variety of publications of the National Association of Insurance
Commissioners ("NAIC"), as well as state laws, regulations and general
administrative rules. Permitted statutory accounting practices encompass all
accounting practices not so prescribed.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts, after intercompany
eliminations, of Meadowbrook Insurance Group, Inc., formerly known as Star
Holding Company, (the "Company"), its wholly owned subsidiary, Star Insurance
Company ("Star"), Star's wholly owned subsidiary, Savers Property and Casualty
Insurance Company ("Savers"), American Indemnity Insurance Company, Ltd.
("American Indemnity"), which is owned 50% by Star and 50% by the Company,
Meadowbrook, Inc. and its consolidated subsidiaries ("Meadowbrook"), a wholly
owned subsidiary which was acquired in November of 1995 (see Note 10), and Crest
Financial Corporation ("Crest") and its subsidiaries, including Williamsburg
National Insurance Co. ("Williamsburg"), which was acquired in July of 1997.
BUSINESS
The Company, through its subsidiaries, is engaged primarily in developing and
managing Alternative Market risk management programs for defined client groups
and their members. This includes providing services, such as reinsurance
brokering, risk management consulting, claims handling, administrative services,
along with various types of property and casualty insurance coverage, including
workers' compensation, general liability and commercial multiple peril. The
Company does not have significant exposures to environmental/asbestos and
catastrophic coverages. Insurance coverage is primarily provided to associations
or similar groups of members, commonly referred to as programs. Four programs
accounted for 46.0%, 37.1%, and 33.6% of the Company's premium revenue in 1997,
1996 and 1995, respectively. The net earned premium of the largest program in
each respective year represented 14.7%, 11.7% and 10.0% of the Company's premium
revenues in 1997, 1996 and 1995, respectively.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
INVESTMENTS
Trading securities are investments which are purchased with the intent of
selling them in the near future. Trading securities are reported at fair value,
with changes in the fair value included in earnings. The Company does not hold
any trading securities. Held to maturity securities are those securities that
the Company has both the intent and ability to hold to maturity, and are
reported at amortized cost. Available for sale securities are those securities
that do not
35
<PAGE> 18
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
meet the requirements of the trading or held to maturity categories. Investments
are classified as available for sale securities in order to be available to be
sold in the future in response to the Company's liquidity needs, changes in
market interest rates, and asset-liability management strategies, among other
reasons. Available for sale securities are reported at fair value, with
unrealized gains and losses reported as a separate component of shareholders'
equity, net of deferred taxes. The Company's investment securities at December
31, 1996 include both available for sale and held to maturity debt securities
whereas at December 31, 1997 there were no held to maturity debt securities.
Realized gains or losses on sale or maturity of investments are determined on
the basis of specific costs of the investments. Discount or premium on debt
securities purchased at other than par value is amortized using the constant
yield method. Investments with other than temporary declines in fair value are
written down to estimated fair value and the related realized losses recognized
in income.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents includes cash on hand and highly liquid short-term
investments. The Company considers all short-term investments purchased with a
maturity of three months or less at the time of acquisition to be cash
equivalents.
DEFERRED POLICY ACQUISITION COSTS
Commissions and other costs of acquiring insurance business that vary with and
are primarily related to the production of new and renewal business are deferred
and amortized over the terms of the policies or reinsurance treaties to which
they relate. Investment earnings are anticipated in determining the
recoverability of such deferred amounts.
FURNITURE AND EQUIPMENT
Furniture and equipment are stated at cost and are depreciated using both
accelerated and straight-line methods over the estimated useful lives of the
assets, generally five to ten years. Upon sale or retirement, the cost of the
asset and related accumulated depreciation are eliminated from their respective
accounts, and the resulting gain or loss is included in income. Repairs and
maintenance are charged to operations when incurred.
INTANGIBLE ASSETS
Goodwill resulting from the acquisition of Crest in 1997 and Association Self
Insurance Services, Inc. ("ASI") in 1996 are amortized on a straight-line basis
over 20 years. Other intangibles are amortized on a straight-line basis over 3
to 5 years.
Annually, the Company evaluates the net carrying value of goodwill to determine
if there has been any impairment in value. The methodology used for this
evaluation entails review of annual operating performance along with anticipated
results for the ensuing year based on operating budgets. At December 31, 1997
the Company concluded that there had been no impairment in the net carrying
value of goodwill.
LOSSES AND LOSS ADJUSTMENT EXPENSES
The liability for losses and loss adjustment expenses ("LAE") represents (1)
case basis estimates of reported losses on direct business, (2) estimates
received from ceding reinsurers on assumed business and (3) actuarial estimates
of incurred but not reported losses and LAE. Such liabilities, by necessity, are
based upon estimates and, while management believes that
36
<PAGE> 19
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
the amount accrued is adequate, the ultimate liability may be greater or less
than the amount provided. The methods for making such estimates and for
establishing the resulting reserves are continually reviewed and updated.
REVENUE RECOGNITION
Premiums written are recognized as earned on a pro rata basis over the life of
the policy term. Unearned premiums represent the portion of premiums written
which are applicable to the unexpired terms of policies in force. Provisions for
unearned premiums on reinsurance assumed from others are made on the basis of
ceding reports when received. Certain premiums are subject to retrospective
premium adjustments. The estimated ultimate premium is recognized over the term
of the insurance contract.
