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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington D.C. 20549** **FORM 10-Q**   þ     **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE    SECURITIES EXCHANGE ACT OF 1934**   **For the quarter ended September 30, 2005** **or** **o** **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.)***26255 American Drive, Southfield, Michigan 48034***(Address, zip code of principal executive offices)***(248) 358-1100***(Registrant’s telephone number, including area code)*     Indicate by check mark whether the Registrant (1) has filedall reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrantwas required to file such reports), and (2) has beensubject to such filing requirements for the past90 days.     Yes þ          No o     Indicate by check mark whether the Registrant is an acceleratedfiler (as defined in Rule 12b-2 of the ExchangeAct).     Yes þ          No o     Indicate by check mark whether the Registrant is a shell company(as defined in Rule 12b-2 of the ExchangeAct).     Yes o          No þ     The aggregate number of shares of the Registrant’s CommonStock, $.01 par value, outstanding on November 1, 2005was 28,684,282.  

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PART 1 -- FINANCIAL INFORMATIONITEM 1 Financial StatementsCONSOLIDATED STATEMENTS OF INCOMECONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMECONSOLIDATED BALANCE SHEETSCONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the Periods ended September 30, 2005 and 2004Item 3. Quantitative and Qualitative Disclosures About Market RiskItem 4. Controls and ProceduresPART II -- OTHER INFORMATIONItem 1. Legal ProceedingsItem 2. Unregistered Sales of Equity Securities and Use of ProceedsItem 6. ExhibitsSIGNATURESSecond Amendment to Credit AgreementCertification of Robert S. Cubbin, Chief Executive Officer, Pursuant to Rule 13a-14(a)Certification of Karen M. Spaun, Senior Vice President and Chief Financial Officer, Pursuant to Rule 13a-14(a)Certification of Robert S. Cubbin, Chief Executive Officer, Pursuant to Section 906Certification of Karen M. Spaun, Senior Vice President and Chief Financial Officer, Pursuant to Section 906

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**TABLE OF CONTENTS**           **Page**     **PART I — FINANCIAL INFORMATION**    ITEM 1 —     FINANCIAL STATEMENTS          Consolidated Statements of Income (unaudited)  2-3       Consolidated Statements of Comprehensive Income (unaudited)  4-5       Consolidated Balance Sheets (unaudited)  6       Consolidated Statement of Cash Flows (unaudited)  7       Notes to Consolidated Financial Statements (unaudited)  8-21     ITEM 2 —     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION    AND RESULTS OF OPERATIONS  22-42     ITEM 3 —     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK  42-43     ITEM 4 —     CONTROLS AND PROCEDURES  43-44 **PART II — OTHER INFORMATION**    ITEM 1 —     LEGAL PROCEEDINGS  45     ITEM 2 —     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS  45     ITEM 6 —     EXHIBITS  45-46     SIGNATURES  47 
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**PART 1 — FINANCIAL INFORMATION****ITEM 1     *FinancialStatements*****MEADOWBROOK INSURANCE GROUP, INC.****CONSOLIDATED STATEMENTS OF INCOME**             **For the Nine Months Ended**  **September 30,**     **2005** **2004**       **(Unaudited)**  **(In thousands,**  **except share data)****Revenues**             Premiums earned              Gross $244,016  $211,125       Ceded  (56,660)  (55,366)            Net earned premiums  187,356   155,759      Net commissions and fees  27,333   32,794      Net investment income  13,159   10,901      Net realized gains (losses)  31   (73)             Total revenues  227,879   199,381        **Expenses**             Losses and loss adjustment expenses  179,669   158,467      Reinsurance recoveries  (66,338)  (61,303)            Net losses and loss adjustment expenses  113,331   97,164      Salaries and employee benefits  39,166   39,417      Policy acquisition and other underwriting expenses  33,740   24,585      Other administrative expenses  19,868   19,367      Interest expense  2,527   1,529              Total expenses  208,632   182,062            Income before taxes and equity earnings  19,247   17,319             Federal and state income tax expense  6,250   6,043      Equity (losses) earnings, of affiliates  (12)  28            Net income $12,985  $11,304            Earnings Per Share              Basic $0.45  $0.39       Diluted $0.44  $0.38     Weighted average number of common shares              Basic  29,052,785   29,040,503       Diluted  29,363,045   29,420,049 The accompanying notes are an integral part of the ConsolidatedFinancial Statements.
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**MEADOWBROOK INSURANCE GROUP, INC.****CONSOLIDATED STATEMENTS OF INCOME**             **For the Three Months Ended**  **September 30,**     **2005** **2004**       **(Unaudited)**  **(In thousands,**  **except share data)****Revenues**             Premiums earned              Gross $82,466  $75,025       Ceded  (19,261)  (22,062)            Net earned premiums  63,205   52,963      Net commissions and fees  9,200   12,669      Net investment income  4,591   3,757      Net realized gains  41   79              Total revenues  77,037   69,468        **Expenses**             Losses and loss adjustment expenses  61,805   57,056      Reinsurance recoveries  (23,336)  (25,227)            Net losses and loss adjustment expenses  38,469   31,829      Salaries and employee benefits  12,913   14,284      Policy acquisition and other underwriting expenses  11,947   8,169      Other administrative expenses  6,037   6,802      Interest expense  948   686              Total expenses  70,314   61,770            Income before taxes and equity earnings  6,723   7,698             Federal and state income tax expense  2,048   2,509      Equity (losses) earnings, of affiliates  (13)  63            Net income $4,662  $5,252            Earnings Per Share              Basic $0.16  $0.18       Diluted $0.16  $0.18     Weighted average number of common shares              Basic  28,957,369   29,059,626       Diluted  29,269,638   29,425,674 The accompanying notes are an integral part of the ConsolidatedFinancial Statements.
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**MEADOWBROOK INSURANCE GROUP, INC.****CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**              **For the Nine Months**  **Ended September 30,**     **2005** **2004**       **(Unaudited)**  **(In thousands)**    Net income $12,985  $11,304      Other comprehensive income (loss), net of tax:              Unrealized losses on securities  (4,844)  (1,386)      Less: reclassification adjustment for losses included in net    income  61   41               Other comprehensive loss, net of tax  (4,783)  (1,345)              Comprehensive income $8,202  $9,959        The accompanying notes are an integral part of the ConsolidatedFinancial Statements.
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**MEADOWBROOK INSURANCE GROUP, INC.****CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**              **For the Three**  **Months Ended**  **September 30,**     **2005** **2004**       **(Unaudited)**  **(In thousands)**    Net income $4,662  $5,252      Other comprehensive income (loss), net of tax:              Unrealized (losses) gains on securities  (3,633)  3,285       Less: reclassification adjustment for (gains) losses    included in net income  (18)  (19)              Other comprehensive (loss) gain, net of tax  (3,651)  3,266               Comprehensive income $1,011  $8,518        The accompanying notes are an integral part of the ConsolidatedFinancial Statements.