Commission and fee income is recorded on the later of the effective date or the
billing date of the policies on which it was earned.
Meadowbrook occasionally guarantees the financing of policies it writes. No
material premium financing guarantees were in effect at December 31, 1997.
The majority of claims processing fees are recognized as revenue over the
estimated life of the claims. For those contracts that provide services beyond
the contractually defined termination date of the related contracts, fees are
defined in an amount equal to management's estimate of the Company's obligation
to continue to provide services.
INCOME TAXES
The Company accounts for its income taxes under Statement of Financial
Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," which
requires the asset and liability method of recording income taxes. Under the
asset and liability method, deferred federal income taxes are recognized for the
tax consequences of "temporary differences" by applying enacted statutory tax
rates to differences between the financial statement carrying amounts and the
tax bases of existing assets and liabilities.
STOCK OPTIONS
Compensation expense, if any, resulting from stock options granted by the
Company is determined based on the difference between the exercise price and the
fair market value of the underlying common stock at the date of grant.
EARNINGS PER SHARE
The Company adopted Statement of Financial Accounting Standards ("SFAS") No 128,
`Earnings Per Share', which replaced the presentation of primary and fully
diluted earnings per share, as computed under Accounting Principles Board (APB)
No. 15 with a presentation of basic and diluted earnings per share. Adoption of
this standard did not have a material impact on reported earnings per share.
Basic earnings per share are based on the weighted average number of common
shares while diluted earnings per share included weighted average number of
common shares and stock options outstanding during the year. Stock options
included in diluted earnings per share are 519,077, 554,122 and 494,310 for the
years ended December 31, 1997, 1996, and 1995, respectively.
37
<PAGE> 20
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
Earnings per share for 1995 has been retroactively adjusted for the effect of
the 2.975532 stock split that occurred on November 20, 1995.
RECLASSIFICATIONS
Certain amounts in the 1996 and 1995 financial statements have been reclassified
to conform with the 1997 presentation.
2. INVESTMENTS AND OTHER FINANCIAL INSTRUMENTS
The estimated fair value of investments in securities is determined based on
published market quotations. Due to the short-term nature of other financial
instruments such as cash equivalents, carrying value approximates fair value.
The cost or amortized cost and estimated fair values of investments in
securities at December 31, 1997 and 1996 are as follows:
<TABLE>
<CAPTION>
December 31, 1997
----------------------------------------------------------
Cost or Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-------------------------------------------------------
<S> <C> <C> <C> <C>
SECURITIES AVAILABLE FOR SALE
DEBT SECURITIES:
Debt securities issued by the
U.S. government and agencies $ 9,997,471 $ 226,050 $ (68,369) $ 10,155,152
Obligations of states and
political subdivisions 116,810,570 3,752,699 (127,293) 120,435,976
Corporate securities 3,586,610 21,192 (59,462) 3,548,340
Certificates of deposit -- -- -- --
Mortgage-backed securities 7,218,864 138,096 (31,075) 7,325,885
-------------------------------------------------------
Total Debt Securities Available for Sale 137,613,515 4,138,037 (286,199) 141,465,353
EQUITY SECURITIES:
Preferred Stocks 3,542,663 277,380 -- 3,820,043
Common Stocks 1,408,882 465,540 (82,258) 1,792,164
-------------------------------------------------------
Total Securities Available for Sale $142,565,060 $4,880,957 $(368,457) $147,077,560
=======================================================
</TABLE>
38
<PAGE> 21
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
In the third quarter of 1997, the Company sold securities that had been
classified as held to maturity for the purpose of generating taxable realized
gains to utilize the tax loss carryforwards which expire in 1997 and for other
short-term operating needs. The specific securities sold and the related
amortized cost and realized gains are as follow:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------
SECURITY AMORTIZED COST REALIZED GAIN
- -----------------------------------------------------------------------------------
<S> <C> <C>
Municipal Bond, Chicago, IL $192,400 $ 16,006
Municipal Bond, Santa Ana, CA 116,295 16,366
Municipal Bond, Wayne County, MI 279,977 25,729
Municipal Bond, Northeastern PA Hospital 201,173 18,355
Municipal Bond, San Diego County, CA COP 178,170 21,174
Municipal Bond, Indiana St Education 180,640 21,560
Municipal Bond, Massachusetts Muni 187,857 15,725
Municipal Bond, Northeastern PA Hospital 200,000 19,528
</TABLE>
The sale of the above held to maturity securities were for reasons other than
those permitted by Statement of Financial Accounting Standards No. 115.
Accordingly, the Company has reclassified the remaining held to maturity
securities (with an amortized cost of $114.1 million and fair value of $115.8
million) to the available for sale category.
<TABLE>
<CAPTION>
December 31, 1996
----------------------------------------------------------
Cost or Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
----------------------------------------------------------
<S> <C> <C> <C> <C>
SECURITIES HELD TO MATURITY
DEBT SECURITIES:
Debt securities issued by the
U.S. government and agencies $ 3,287,309 $ 67,895 $ (2,213) $ 3,352,991
Obligations of states and
political subdivisions 110,265,406 2,456,081 (70,308) 112,651,179
Corporate securities 299,902 18,878 -- 318,780
Certificates of deposit 95,000 -- -- 95,000
Mortgage-backed securities 6,169,051 34,293 (135,928) 6,067,416
----------------------------------------------------------
Total Debt Securities Held to Maturity $120,116,668 $2,577,147 ($ 208,449) $122,485,366
==========================================================
SECURITIES AVAILABLE FOR SALE
DEBT SECURITIES:
Debt securities issued by the
U.S. government and agencies $ 2,995,204 $ 3,856 $ (1,250) $ 2,997,810
Obligations of states and
political subdivisions 7,897,953 15,279 (105,136) 7,808,096
Corporate securities 2,200,733 22,818 (1,427) 2,222,124
Mortgage-backed securities 2,931,914 2,874 (7,337) 2,927,451
----------------------------------------------------------
Total Debt Securities Available for Sale 16,025,804 44,827 (115,150) 15,955,481
EQUITY SECURITIES:
Mutual funds 1,562,999 -- (142,050) 1,420,949
----------------------------------------------------------
Total Securities Available for Sale $ 17,588,803 $ 44,827 $ (257,200) $ 17,376,430
</TABLE>
39
<PAGE> 22
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
Gross unrealized appreciation and depreciation on available for sale securities
were as follows:
<TABLE>
<CAPTION>
December 31, 1997 1996
------------------------
<S> <C> <C>
Unrealized appreciation $ 4,880,957 $ 44,827
Unrealized depreciation (368,457) (257,200)
------------------------
Net unrealized appreciation (depreciation) 4,512,500 (212,373)
Deferred federal income taxes (1,534,251) 72,207
------------------------
Net unrealized appreciation (depreciation) on
investments, net of deferred federal income taxes $ 2,978,249 $(140,166)
========================
</TABLE>
The gross change, before tax (expense)/benefit, in unrealized
appreciation/(depreciation), on available for sale debt securities was
$3,922,161 for 1997, ($70,323) for 1996 and zero for 1995, as no available for
sale debt securities were owned during 1995. The gross change in unrealized
appreciation/(depreciation) on available for sale equity securities was
$802,712, $21,288, and $111,287 in 1997, 1996 and 1995, respectively. The
unrecorded change in market value over book value on held to maturity debt
securities was ($172,092) and $4,705,510 for 1996 and 1995, respectively. There
were no held to maturity debt securities at December 31, 1997.
The realized gains (losses) on the sale of available for sale debt securities
and equity securities for the year ended December 31, 1997 were $510,659 and
($377,110), respectively. The proceeds from these sales were $19.4 million and
$0.5 million, respectively.
The amortized cost and estimated fair value of available for sale securities at
December 31, 1997, by contractual maturity, are shown below. Expected maturities
may differ from contractual maturities because certain borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties.
<TABLE>
<CAPTION>
Available for Sale
-----------------------------
Estimated
Amortized Fair
Cost Value
-----------------------------
<S> <C> <C>
Due in one year or less $ 12,057,540 $ 12,106,695
Due after one year through five years 43,097,364 44,004,886
Due after five years through ten years 47,807,558 50,003,753
Due after ten years 26,612,431 27,209,599
Mortgage-backed securities 8,038,622 8,140,420
-----------------------------
$137,613,515 $141,465,353
=============================
</TABLE>
40
<PAGE> 23
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
Net investment income for the last three years ended December 31 was as follows:
<TABLE>
<CAPTION>
1997 1996 1995
----------------------------------------
<S> <C> <C> <C>
INVESTMENT INCOME ON:
Debt securities $7,154,057 $6,474,620 $4,534,225
Equity securities 245,449 120,617 120,704
Cash and cash equivalents 1,070,328 1,706,296 925,736
----------------------------------------
Total gross investment income 8,469,834 8,301,533 5,580,665
Less investment expenses 341,827 299,461 255,744
----------------------------------------
Net investment income $8,128,007 $8,002,072 $5,324,921
========================================
</TABLE>
United States government obligations, municipal bonds, and bank certificates of
deposit aggregating $17,628,773 and $16,027,911 were on deposit with state
regulatory authorities as required by law at December 31, 1997 and 1996,
respectively.
3. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company regularly updates its reserve estimates as new information becomes
available and further events occur which may impact the resolution of unsettled
claims. Changes in prior reserve estimates are reflected in results of
operations in the year such changes are determined to be needed and recorded.
Activity in the reserves for losses and loss adjustment expenses is summarized
as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
-----------------------
<S> <C> <C>
Balance, beginning of year $92,390 $86,986
Less reinsurance recoverables 26,615 22,318
-----------------------
Net balance, beginning of year 65,775 64,668
-----------------------
Incurred related to:
Current year 34,908 40,875
Prior years 1,235 390
-----------------------
Total incurred 36,143 41,265
-----------------------
Paid related to:
Current year 9,506 16,754
Prior years 31,626 23,404
-----------------------
Total paid 41,132 40,158
-----------------------
Net balance, end of year 60,786 65,775
Plus reinsurance recoverables 38,193 26,615
-----------------------
Balance, end of year $98,979 $92,390
=======================
</TABLE>
As a result of unfavorable development in estimates of prior accident years'
reserves, the provision for losses and loss adjustment expenses increased by
$1,235,000 and $390,000 in 1997 and 1996, respectively. This adverse development
reflects the runoff of discontinued Surety Bond business.