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**MEADOWBROOK INSURANCE GROUP, INC.****CONSOLIDATED BALANCE SHEETS**             **September 30,** **December 31,**  **2005** **2004**       **(Unaudited)**    **(In thousands,**  **except share data)****ASSETS**    Investments             Debt securities available for sale, at fair value (amortized    cost of $382,183 and $324,966) $382,250  $332,242      Equity securities available for sale, at fair value (cost of $0)  —   39              Total investments  382,250   332,281      Cash and cash equivalents  51,897   69,875      Accrued investment income  4,631   4,331      Premiums and agent balances receivable, net  105,815   84,094      Reinsurance recoverable on:              Paid losses  15,095   17,908       Unpaid losses  181,262   151,161      Prepaid reinsurance premiums  24,743   26,075      Deferred policy acquisition costs  26,594   25,167      Deferred federal income taxes  16,354   14,956      Goodwill  28,997   28,997      Other assets  44,168   46,851              Total assets $881,806  $801,696         **LIABILITIES AND SHAREHOLDERS’ EQUITY**    Liabilities             Losses and loss adjustment expenses $443,294  $378,157      Unearned premiums  143,312   134,302      Debt  2,298   12,144      Debentures  55,930   35,310      Accounts payable and accrued expenses  28,997   38,837      Reinsurance funds held and balances payable  15,388   17,832      Payable to insurance companies  5,526   6,990      Other liabilities  13,107   10,614              Total liabilities  707,852   634,186            Commitments and contingencies (Note 6)            Shareholders’ Equity             Common stock, $0.01 stated value; authorized    50,000,000 shares; 28,759,282 and 29,074,832 shares    issued and outstanding  288   290      Additional paid-in capital  124,968   126,085      Retained earnings  49,512   37,175      Note receivable from officer  (859)  (868)     Accumulated other comprehensive income  45   4,828              Total shareholders’ equity  173,954   167,510              Total liabilities and shareholders’ equity $881,806  $801,696        The accompanying notes are an integral part of the ConsolidatedFinancial Statements.
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**MEADOWBROOK INSURANCE GROUP, INC.****CONSOLIDATED STATEMENTS OF CASH FLOWS**              **For the Nine Months**  **Ended September 30,**     **2005** **2004**       **(Unaudited)**  **(In thousands)****Cash Flows From Operating Activities**             Net income $12,985  $11,304      Adjustments to reconcile net income to net cash provided by    operating activities:              Amortization of other intangible assets  277   284       Amortization of deferred debenture issuance costs  116   73       Depreciation of furniture, equipment, and building  1,853   1,087       Net accretion of discount and premiums on bonds  1,786   1,318       Loss on sale of investments, net  94   63       Gain on sale of fixed assets  (148)  (22)      Stock-based employee compensation  32   61       Long-term incentive plan expense  585   488       Deferred income tax expense  1,067   2,193      Changes in operating assets and liabilities:             Decrease (increase) in:              Premiums and agent balances receivable  (21,721)  (22,572)      Reinsurance recoverable on paid and unpaid losses  (27,289)  (11,104)      Prepaid reinsurance premiums  1,332   (3,514)      Deferred policy acquisition costs  (1,427)  (3,918)      Other assets  6,172   4,244      Increase (decrease) in:              Losses and loss adjustment expenses  65,137   32,677       Unearned premiums  9,010   20,035       Payable to insurance companies  (1,464)  (106)      Reinsurance funds held and balances payable  (2,444)  5,946       Other liabilities  2,746   4,807               Total adjustments  35,714   32,040              Net cash provided by operating activities  48,699   43,344        **Cash Flows From Investing Activities**             Purchase of debt securities available for sale  (174,301)  (87,022)     Proceeds from sales and maturities of debt securities available    for sale  115,196   38,294      Proceeds from sales of equity securities available for sale  8   —      Capital expenditures  (14,050)  (3,156)     Purchase of books of business  (342)  (361)     Proceeds from sale of assets  633   2,784      Deconsolidation of subsidiary  —   (4,218)     Other investing activities  (1,942)  2,398              Net cash used in investing activities  (74,798)  (51,281)       **Cash Flows From Financing Activities**             Proceeds from lines of credit  6,388   9,829      Payment of lines of credit  (16,234)  (13,585)     Net proceeds from debentures  19,400   24,250      Book overdraft  1,172   (607)     Stock options exercised  995   125      Share repurchases of common stock  (3,404)  —      Other financing activities  (196)  14              Net cash provided by financing activities  8,121   20,026             Net (decrease) increase in cash and cash equivalents  (17,978)  12,089      Cash and cash equivalents, beginning of period  69,875   50,647             Cash and cash equivalents, end of period $51,897  $62,736        The accompanying notes are an integral part of the ConsolidatedFinancial Statements.
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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****(Unaudited)****Note 1 — Summary of Significant AccountingPolicies*****Basis of Presentation and Management Representation***     The consolidated financial statements include accounts, afterelimination of intercompany accounts and transactions, ofMeadowbrook Insurance Group, Inc. (the “Company”), itswholly owned subsidiary Star Insurance Company(“Star”), and Star’s wholly owned subsidiaries,Savers Property and Casualty Insurance Company, WilliamsburgNational Insurance Company, and Ameritrust Insurance Corporation(which are collectively referred to as the “InsuranceCompany Subsidiaries”), and Preferred Insurance Company,Ltd. The consolidated financial statements also includeMeadowbrook, Inc., Crest Financial Corporation, and theirsubsidiaries. In addition, the consolidated financial statementsinclude the equity earnings of the Company’s wholly ownedunconsolidated subsidiaries, American Indemnity InsuranceCompany, Ltd., Meadowbrook Capital Trust I, and MeadowbrookCapital Trust II.     In the opinion of management, the consolidated financialstatements reflect all normal recurring adjustments necessary topresent a fair statement of the results for the interim period.Preparation of financial statements under generally acceptedaccounting principles requires management to make estimates.Actual results could differ from those estimates. The results ofoperations for the three months and nine months endedSeptember 30, 2005, are not necessarily indicative of theresults expected for the full year.     These financial statements and the notes thereto should be readin conjunction with the Company’s audited financialstatements and accompanying notes included in its annual reporton Form 10-K, as filed with the United States Securitiesand Exchange Commission, for the year ended December 31,2004.     Certain amounts in the 2004 financial statements and notes toconsolidated financial statements have been reclassified toconform to the 2005 presentation. These amounts specificallyrelate to state income tax expense, the allocation of corporateoverhead, and a reclassification of revenue and net incomerelated to a specific subsidiary. State income tax expense hasbeen reclassified from total expenses to federal and stateincome tax expense. The Company’s segment information hasbeen reclassified to include an allocation of corporate overheadfrom the specialty risk management operations segment to theagency operations segment. This reclassification for theallocation of corporate overhead more accurately presents theCompany’s segments as a result of improved cost allocationinformation. Previously, 100% of corporate overhead wasallocated to specialty risk management operations. In addition,the Company reclassified revenues and the overall net incomerelated to a specific subsidiary from the agency operationssegment to the specialty risk management operations segment.Refer to Note 7* — Segment Information*foradditional information.***Revenue Recognition***     Premiums written are recognized as earned on a pro rata basisover the life of the policy term. Unearned premiums representthe portion of premiums written that are applicable to theunexpired terms of policies in force. Provisions for unearnedpremiums on reinsurance assumed from others are made on thebasis of ceding reports when received and actuarial estimates.Certain premiums are subject to retrospective premiumadjustments. Premiums are recognized over the term of theinsurance policy.     Fee income, which includes risk management consulting, losscontrol, and claims services, is recognized during the periodthe services are provided. Depending on the terms of thecontract, claims processing fees are recognized as revenue overthe estimated life of the claims, or the estimated life of thecontract. For those contracts that provide services beyond theexpiration or termination of the contract, fees are deferred inan amount equal to management’s estimate of theCompany’s obligation to continue to provide services.     Commission income, which includes reinsurance placement, isrecorded on the later of the effective date or the billing dateof the policies on which they are earned. Commission income isreported net of sub-producer commission expense. Profit sharingcommissions from insurance companies are recognized whendeterminable, which is when such commissions are received.