4. REINSURANCE
The insurance subsidiaries cede insurance to other insurers under pro rata and
excess-of-loss contracts. These reinsurance arrangements diversify the Company's
business and minimize its losses arising from large risks or from hazards of an
unusual nature. The ceding of insurance does not discharge the original insurer
from its primary liability to its policyholder, and in the event that all or any
of the reinsuring companies are unable to meet their obligations under
41
<PAGE> 24
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
existing reinsurance agreements, the subsidiaries would be liable for such
defaulted amounts. In order to minimize its exposure to significant losses from
reinsurer insolvencies, the Company evaluates the financial condition of its
reinsurers and monitors the economic characteristics of the reinsurers on an
ongoing basis. The Company also assumes insurance from other insurers and
reinsurers, both domestic and foreign, under pro rata and excess-of-loss
contracts.
The Company receives ceding commissions in conjunction with reinsurance
activities. These ceding commissions are offset against the related underwriting
expenses and were $22,168,969, $14,843,140, and $7,931,632 for 1997, 1996, and
1995, respectively.
In December 1996, Star ceded $11.9 million of surety bond unearned premium to
Connecticut Surety Company. Liabilities due to Star at December 31, 1996 were
secured by a cut-through reinsurance endorsement provided by NAC Reinsurance
Corporation. Future liabilities will be further secured by letters of credit and
funds withheld trusts. This transaction had no material impact on net income,
since ceding commissions received offset the amortization of deferred
acquisition costs.
Reconciliations of direct to net premiums, on both written and earned bases, for
1997, 1996, and 1995 are as follows:
<TABLE>
<CAPTION>
1997 1996 1995
--------------------------------------------------------------------------------------------------
Written Earned Written Earned Written Earned
--------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Direct $ 133,476,972 $ 118,980,133 $ 112,279,247 $ 113,874,603 $ 117,633,933 $ 108,332,771
Assumed 13,262,230 14,333,787 3,300,609 3,050,245 5,485,181 6,915,229
Ceded (71,774,361) (64,820,760) (42,822,340) (32,378,004) (29,481,367) (32,549,722)
--------------------------------------------------------------------------------------------------
Net $ 74,964,841 $ 68,493,160 $ 72,757,516 $ 84,546,844 $ 93,637,747 $ 82,698,278
==================================================================================================
</TABLE>
One reinsurer accounts for 26.8% of ceded premiums.
5. DEFERRED POLICY ACQUISITION COSTS
The following reflects the amounts of policy acquisition costs deferred and
amortized (in thousands):
<TABLE>
<CAPTION>
--------------------------------
For the years ended December 31: 1997 1996 1995
--------------------------------
<S> <C> <C> <C>
Balance, beginning of period $ 4,265 $ 9,064 $ 4,691
Acquisition costs deferred 8,374 7,036 19,119
Amortized to expense during the period (6,030) (11,835) (14,746)
--------------------------------
Balance, end of period $ 6,609 $ 4,265 $ 9,064
================================
</TABLE>
6. INCOME TAXES
The provision for income taxes consists of the following (in thousands):
<TABLE>
<CAPTION>
----------------------------------
For the years ended December 31: 1997 1996 1995
----------------------------------
<S> <C> <C> <C>
Current tax expense $ 2,114 $ 3,523 $ 1,985
Deferred tax expense/(benefit) 2,229 (1,361) 283
----------------------------------
Total provision for income taxes $ 4,343 $ 2,162 $ 2,268
==================================
</TABLE>
42
<PAGE> 25
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
A reconciliation of the Company's tax provision on income from operations to the
U.S. federal income tax rate of 34% in 1997, 1996, and 1995 is as follows (in
thousands):
<TABLE>
<CAPTION>
For the Years Ended
December 31
-----------------------------------
1997 1996 1995
-----------------------------------
<S> <C> <C> <C>
Tax provision at statutory rate $ 5,911 $ 3,695 $ 3,226
Tax effect of:
Tax exempt interest (1,658) (1,566) (1,016)
Other, net 90 33 58
-----------------------------------
Federal income tax expense $ 4,343 $ 2,162 $ 2,268
===================================
Effective tax rate 25.0% 19.9% 23.9%
</TABLE>
Deferred federal income taxes, under SFAS No. 109, reflect the estimated future
tax effect of temporary differences between the bases of assets and liabilities
for financial reporting purposes and such amounts as measured by tax laws and
regulations.
The components of deferred tax assets and liabilities as of December 31, 1997
and 1996 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
----------------------------------------------------------------
Deferred Deferred Deferred Deferred
Tax Tax Tax Tax
Assets Liabilities Assets Liabilities
----------------------------------------------------------------
<S> <C> <C> <C> <C>
Unpaid losses and loss
adjustment expenses $4,263 $ -- $4,613 $ --
Unearned premium reserves 1,976 -- 1,325 --
Unrealized (Gain) / Loss -- 1,534 72 --
Deferred policy acquisition expense -- 2,247 -- 1,442
Deferred compensation 391 -- 500 --
Deferred fee recognition 385 -- 1,564 --
Other 150 504 56 64
----------------------------------------------------------------
Total deferred taxes $7,165 $4,285 $8,130 $1,506
----------------------------------------------------------------
Net deferred tax assets $2,880 $6,624
================================================================
</TABLE>
7. LINES OF CREDIT AND LETTERS OF CREDIT
At December 31, 1997, the Company and its subsidiaries had one unsecured line of
credit with a bank which permits borrowings up to $15,000,000 and expires on and
is payable by January 1, 2000. This line bears interest at one percent under the
prime rate (prime was 8.50% at December 31, 1997). The Company also has the
option to elect a eurodollar based rate in place of prime. At December 31, 1997,
$10,339,507 was outstanding under this line.
In addition, one subsidiary had a secured line of credit with a bank which
permits borrowings up to 30% of the accounts receivable which secure the line.
The line expires February 28, 1998 and is automatically renewable each year.
This line bears interest at 3/4% under the prime rate (prime was 8.50% at
December 31, 1997). At December 31, 1997, $1,124,671 was outstanding under this
line.
As of December 31, 1997, a standby letter of credit of $10,320,000 had been
issued by a bank to an insurance subsidiary of the Company, under an agreement
expiring June 30, 1998, with extensions granted on a yearly basis. This letter
of credit is being utilized as security for a surety bond filed with one state.
This bond was filed as a requirement for writing workers'
43
<PAGE> 26
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
compensation business in that state. The letter of credit is collateralized by
specifically identified marketable securities of the subsidiary, with a total
fair market value of 110% of the $10,320,000 letter of credit.
8. SHAREHOLDERS' EQUITY
The Company issued 2,300,000 shares of common stock at a price of $21 a share
through an initial public offering in November 1995. Simultaneously, the Company
changed its name from Star Holding Company to Meadowbrook Insurance Group, Inc.
and acquired the common stock of Meadowbrook in exchange for 2,419,118 shares of
common stock of the Company. Upon acquisition, Meadowbrook declared and paid a
dividend to the Company in the form of 613,171 shares of common stock of the
Company which it held; such shares have been retired.
A significant portion of the Company's consolidated assets represents assets of
the Company's insurance subsidiaries that may not be transferable to the holding
company in the form of dividends, loans or advances. The restriction on the
transferability to the holding company from its insurance subsidiaries is
limited by Michigan regulatory guidelines which are as follows: The maximum
discretionary dividend that may be declared, based on data from the preceding
calendar year, is the greater of the insurance company's net income (excluding
realized capital gains) OR ten percent of the insurance company's policyholders'
surplus (excluding unrealized gains). These dividends are further limited by a
clause in the Michigan law which prohibits an insurer from declaring dividends
except out of earned surplus earnings of the company. Since Star is the parent
insurance company, its maximum dividend calculation represents the combined
insurance companies. Based upon the 1997 statutory financial statements of Star
Insurance Company, the maximum dividend that may be paid by Star as of January
1, 1998, without prior approval of the Michigan Commissioner of Insurance, is
$6.9 million, which is the amount of earned surplus. No dividends were paid or
returned in 1997,1996 and 1995.
Summarized 1997 and 1996 statutory basis information for the primary insurance
subsidiaries, which differs from generally accepted accounting principles,
follows:
<TABLE>
<CAPTION>
1997 1996
----------------------------- ----------------------------
Star Savers Star Savers
----------------------------- ----------------------------
<S> <C> <C> <C> <C>
Statutory capital and surplus $ 70,050,890 $ 21,777,562 $ 64,642,412 $ 20,711,906
Minimum statutory capital
and surplus 5,000,000 20,000,000 5,000,000 20,000,000
Statutory net income 8,274,148 4,175,272 7,503,071 3,920,748
Net investment income 6,760,010 2,978,422 4,810,325 2,380,230
</TABLE>
The net investment income and statutory net income in 1995 for Star were
$3,048,077 and $196,706, respectively, and for Savers were $2,053,687 and
$2,587,872.
The statutory capital and surplus, net investment income and statutory net
income since the date of acquisition July 1, 1997 for Williamsburg were
$6,372,522, $257,914 and $400,884, respectively.
9. STOCK OPTIONS
The Company, through its 1995 Stock Option Plan ("the Plan"), may grant options
to key executives of the Company and its subsidiaries of up to 2,000,000 shares
of the Company's common stock. The Plan is administered by a committee (the
"Committee") appointed by the Board of Directors. Option shares may be exercised
subject to the terms of the Plan and the terms prescribed by the Committee at
the time of grant. Currently, the Plan's options have either five or ten year
terms and are exercisable/vest in equal increments over the option term.