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**     The Company reviews, on an ongoing basis, the collectibility ofits receivables and establishes an allowance for estimateduncollectible accounts.     Realized gains or losses on sale of investments are determinedon the basis of specific costs of the investments. Dividendincome is recognized when declared and interest income isrecognized when earned. Discount or premium on debt securitiespurchased at other than par value is amortized using theeffective yield method. Investments with other than temporarydeclines in fair value are written down to their estimated netfair value and the related realized losses are recognized inincome.***Earnings Per Share***     Basic earnings per share are based on the weighted averagenumber of common shares outstanding during the period, whilediluted earnings per share includes the weighted average numberof common shares and potential dilution from shares issuablepursuant to stock options using the treasury stock method.     Outstanding options of 619,092 and 976,020 for the nine monthsended September 30, 2005 and 2004, respectively, have beenexcluded from the diluted earnings per share, as they wereanti-dilutive. Shares issuable pursuant to stock optionsincluded in diluted earnings per share were 310,260 and 307,386for the nine months ended September 30, 2005 and 2004,respectively. In addition, shares issuable pursuant tooutstanding warrants included in diluted earnings per share were72,160 for the nine months ended September 30, 2004. Therewere no outstanding warrants as of September 30, 2005.     Outstanding options of 619,092 and 976,020 for the three monthsended September 30, 2005 and 2004, respectively, have beenexcluded from the diluted earnings per share, as they wereanti-dilutive. Shares issuable pursuant to stock optionsincluded in diluted earnings per share were 312,269 and 296,481for the three months ended September 30, 2005 and 2004,respectively. In addition, shares issuable pursuant tooutstanding warrants included in diluted earnings per share were69,567 for the three months ended September 30, 2004. Therewere no outstanding warrants as of September 30, 2005.***Stock Options***     Effective January 1, 2003, the Company adopted therequirements of Statement of Financial Accounting Standards(“SFAS”) No. 148, *“Accounting forStock-Based Compensation — Transition andDisclosure — an amendment of FASB StatementNo. 123,”*utilizing the prospective method. Underthe prospective method, stock-based compensation expense isrecognized for awards granted after the beginning of the fiscalyear in which the change is made. Upon implementation ofSFAS No. 148 in 2003, the Company is recognizingstock-based compensation expense for awards granted afterJanuary 1, 2003.     Prior to the adoption of SFAS No. 148, the Companyapplied the intrinsic value-based provisions set forth in APBOpinion No. 25. Under the intrinsic value method,compensation expense is determined on the measurement date,which is the first date when both the number of shares theemployee is entitled to receive, and the exercise price areknown. Compensation expense, if any, resulting from stockoptions granted by the Company is determined based upon thedifference between the exercise price and the fair market valueof the underlying common stock at the date of grant. TheCompany’s Stock Option Plan requires the exercise price ofthe grants to be at the current fair market value of theunderlying common stock.     The Company, through its 1995 and 2002 Amended and RestatedStock Option Plans (the “Plans”), may grant options tokey executives and other members of management of the Companyand its subsidiaries in amounts not to exceed 2,000,000 sharesof the Company’s common stock allocated for each plan. ThePlans are administered by the Compensation Committee (the“Committee”) of the Board of Directors. Option sharesmay be exercised subject to the terms of the Plans and the termsprescribed by the Committee at the time of grant. Currently, thePlans’ options have either five or ten-year terms and areexercisable and vest in equal increments over the option term.