44
<PAGE> 27
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
Effective for December 31, 1996 year-end financial statements, the Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No. 123 (SFAS No. 123), "Accounting for Stock-Based Compensation." This standard
permits the Company to adopt the SFAS No. 123 fair value based method of
accounting for stock based compensation plans or to continue to apply the
valuation provisions of existing accounting standards (APB No. 25). The Company
has elected to continue measuring compensation expense under APB No. 25 and has
adopted the disclosure requirements of SFAS No. 123. If compensation cost for
stock option grants had been determined based on the fair value method
prescribed by SFAS No. 123, net income and earnings per share on a pro forma
basis for 1997, 1996 and 1995 would be as follows:
<TABLE>
<CAPTION>
1997 1996 1995
------------------------------------------------------------
<S> <C> <C> <C>
Reported net income $ 13,042,456 $ 8,706,024 $ 7,219,870
Pro forma net income, using SFAS No. 123 $ 12,784,733 $ 8,635,170 *$ 7,219,870
Earnings per share, diluted:
Reported $ 1.42 $ 0.95 $ 1.32
Pro forma, using SFAS No. 123 $ 1.39 $ 0.94 *$ 1.32
</TABLE>
*Options granted during 1995 did not become exercisable until 1996, and
therefore no pro forma compensation expense until 1996.
The Black-Scholes valuation model utilized the following annualized assumptions
for all applicable years: Risk-free interest rate of 6.25% for 1997 and 6.5% for
both 1996 and 1995, dividend yield of $.08 per share, and volatility factor for
the expected market price of the Company's common stock of .243. The
weighted-average expected life of options for the 1997, 1996 and 1995 grants are
7.5, 7.61, and 7.74 years, respectively.
The following is a summary of the Company's stock option activity and related
information for the years ended December 31:
<TABLE>
<CAPTION>
1997 1996 1995
--------------------------------------------------------------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
--------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding - beginning of year 953,799 $11.78 949,434 $ 10.28 209,775 $8.34
Exchange of existing options -- -- -- -- 572,285 $11.34
Granted 101,754 $22.71 63,280 $30.45 167,374 $9.11
Exercised (35,409) $6.82 (45,524) $7.00 -- --
Forfeited -- -- (13,391) $10.25 --
--------------------------------------------------------------------------
Outstanding - end of year 1,020,144 $13.04 953,799 $11.78 949,434 $10.28
==========================================================================
Exercisable at end of year 442,829 $10.65 326,017 $9.03 227,952 $6.64
Weighted-average fair value of
options granted during the year $ 7.30 -- $7.65 -- $1.82* --
</TABLE>
Note: SFAS 123 requires disclosure for 1995 and 1996 only.
* Options granted during 1995 did not become exercisable until 1996, and
therefore no pro forma compensation expense until 1996.
45
<PAGE> 28
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
The following table summarizes information about stock options outstanding at
December 31, 1997:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
--------------------------------------------------------------------
Weighted- Weighted- Weighted-
Average Average Average
Range of Remaining Exercise Exercise
Exercise Prices Options Lie Price Options Price
- ------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$ 5.10 to $ 8.11 515,661 3.8 years $ 6.32 277,461 $ 5.81
$10.25 to $12.17 133,900 7.1 $11.10 46,117 $11.24
$21.00 to $30.45 370,583 7.8 $23.08 119,251 $21.68
--------------------------------------------------------------------
1,020,144 6.8 $13.04 442,829 $10.65
====================================================================
</TABLE>
No compensation cost has been recorded for stock option grants issued during
1997, 1996 and 1995, as the market value equaled the exercise price at the date
of grant. All pre-IPO outstanding options of Meadowbrook and the Company were
exchanged for 743,885 options to purchase the Company's stock under the
Meadowbrook Insurance Group, Inc. 1995 Stock Option Plan. The exercise prices of
the new options are equivalent to the exercise prices of the exchanged options
after reflecting the effects of the stock split and share exchange related to
the acquisition of Meadowbrook (refer to Note 10). Additionally, all non-vested
Meadowbrook stock awards were exchanged for 205,549 options to purchase the
Company's common stock at $21 a share.
46
<PAGE> 29
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
10. ACQUISITION OF SUBSIDIARY
In July of 1997, the Company acquired Crest, at a purchase price of $9.4
million, resulting in $3.2 million of goodwill. Crest is a California based
holding company which holds 100% of Williamsburg, an insurance carrier, and
Crest Financial Services, a risk management service company. Crest provides
these services primarily to the trucking industry within California.
In November of 1996, the Company acquired ASI of Alabama at a purchase price of
$5.2 million, resulting in $5.2 million of goodwill. The purchase price is
subject to reduction, contingent on a specific contract renewal. The acquisition
was accounted for as a purchase. The effect of the acquisition was not material
to the Company's results of operations.
On November 20, 1995, the Company acquired Meadowbrook, Inc., an affiliated
company formed in 1955. The acquisition of Meadowbrook represents an exchange of
non-monetary assets by a promoter/shareholder for common stock of the Company
and is recorded at the transferor's historical basis (see Note 10).
The following pro forma financial information reflects this transaction as if it
has been completed as of January 1, 1995 (unaudited):
<TABLE>
<CAPTION>
1995
---------
<S> <C>
Revenues
Risk management fees and commissions $ 15,766
Net earned premium 82,698
Net investment income 5,613
Other income 83
---------
Total revenues 104,160
---------
Expenses
Net losses and LAE 41,673
Underwriting and other expenses 28,740
Salaries and employees benefits 20,001
Interest expense 576
---------
Total expenses 90,990
---------
Pretax Income 13,170
Taxes (3,495)
---------
Net Income $ 9,675
=========
Earnings per share $ 1.37
</TABLE>
11. EMPLOYEE BENEFIT PLANS
Company employees over the age of 21 who have completed 12 months of service and
worked at least 1,000 hours during those 12 months are eligible for
participation in Meadowbrook's 401(K) Profit Sharing Plan. The plan provides for
discretionary matching contributions and/or profit sharing contributions at the
discretion of the Board of Directors. In 1997, 1996 and 1995, the matching
contributions were $357,542, $295,671 and $23,721, respectively. Profit sharing
contributions were $424,459 and $53,916 in 1996 and 1995, respectively. There
were no profit sharing contributions in 1997. The increases in 1996 over 1995
reflects that there was only forty days of activity during 1995, from the date
of the Meadowbrook acquisition on November 20,1995 through December 31, 1995.
47
<PAGE> 30
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
12. COMMITMENTS AND CONTINGENCIES
The Company has certain operating lease agreements for its offices and
equipment. At December 31, 1997, future minimum rental payments required under
non-cancelable long-term operating leases are as follows:
<TABLE>
<CAPTION>
<S> <C>
1998 $ 2,495,318
1999 2,228,231
2000 2,154,920
2001 1,646,569
2002 1,335,113
Thereafter 2,248,327
------------
Total minimum lease commitments $ 12,108,478
============
</TABLE>
Rent expense for the year ended December 31, 1997, and 1996 amounted to
$1,972,044, and $1,480,000, respectively. Rent expense during 1995 was
immaterial.
On June 26, 1995, two shareholders of a former agent of Star initiated legal
proceedings against, among others, Star and Meadowbrook. The plaintiffs have
requested injunctive relief, compensatory damages, punitive and exemplary
damages, and attorney's fees in an unspecified amount. The Nevada Insurance
Department revoked the license of the first plaintiff and denied further
licensing of the second plaintiff. The Company is vigorously defending itself
and has filed counterclaims against the plaintiffs. While the Company believes
that it has meritorious defenses and counterclaims in this lawsuit, there can be
no assurance that the Company's results of operations and financial condition
will not be materially adversely affected by this lawsuit. The ultimate outcome
of the lawsuit cannot be determined at this time, and the Company is unable to
estimate the range of possible loss, if any.
13. RELATED PARTY TRANSACTIONS
The Company and its subsidiaries have a management services agreement with
Meadowbrook, under which Meadowbrook furnishes their accounting, financial
reporting, underwriting, reinsurance, sales, claims, loss prevention and general
management services. The terms of the agreement continue through 1997 and
automatically renew for successive five-year periods unless terminated by either
party 90 days prior to expiration.
Fees under the agreement are a combination of fixed charges and profit sharing
based on the results of operations. The fees expensed were $10,571,636 for 1995
prior to acquisition. Subsequent to the acquisition in November 1995, such fees
are eliminated in consolidation.
Prior to the acquisition of Meadowbrook, it acted as an agent and produced a
significant portion of the business written by the Company's insurance
subsidiaries. Subsequent to the acquisition, effects of the transactions are
eliminated in consolidation. There are no amounts as of and for the years ended
December 31, 1997 and 1996, as the effects of related party transactions are now
eliminated in consolidation. The 1995 results of operations include commissions
and claims & loss control fees from affiliates of $775,179 and $2,927,998,
respectively.
48
<PAGE> 31
Meadowbrook Insurance Group, Inc.
Notes to Consolidated Financial Statements
13. QUARTERLY FINANCIAL DATA (unaudited)
<TABLE>
<CAPTION>
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
- -------------------------------------------------------------------------------------------------------
(in thousands, except per share and ratio data)
<S> <C> <C> <C> <C>
1997:
Gross written premium $32,990 $30,558 $33,347 $49,844
Net written premium 18,256 16,246 16,178 24,285
Net earned premium 14,791 16,963 17,150 19,589
Net commissions and fees 5,640 5,406 7,166 6,148
Net investment income and realized gains/losses 1,947 2,031 2,056 2,228
Net losses and LAE incurred 7,879 11,253 8,400 8,611
Policy acquisition and other expenses 4,329 2,189 6,725 6,937
Net income 2,973 3,495 3,178 3,397
Earnings per share $0.33 $0.38 $0.35 $0.37
Dividends declared per share $0.02 $0.02 $0.02 $0.02
GAAP combined ratio 88.1% 89.4% 89.9% 91.3%
</TABLE>
<TABLE>
<CAPTION>
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
- -------------------------------------------------------------------------------------------------------
(in thousands, except per share and ratio data)
<S> <C> <C> <C> <C>
1996:
Gross written premium $31,231 $27,995 $25,791 $30,563
Net written premium 22,675 20,400 18,664 11,019
Net earned premium 21,266 20,103 22,429 20,749
Net commissions and fees 4,598 4,043 3,291 4,634
Net investment income and realized gains/losses 2,002 1,993 1,945 2,087
Net losses and LAE incurred 11,709 7,746 11,738 10,072
Policy acquisition and other expenses 6,701 8,455 9,392 7,531
Net income 2,773 3,114 492* 2,327
Earnings per share $0.30 $0.34 $0.05 $0.26
Dividends declared per share ,$0.02 $0.02 $0.02 $0.02
GAAP combined ratio 97.4% 93.5% 101.4% 95.8%
</TABLE>
*Due to the adverse development in the surety bond business related to
discounted agents
49
<PAGE> 1
EXHIBIT 21
<TABLE>
<S><C>
Meadowbrook Insurance Group, Inc.
t/k/a Star Holding Company 50%
Meadowbrook, American
Inc. Indemnity
Insurance Co., Ltd.