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**     In 2004, the Company’s Board of Directors approved theadoption of a Long Term Incentive Plan (the “LTIP”).The LTIP provides participants with the opportunity to earn cashand stock awards based upon the achievement of specifiedfinancial goals over a three-year performance period with thefirst performance period commencing January 1, 2004. At theend of the three-year performance period, and if the performancetarget is achieved, the Committee shall determine the amount ofLTIP awards that are payable to participants in the LTIP.One-half of any LTIP award will be payable in cash and one-halfof the award will be payable in the form of a restricted stockaward. If the Company achieves the three-year performancetarget, payment of the award would be made in three annualinstallments. The number of shares of Company’s commonstock subject to the restricted stock award shall equal thedollar amount of one-half of the LTIP award divided by the fairmarket value of Company’s common stock on the first date ofthe performance period. The restricted stock awards shall bemade subject to the terms and conditions of the LTIP and Plans.The Company accrues awards based upon the criteria set forth andapproved by the Committee, as included in the LTIP. AtSeptember 30, 2005 and December 31, 2004, the Companyhad $2.5 million and $1.3 million accrued under theLTIP, respectively.     If compensation cost for stock option grants had been determinedbased on a fair value method, net income and earnings per shareon a pro forma basis for the periods ending September 30,2005 and 2004 would be as follows (in thousands):            **For the Nine Months**  **Ended September 30,**     **2005** **2004**         Net income, as reported $12,985  $11,304     Stock-based employee compensation expense included in reported    income, net of related tax effects  21   40     Total stock-based employee compensation expense determined under    fair-value-based methods for all awards, net of related tax    effects  (161)  (344)           Pro forma net income $12,845  $11,000            Earnings per share:             Basic — as reported $0.45  $0.39      Basic — pro forma $0.44  $0.38      Diluted — as reported $0.44  $0.38      Diluted — pro forma $0.44  $0.37 
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**            **For the Three Months**  **Ended September 30,**     **2005** **2004**         Net income, as reported $4,662  $5,252     Stock-based employee compensation expense included in reported    income, net of related tax effects  6   11     Total stock-based employee compensation expense determined under    fair-value-based methods for all awards, net of related tax    effects  (40)  (93)           Pro forma net income $4,628  $5,170            Earnings per share:             Basic — as reported $0.16  $0.18      Basic — pro forma $0.16  $0.18      Diluted — as reported $0.16  $0.18      Diluted — pro forma $0.16  $0.18      No options were granted during the nine months and three monthsending September 30, 2005 or 2004.     Compensation expense of $32,000 and $61,000 has been recorded inthe nine months ended September 30, 2005 and 2004,respectively, under SFAS 148. Compensation expense of$9,000 and $17,000 has been recorded in the three months endedSeptember 30, 2005 and 2004, respectively.***Recent Accounting Pronouncements***     In December 2004, the Financial Accounting Standards Board(“FASB”) issued SFAS No. 123 (revised 2004),*“Share-Based Payment”*(“SFAS 123(R)”), which replacesSFAS No. 123, *“Accounting for Stock Issued toEmployees.”*SFAS 123(R) requires all share-basedpayments to employees to be recognized in the financialstatements based on their fair values. The pro forma disclosurespreviously permitted under SFAS 123, will no longer be analternative to financial statement recognition. Commencing inthe first quarter of 2003, the Company began expensing the fairvalue of all stock options granted since January 1, 2003under the prospective method. Under SFAS 123(R), theCompany must determine the appropriate fair value model to beused for valuing share-based payments, the amortization methodfor compensation cost and the transition method to be used atthe date of adoption. The transition methods include prospectiveand retroactive adoption options. Under the retroactive options,prior periods may be restated either as of the beginning of theyear of adoption or for all periods presented. The prospectivemethod requires that compensation expense be recorded at thebeginning of the first quarter of adoption of SFAS 123(R)for all unvested stock options and restricted stock based uponthe previously disclosed SFAS 123 methodology and amounts.The retroactive methods would record compensation expensebeginning with the first period restated for all unvested stockoptions and restricted stock. On April 14, 2005, theSecurities and Exchange Commission adopted a new rule thatdelays the compliance dates for SFAS 123(R). Under the newrule, SFAS 123(R) is effective for public companies forannual, rather than interim periods, that begin afterJune 15, 2005. Therefore, the Company is required to adoptSFAS 123(R) in the first quarter of 2006, or beginningJanuary 1, 2006. The Company has evaluated the requirementsof SFAS 123(R) and has determined the impact on itsfinancial statements related to existing stock options isimmaterial.     In May 2005, the FASB issued SFAS No. 154,*“Accounting Changes and Error Corrections, a replacementof APB Opinion No. 20 and FASB StatementNo. 3.”* SFAS No. 154 replaces thementioned pronouncements and changes the requirements for theaccounting and reporting of a change in an accounting principle.This Statement applies to all voluntary changes in accountingprinciple, as well as changes required by an accountingpronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions. However, when apronouncement includes specific transition provisions, thoseprovisions
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**should be followed. SFAS No. 154 requiresretrospective application to prior period financial statementsfor changes in accounting principle, unless it is impracticableto determine either the period-specific effects or thecumulative effect of the change. SFAS No. 154 alsorequires that retrospective application of a change inaccounting principle be limited to the direct effects of thechange. Indirect effects of a change in accounting principleshould be recognized in the period of the accounting change.SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning afterDecember 15, 2005. However, early adoption is permitted foraccounting changes and corrections of errors made in fiscalyears beginning after the date this Statement was issued. TheCompany is required to adopt the provisions ofSFAS No. 154, as applicable, beginning in 2006.Management believes the adoption of SFAS No. 154 willnot have a material impact on its consolidated financialstatements.     In July 2005, the FASB issued an exposure draft of a proposedinterpretation on accounting for uncertain tax positions underSFAS No. 109 *“Accounting for IncomeTaxes.”*If adopted as proposed, the pronouncement willbe effective December 31, 2005 and only those tax benefitsthat meet the probable recognition threshold may be recognizedor continue to be recognized as of the effective date. TheCompany has evaluated the impact this proposed interpretationwill have on its financial statements and does not expect it tohave a material impact.**Note 2 — Reinsurance**     The Insurance Company Subsidiaries cede insurance to otherinsurers under pro-rata and excess-of-loss contracts. Thesereinsurance arrangements diversify the Company’s businessand minimize its exposure to large losses or from hazards of anunusual nature. The ceding of insurance does not discharge theoriginal insurer from its primary liability to its policyholder.In the event that all or any of the reinsuring companies areunable to meet their obligations, the Insurance CompanySubsidiaries would be liable for such defaulted amounts.Therefore, the Company is subject to credit risk with respect tothe obligations of its reinsurers. In order to minimize itsexposure to significant losses from reinsurer insolvencies, theCompany evaluates the financial condition of its reinsurers andmonitors the economic characteristics of the reinsurers on anongoing basis. The Company also assumes insurance from otherinsurers and reinsurers, both domestic and foreign, underpro-rata and excess-of-loss contracts. Based uponmanagement’s evaluation, they have concluded thereinsurance agreements entered into by the Company transfer bothsignificant timing and underwriting risk to the reinsurer and,accordingly, are accounted for as reinsurance under theprovisions of SFAS. No. 113 *“Accounting andReporting for Reinsurance for Short-Duration and Long-DurationContracts.”*     Intercompany pooling agreements are commonly entered intobetween affiliated insurance companies, so as to allow thecompanies to utilize the capital and surplus of all of thecompanies, rather than each individual company. Under poolingarrangements, companies share in the insurance business that isunderwritten and allocate the combined premium, losses andrelated expenses between the companies within the poolingarrangement. Effective January 1, 2005, the InsuranceCompany Subsidiaries entered into an Inter-Company ReinsuranceAgreement (the “Pooling Agreement”). This PoolingAgreement includes Star, Ameritrust Insurance Corporation(“Ameritrust”), Savers Property and Casualty InsuranceCompany (“Savers”) and Williamsburg National InsuranceCompany (“Williamsburg”). Pursuant to the PoolingAgreement, Savers, Ameritrust and Williamsburg have agreed tocede to Star and Star has agreed to reinsure 100% of theliabilities and expenses of Savers, Ameritrust and Williamsburg,relating to all insurance and reinsurance policies issued bythem. In return, Star agrees to cede and Savers, Ameritrust andWilliamsburg have agreed to reinsure Star for their respectivepercentages of the liabilities and expenses of Star. The PoolingAgreement was filed with the applicable regulatory authorities.Any changes to the Pooling Agreement must be submitted to theapplicable regulatory authorities.     At September 30, 2005, the Company had reinsurancerecoverables for paid and unpaid losses of $196.4 million.The Company customarily collateralizes reinsurance balances duefrom non-admitted reinsurers through funds withheld trusts orletters of credit. The largest unsecured reinsurance recoverableis
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**due from an admitted reinsurer with an “A” A.M. Bestrating and accounts for 37.0%, or $72.6 million, of thetotal recoverable for paid and unpaid losses.     The Company maintains an excess-of-loss reinsurance treatydesigned to protect against large or unusual loss and lossadjustment expense activity. The Company determines theappropriate amount of reinsurance primarily based on theCompany’s evaluation of the risks accepted, but alsoconsiders analysis prepared by consultants and reinsurers and onmarket conditions including the availability and pricing ofreinsurance. To date, there have been no material disputes withthe Company’s excess-of-loss reinsurers. No assurance canbe given, however, regarding the future ability of any of theCompany’s excess-of-loss reinsurers to meet theirobligations.     Under the workers’ compensation reinsurance treaty,reinsurers are responsible for 100% of each loss in excess of$350,000, up to $5.0 million for each claimant, on lossesoccurring prior to April 1, 2005. The Company increased itsretention from $350,000 to $750,000, for losses occurring on orafter April 1, 2005. In addition, there is coverage forloss events involving more than one claimant up to$50.0 million per occurrence. In a loss event involvingmore than one claimant, the per claimant coverage is$10.0 million.     Under the core liability reinsurance treaty, the reinsurers areresponsible for 100% of each loss in excess of $350,000, up to$2.0 million per occurrence on policies effective prior toJune 1, 2005. The Company increased its retention from$350,000 to $500,000, for losses occurring on policies effectiveon or after June 1, 2005. The Company also purchased anadditional $3.0 million of reinsurance clash coverage inexcess of the $2.0 million to cover amounts that may be inexcess of the $2.0 million policy limit, such as expensesassociated with the settlement of claims or awards in excess ofpolicy limits. Reinsurance clash coverage reinsures a loss whentwo or more policies are involved in a common occurrence.     The Company has a separate treaty to cover liabilityspecifically related to commercial trucking, where reinsurersare responsible for 100% of each loss in excess of $350,000, upto $1.0 million. In addition, the Company purchased anadditional $1.0 million of reinsurance clash coverage. TheCompany also established a separate treaty to cover liabilityrelated to chemical distributors and repackagers, wherereinsurers are responsible for 100% of each loss in excess of$500,000, up to $1.0 million, applied separately to generalliability and auto liability.     Under the property reinsurance treaty, reinsurers areresponsible for 100% of the amount of each loss in excess of$500,000, up to $5.0 million per location for anoccurrence. In addition, there is coverage for loss eventsinvolving multiple locations up to $20.0 million after theCompany has incurred $750,000 in loss.     Under the semi-automatic facultative reinsurance treaties,covering the Company’s umbrella policies, the reinsurersare responsible for a minimum of 85% of the first million incoverage and 100% of each of the second through fifth million ofcoverage, up to $5.0 million. The reinsurers pay a cedingcommission to reimburse the Company for its expenses associatedwith the treaties.     Effective September 30, 2004, the Company amended anexisting reinsurance agreement that provided reinsurancecoverage for policies with effective dates from August 1,2003 to July 31, 2004, which were written in theCompany’s public entity excess liability program. Thisreinsurance agreement provided coverage on an excess-of-lossbasis for each occurrence in excess of the policyholder’sself-insured and the Company’s retained limit. Thisreinsurance agreement was amended by revising premium rate andloss coverage terms, which effected the transfer of risk to thereinsurer and reduced the net estimated costs of reinsurance tothe Company. The amended reinsurance cost for this coverage is aflat percentage of premium subject to this treaty and providesreinsurance coverage of $4.0 million in excess of$1.0 million for each occurrence in excess of thepolicyholder’s self-insured retention. These amended termswere applicable to the renewal of this reinsurance agreement forthe period August 1, 2004 to January 31, 2006.     In addition, the Company purchased $10.0 million in excessof $5.0 million for each occurrence, which is above theunderlying $5.0 million of coverage for the Company’spublic entity excess liability program. Under
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**this agreement, reinsurers are responsible for 100% of each lossin excess of $5.0 million for all lines, exceptworkers’ compensation, which is covered by theCompany’s core catastrophic workers’ compensationtreaty structure up to $50.0 million per occurrence.     Additionally, several small programs have separate reinsurancetreaties in place, which limit the Company’s exposure to$350,000 or less.     Facultative reinsurance is purchased for property values inexcess of $5.0 million, casualty limits in excess of$2.0 million, or for coverage not covered by a treaty.     In its risk-sharing programs, the Company is also subject tocredit risk with respect to the payment of claims by itsclients’ captive, rent-a-captive, large deductibleprograms, indemnification agreements, and on the portion of riskexposure either ceded to the captives, or retained by theclients. The capitalization and credit worthiness of prospectiverisk-sharing partners is one of the factors considered by theCompany in entering into and renewing risk-sharing programs. TheCompany collateralizes balances due from its risk-sharingpartners through funds withheld trusts or letters of credit. AtSeptember 30, 2005, the Company had risk exposure in excessof collateral in the amount of $10.6 million on theseprograms, of which the Company has an allowance of$8.5 million, related to these exposures. At June 30,2005, the Company increased its exposure allowance related toreinsurance recoverables for a specific discontinued suretyprogram. The Company had received an updated financial reportfrom the liquidator of the defunct reinsurer on that program.Based upon this information, the Company increased the allowancein relation to this program to 100% of the uncollateralizedexposure as of June 30, 2005. The Company’s total netexposure, after collateral and allowances, for uncollectiblereinsurance at September 30, 2005, was $2.1 million,up from $1.9 million at June 30, 2005.     The Company has historically maintained an allowance for thepotential uncollectibility of certain reinsurance balances duefrom some risk-sharing partners, some of which are in litigationwith the Company. At the end of each quarter, an analysis ofthese exposures is conducted to determine the potential exposureto uncollectibility. As of September 30, 2005, managementbelieves that this allowance is adequate. No assurance can begiven, however, regarding the future ability of any of theCompany’s risk-sharing partners to meet their obligations.**Note 3 — Debt*****Lines of Credit***     In November 2004, the Company entered into a revolving line ofcredit for up to $25.0 million. The revolving line ofcredit replaced the Company’s former term loan and line ofcredit and expires in November 2007. The Company had drawnapproximately $9.0 million on this new revolving line ofcredit to pay off its former term loan. The Company used therevolving line of credit to meet short-term working capitalneeds. Under the revolving line of credit, the Company andcertain of its non-regulated subsidiaries pledged securityinterests in certain property and assets of the Company andnamed subsidiaries.     At September 30, 2005, there was no outstanding balance onthe revolving line of credit. On December 31, 2004, theCompany had an outstanding balance of $9.0 million on therevolving line of credit.     The revolving line of credit provides for interest at a variablerate based, at the Company’s option, upon either a primebased rate or LIBOR-based rate. On prime based borrowings, theapplicable margin ranges from 75 to 25 basis points below prime.On LIBOR-based borrowings, the applicable margin ranges from 125to 175 basis points above LIBOR. The margin for all loansis dependent on the sum of non-regulated earnings beforeinterest, taxes, depreciation, amortization, and non-cashimpairment charges related to intangible assets for thepreceding four quarters, plus dividends paid or payable to theCompany from subsidiaries during such period (“AdjustedEBITDA”). For the three month period endingSeptember 30, 2005, the average interest rate forLIBOR-based borrowings was 4.7%.