Star Crest Financial
Insurance Co. (50%) Corporation
Williamsburg
Savers Property National
and Casualty Insurance Co.
Insurance Co.
Association American
Self Insurance Highway
Services, Inc. Carriers Association
Meadowbrook Liberty
Intermediaries, Premium Finance,
Inc. Inc.
Meadowbrook Interline
Risk Insurance Services,
Management, Inc. Inc.
Meadowbrook of Commercial
Nevada, Inc. Carriers Insurance
Agency, Inc.
Meadowbrook
Insurance
Agency, Inc.
Meadowbrook
Risk
Management, Ltd.
(Barbados)
Meadowbrook
Risk Management
Limited
(Bermuda):
(80%)
Meadowbrook
International, Ltd.
</TABLE>
<PAGE> 1
EXHIBIT 23
[LETTERHEAD OF COOPERS & LYBRAND]
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration statement of
Meadowbrook Insurance Group, Inc. on Form S-8 of our report dated March 19,
1998, on our audits of the consolidated financial statements and financial
statement schedule of Meadowbrook Insurance Group, Inc. as of December 31, 1997
and 1996, and for the years ended December 31, 1997, 1996 and 1995, which
report was incorporated by reference in this Annual Report on Form 10-K.
COOPERS & LYBRAND LLP
Detroit, Michigan
March 30, 1998
<PAGE> 1
EXHIBIT 24
POWER OF ATTORNEY
-----------------
KNOW ALL MEN BY THESE PRESENTS: That the undersigned officers and
directors of Meadowbrook Insurance Group, Inc., a Michigan corporation, do
hereby constitute and appoint Joseph C. Henry and Robert S. Cubbin, and each
of them, the lawful attorneys and agents or attorney and agent, with power and
authority to do any and all acts and things and to execute any and all
instruments which said attorneys and agents, and any one of them, determine
may be necessary or advisable or required to enable said corporation to comply
with the Securities Act of 1933 as amended, and any rules or regulations or
requirements of the Securities and Exchange Commission in connection with this
Registration Statement. Without limiting the generality of the foregoing power
and authority, the powers granted include the power and authority to sign the
names of the undersigned officers and directors in the capacities indicated
below to this Registration Statement, to any and all amendments, both pre-
effective and post-effective, and supplements to this Registration Statement,
and to any and all instruments or documents filed as part of or in conjunction
with this Registration Statement or amendments or supplements thereto, and
each of the undersigned hereby ratifies and confirms all that said attorneys
and agents or any of them shall do or cause to be done by virtue hereof. This
Power of Attorney may be signed in several counterparts.
IN WITNESS WHEREOF, each of the undersigned has executed this Power of
Attorney as of the date indicated opposite his name.
Signature Title Date
--------- ----- ----
Chairman, Chief March 26, 1998
Merton J. Segal Executive Officer and
- ------------------------- Director (Principal
Merton J. Segal Executive Officer)
Warren D. Gardner President and Director March 26, 1998
- -------------------------
Warren D. Gardner
Office of the President
James R. Parry and Director March 26, 1998
- -------------------------
James R. Parry
Secretary, Office of the
Robert S. Cubbin President and Director March 26, 1998
- -------------------------
Robert S. Cubbin
Treasurer, Office of the
Joseph C. Henry President and Director March 26, 1998
- -------------------------
Joseph C. Henry
Bruce E. Thal Director March 26, 1998
- -------------------------
Bruce E. Thal
Joseph S. Dresner Director March 26, 1998
- -------------------------
Joseph S. Dresner
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<DEBT-HELD-FOR-SALE> 141,465
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 5,612
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 147,077
<CASH> 20,215
<RECOVER-REINSURE> 48,081
<DEFERRED-ACQUISITION> 6,609
<TOTAL-ASSETS> 328,642
<POLICY-LOSSES> 98,979
<UNEARNED-PREMIUMS> 59,168
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 0
0
0
<COMMON> 86
<OTHER-SE> 115,360
<TOTAL-LIABILITY-AND-EQUITY> 328,642
68,493
<INVESTMENT-INCOME> 8,128
<INVESTMENT-GAINS> 134
<OTHER-INCOME> 24,370
<BENEFITS> 36,143
<UNDERWRITING-AMORTIZATION> 6,030
<UNDERWRITING-OTHER> 41,566
<INCOME-PRETAX> 17,386
<INCOME-TAX> 4,343
<INCOME-CONTINUING> 13,043
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 13,043
<EPS-PRIMARY> 1.51
<EPS-DILUTED> 1.42
<RESERVE-OPEN> 65,755
<PROVISION-CURRENT> 34,908
<PROVISION-PRIOR> 1,235
<PAYMENTS-CURRENT> 9,506
<PAYMENTS-PRIOR> 31,626
<RESERVE-CLOSE> 60,786
<CUMULATIVE-DEFICIENCY> 1,235
</TABLE>