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**     Debt covenants consist of: (1) maintenance of the ratio ofAdjusted EBITDA to interest expense of 2.0 to 1.0,(2) minimum net worth of $130.0 million and increasingannually, commencing June 30, 2005, by fifty percent of theprior year’s positive net income, (3) minimumA.M. Best rating of “B”, and (4) on anannual basis, a minimum Risk Based Capital Ratio for Star of1.75 to 1.00. As of September 30, 2005, the Company was incompliance with these covenants.     In addition, a non-insurance premium finance subsidiary of theCompany maintains a line of credit with a bank, which permitsborrowings up to 75% of the accounts receivable, whichcollateralize the line of credit. At September 30, 2005,this line of credit had an outstanding balance of$2.3 million. On April 26, 2005, the terms of thisline of credit were modified. The modifications included adecrease in the line of credit from $8.0 million to$6.0 million. The interest terms of this line of creditprovide for interest at the prime rate minus 0.5%, or aLIBOR-based rate, plus 2.0%. At September 30, 2005, theLIBOR-based option was 5.6% and the average interest rate was5.6%.***Senior Debentures***     In April 2004, the Company issued senior debentures in theamount of $13.0 million. The senior debentures mature inthirty years and provide for interest at the three-month LIBOR,plus 4.0%, which is non-deferrable. The senior debentures arecallable by the Company at par after five years from the date ofissuance. Associated with this transaction, the Company incurred$390,000 of commissions paid to the placement agents. Theseissuance costs have been capitalized and are included in otherassets on the balance sheet, which are being amortized overseven years as a component of interest expense.     In May 2004, the Company issued senior debentures in the amountof $12.0 million. The senior debentures mature in thirtyyears and provide for interest at the three-month LIBOR, plus4.2%, which is non-deferrable. The senior debentures arecallable by the Company at par after five years from the date ofissuance. Associated with this transaction, the Company incurred$360,000 of commissions paid to the placement agents. Theseissuance costs have been capitalized and are included in otherassets on the balance sheet, which are being amortized overseven years as a component of interest expense.     The Company contributed $9.9 million of the proceeds to itsInsurance Company Subsidiaries in December 2004. The remainingproceeds from the issuance of the senior debentures may be usedto support future premium growth through further contributionsto the Insurance Company Subsidiaries and general corporatepurposes.***Junior Subordinated Debentures***     In September 2005, Meadowbrook Capital Trust II (the“Trust II”), an unconsolidated subsidiary trustof the Company, issued $20.0 million of mandatorilyredeemable trust preferred securities (“TPS”) to atrust formed by an institutional investor. Contemporaneously,the Company issued $20.6 million in junior subordinateddebentures, which includes the Company’s investment in thetrust of $620,000. These debentures have financial terms similarto those of the TPS, which includes the deferral of interestpayments at any time, or from time-to-time, for a period notexceeding five years, provided there is no event of default.These debentures mature in thirty years and provide for interestat the three-month LIBOR, plus 3.58%. These debentures arecallable by the Company at par beginning in October 2010.     The Company received $19.4 million in net proceeds, afterthe deduction of approximately $600,000 of commissions paid tothe placement agents in the transaction. These issuance costshave been capitalized and are included in other assets on thebalance sheet, which will be amortized over seven years as acomponent of interest expense.     The Company contributed $10.0 million of the proceeds fromthe issuance of these debentures to its Insurance CompanySubsidiaries and the remaining balance will be used for generalcorporate purposes.
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**     In September 2003, Meadowbrook Capital Trust (the“Trust”), an unconsolidated subsidiary trust of theCompany, issued $10.0 million of mandatorily redeemable TPSto a trust formed by an institutional investor.Contemporaneously, the Company issued $10.3 million injunior subordinated debentures, which includes theCompany’s investment in the trust of $310,000. Thesedebentures have financial terms similar to those of the TPS,which includes the deferral of interest payments at any time, orfrom time-to-time, for a period not exceeding five years,provided there is no event of default. These debentures maturein thirty years and provide for interest at the three-monthLIBOR, plus 4.05%. These debentures are callable by the Companyat par beginning in October 2008.     The Company received $9.7 million in net proceeds, afterthe deduction of approximately $300,000 of commissions paid tothe placement agents in the transaction. These issuance costshave been capitalized and are included in other assets on thebalance sheet, which are being amortized over seven years as acomponent of interest expense.     The Company contributed $6.3 million of the proceeds fromthe issuance of these debentures to its Insurance CompanySubsidiaries and the remaining balance has been used for generalcorporate purposes.     The junior subordinated debentures are unsecured obligations ofthe Company and are junior to the right of payment to all seniorindebtedness of the Company. The Company has guaranteed that thepayments made to both Trusts will be distributed by the Truststo the holders of the TPS.     The Company estimates that the fair value of the above mentionedjunior subordinated debentures and senior debentures issuedapproximate the gross proceeds of cash received at the time ofissuance.     The seven year amortization period in regard to the issuancecosts represents management’s best estimate of theestimated useful life of the bonds related to both the seniordebentures and junior subordinated debentures described above.**Note 4 — Shareholders’ Equity**     At September 30, 2005, shareholders’ equity was$174.0 million, or a book value of $6.05 per common share,compared to $167.5 million, or a book value of $5.76 percommon share, at December 31, 2004.     In November 2004, the Company’s Board of Directorsauthorized management to repurchase up to 1,000,000 shares ofits common stock in market transactions for a period not toexceed twenty-four months. For the nine months and three monthsended September 30, 2005, the Company purchased and retired634,900 and 426,110 shares of common stock for a total cost ofapproximately $3.4 million and $2.3 million,respectively. The Company did not repurchase any common stockduring 2004. As of September 30, 2005, the cumulativeamount the Company repurchased and retired under the currentshare repurchase plan was 634,900 shares of common stock for atotal cost of approximately $3.4 million.     At the Company’s regularly scheduled board meeting onOctober 28, 2005, the Company’s Board of Directorsauthorized management to purchase up to 1,000,000 shares, orapproximately 3%, of the Company’s common stock in markettransactions for a period not to exceed twenty-four months.**Note 5 — Regulatory Matters and RatingAgencies**     A significant portion of the Company’s consolidated assetsrepresent assets of the Insurance Company Subsidiaries that atthis time, without prior approval of the State of MichiganOffice of Financial and Insurance Services (“OFIS”),cannot be transferred to the holding company in the form ofdividends, loans or advances. The restriction on thetransferability to the holding company from its InsuranceCompany Subsidiaries is regulated by Michigan insuranceregulatory statutes which, in general, are as follows: themaximum discretionary dividend that may be declared, based ondata from the preceding calendar year, is the greater of eachinsurance company’s net income (excluding realized capitalgains) or ten percent of the
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**insurance company’s surplus (excluding unrealized gains).These dividends are further limited by a clause in the Michiganlaw that prohibits an insurer from declaring dividends, exceptfrom surplus earnings of the company. Earned surplus balancesare calculated on a quarterly basis. Since Star is the parentinsurance company, its maximum dividend calculation representsthe combined Insurance Company Subsidiaries’ surplus. Basedupon the 2004 statutory financial statements, Star may only paydividends to the Company during 2005 with the prior approval ofOFIS. Star’s earned surplus position at December 31,2004 was negative $13.7 million. At September 30,2005, earned surplus was negative $7.1 million. Nostatutory dividends were paid in 2004 or 2005.     Insurance operations are subject to various leverage tests (e.g.premium to statutory surplus ratios), which are evaluated byregulators and rating agencies. The Company’s targets forgross and net written premium to statutory surplus are 3.0 to1.0 and 2.5 to 1.0, respectively. As of September 30, 2005,on a statutory combined basis, the gross and net premiumleverage ratios were 2.4 to 1.0 and 1.9 to 1.0, respectively.     The National Association of Insurance Commissioners(“NAIC”) has adopted a risk-based capital(“RBC”) formula to be applied to all property andcasualty insurance companies. The formula measures requiredcapital and surplus based on an insurance company’sproducts and investment portfolio and is used as a tool toevaluate the capital of regulated companies. The RBC formula isused by state insurance regulators to monitor trends instatutory capital and surplus for the purpose of initiatingregulatory action. In general, an insurance company must submita calculation of its RBC formula to the insurance department ofits state of domicile as of the end of the previous calendaryear. These laws require increasing degrees of regulatoryoversight and intervention as an insurance company’s RBCdeclines. The level of regulatory oversight ranges fromrequiring the insurance company to inform and obtain approvalfrom the domiciliary insurance commissioner of a comprehensivefinancial plan for increasing its RBC to mandatory regulatoryintervention requiring an insurance company to be placed underregulatory control in a rehabilitation or liquidation proceeding.     At December 31, 2004, all of the Insurance CompanySubsidiaries were in compliance with RBC requirements. Starreported statutory surplus of $120.7 million atDecember 31, 2004, compared to the minimum thresholdrequiring regulatory involvement of $56.9 million in 2004.At September 30, 2005, Star’s statutory surplus was$138.9 million.**Note 6 — Commitments and Contingencies**     In June 2003, the Company entered into a guaranty agreement witha bank. The Company is guaranteeing payment of a$1.5 million term loan issued by the bank to anunaffiliated insurance agency. In the event of default on theterm loan by the insurance agency, the Company is obligated topay any outstanding principal (up to a maximum of$1.5 million), as well as any accrued interest on the loan,and any costs incurred by the bank in the collection process. Inexchange for the Company’s guaranty, the president andmember of the unaffiliated insurance agency pledged 100% of thecommon stock of two insurance agencies that he wholly owns. Inthe event of default of the term loan by the unaffiliatedinsurance agency, the Company has the right to sell all or aportion of the pledged assets (the common stock of the twoinsurance agencies) and use the proceeds from the sale torecover any amounts paid under the guaranty agreement. Anyexcess proceeds would be paid to the shareholder. As ofSeptember 30, 2005, no liability has been recorded withrespect to the Company’s obligations under the guarantyagreement, since the collateral is in excess of the guaranteedamount.     In July 2005, the Company made a $2.5 million loan, at aneffective interest rate equal to the three-month LIBOR, plus5.2%, to an unaffiliated insurance agency. This agency has beena producer for the Company for over ten years. Under the termsof the agreement, the Company may demand repayment of theprincipal, plus accrued interest at any time. As security forthe loan, the shareholder has pledged 100% of the
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**common shares of the unaffiliated insurance agency and threeother insurance agencies, and has executed a personal guaranty.     The Company, and its subsidiaries, are subject at times tovarious claims, lawsuits and proceedings relating principally toalleged errors or omissions in the placement of insurance,claims administration, consulting services and other businesstransactions arising in the ordinary course of business. Whereappropriate, the Company vigorously defends such claims,lawsuits and proceedings. Some of these claims, lawsuits andproceedings seek damages, including consequential, exemplary orpunitive damages, in amounts that could, if awarded, besignificant. Most of the claims, lawsuits and proceedingsarising in the ordinary course of business are covered by errorsand omissions insurance or other appropriate insurance. In termsof deductibles associated with such insurance, the Company hasestablished provisions against these items, which are believedto be adequate in light of current information and legal advice.In accordance with SFAS No. 5, *“Accounting forContingencies,”* if it is probable that an asset hasbeen impaired or a liability has been incurred as of the date ofthe financial statements and the amount of loss is estimable; anaccrual for the costs to resolve these claims is recorded by theCompany in its consolidated balance sheets. Period expensesrelated to the defense of such claims are included in otheroperating expenses in the accompanying consolidated statementsof income. Management, with the assistance of outside counsel,adjusts such provisions according to new developments or changesin the strategy in dealing with such matters. On the basis ofcurrent information, the Company does not expect the outcome ofthe claims, lawsuits and proceedings to which the Company issubject to, either individually, or in the aggregate, will havea material adverse effect on the Company’s financialcondition. However, it is possible that future results ofoperations or cash flows for any particular quarter or annualperiod could be materially affected by an unfavorable resolutionof any such matters.**Note 7 — Segment Information**     The Company defines its operations as specialty risk managementoperations and agency operations based upon differences inproducts and services. The separate financial information ofthese segments is consistent with the way results are regularlyevaluated by management in deciding how to allocate resourcesand in assessing performance. Intersegment revenue is eliminatedupon consolidation. It would be impracticable for the Company todetermine the allocation of assets between the two segments.***Specialty Risk Management Operations***     The specialty risk management operations segment focuses onspecialty or niche insurance business in which it providesvarious services and coverages tailored to meet specificrequirements of defined client groups and their members. Theseservices include risk management consulting, claimsadministration and handling, loss control and prevention, andreinsurance placement, along with various types of property andcasualty insurance coverage, including workers’compensation, commercial multiple peril, general liability,commercial auto liability, and inland marine. Insurance coverageis provided primarily to associations or similar groups ofmembers and to specified classes of business of theCompany’s agent-partners. The Company recognizes revenuerelated to the services and coverages the specialty riskmanagement operations provides within seven categories: netearned premiums, management fees, claims fees, loss controlfees, reinsurance placement, investment income, and net realizedgains (losses).***Agency Operations***     The Company earns commissions through the operation of itsretail property and casualty insurance agency, which was formedin 1955. The agency is one of the largest agencies in Michiganand, with acquisitions, has expanded into California. The agencyoperations produce commercial, personal lines, life, andaccident and health insurance, for more than fifty unaffiliatedinsurance carriers.
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**     The following table sets forth the segment results (inthousands):             **For the Nine Months**  **Ended September 30,**     **2005** **2004**         Revenues             Net earned premiums $187,356  $155,759      Management fees  12,624   12,557      Claims fees  5,317   11,427      Loss control fees  1,739   1,629      Reinsurance placement  563   301      Investment income  13,012   10,884      Net realized losses  (52)  (73)             Specialty risk management  220,559   192,484      Agency operations(2)  8,859   7,646      Reconciling items(3)  230   17      Intersegment revenue(2)  (1,769)  (766)             Consolidated revenue $227,879  $199,381            Pre-tax income:             Specialty risk management(1) & (2) $21,942  $19,182      Agency operations(1) & (2)  2,669   1,841      Other corporate  (5,364)  (3,704)             Consolidated pre-tax income $19,247  $17,319        
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**             **For the Three Months**  **Ended September 30,**     **2005** **2004**         Revenues             Net earned premiums $63,205  $52,963      Management fees  4,328   3,948      Claims fees  1,799   5,998      Loss control fees  611   552      Reinsurance placement  124   184      Investment income  4,458   3,751      Net realized gains  40   79              Specialty risk management  74,565   67,475      Agency operations(2)  2,917   2,657      Reconciling items  134   6      Intersegment revenue(2)  (579)  (670)             Consolidated revenue $77,037  $69,468            Pre-tax income:             Specialty risk management(1) & (2) $7,959  $8,799      Agency operations(1) & (2)  687   239      Other corporate  (1,923)  (1,340)             Consolidated pre-tax income $6,723  $7,698         (1)     The Company’s agency operations include an allocation of    corporate overhead, which includes expenses associated with    accounting, information services, legal, and other corporate    services. The corporate overhead allocation excludes those    expenses specific to the holding company. Prior to    January 1, 2005, corporate overhead was only reflected in    the specialty risk management operations segment. This    reclassification for the allocation of corporate overhead more    accurately presents the Company’s segments as a result of    improved cost allocation information. As a result, the segment    information for the periods ended September 30, 2004, have    been adjusted to reflect this allocation. For the nine months    ended September 30, 2005 and 2004, the allocation of    corporate overhead to the agency operations segment was    $2.3 million and $2.6 million, respectively. For the    three months ended September 30, 2005 and 2004, the    allocation of corporate overhead to the agency operations    segment was $609,000 and $948,000, respectively. (2)     In addition to the reclassification for the allocation of    corporate overhead as described above, the Company also    reclassified 2004 revenues related to the conversion of a    west-coast commercial transportation program, which was    converted to a specialty risk program with one of its    subsidiaries, from the agency operations segment to the    specialty risk management operations segment. Accordingly, the    agency operations revenue and intersegment revenue have been    reclassified. As a result, $5.6 million and    $1.8 million was reclassified within the agency operations    segment and the intersegment revenue for the nine months and    three months ended September 30, 2004, respectively. In    addition, the overall net income related to this subsidiary was    reclassified from the agency operations to the specialty risk    management operations segment. As a result, pre-tax net income    of $2.3 million and $951,000 related to this subsidiary was    reclassified to the specialty risk management operations pre-tax    income from the agency operations segment for the nine months    and three months ended September 30, 2004, respectively. (3)     On December 4, 2003, the Company entered into a Purchase    and Sale Agreement with an unaffiliated third party for the sale    of land. In July 2004, a land contract was executed and the    transaction closed in escrow subject to the conveyance of    certain land by the city to both parties. On May 18, 2005,    the settlement of the land contract was completed. The sale of    this land resulted in a total gain of approximately $464,000. In    accordance with SFAS No. 66 *“Accounting for    Sales of Real Estate,”*the Company recorded this    transaction based on the installment method of accounting.    Accordingly, the Company recorded a gain of $82,000, as of    June 30, 2005, which reflects a portion of the total gain    allocated proportionately based on the down payment to the total    purchase price. The remaining $382,000 will be deferred until    the land contract is paid in full, or as principal payments are    received.
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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****(Unaudited)**    The reconciling item included in the revenue relates to interestincome and the above mentioned gain in the holding company. Thefollowing table sets forth the components of other corporatepre-tax income (loss) (in thousands):           **For the Nine Months**  **Ended September 30,**     **2005** **2004**         Holding company expenses $(2,560) $(1,891)    Amortization  (277)  (284)    Interest expense  (2,527)  (1,529)         $(5,364) $(3,704)                  **For the Three Months**  **Ended September 30,**     **2005** **2004**         Holding company expenses $(882) $(562)    Amortization  (93)  (92)    Interest expense  (948)  (686)         $(1,923) $(1,340)       **Note 8 — Subsequent Events**     On October 4, 2005, the Company entered into two interestrate swap transactions with LaSalle Bank (“LaSalle”)to mitigate its interest rate risk on $5.0 million and$20.0 million of the Company’s senior debentures andtrust preferred securities, respectively. The Company willrecognize these transactions in accordance withSFAS No. 133 *“Accounting for DerivativeInstruments and Hedging Activities,”*as subsequentlyamended. These interest rate swap transactions have beendesignated as a cash flow hedge and are deemed a highlyeffective transaction under SFAS No. 133. Inaccordance with SFAS No. 133, these interest rate swaptransactions will be recorded at fair value on the balance sheetand any changes in their fair value will be accounted for withinother comprehensive income. The interest differential to be paidor received will be accrued and will be recognized as anadjustment to interest expense.     The first interest rate swap transaction, which relates to$5.0 million of the Company’s $12.0 millionissuance of senior debentures, has an effective date ofOctober 6, 2005 and ending date of May 24, 2009. TheCompany is required to make certain quarterly fixed ratepayments to LaSalle calculated on a notional amount of$5.0 million, non-amortizing, based on a fixed annualinterest rate of 8.925%. LaSalle is obligated to make quarterlyfloating rate payments to the Company referencing the samenotional amount, based on the three-month LIBOR, plus 4.20%.     The second interest rate swap transaction, which relates to$20.0 million of the Company’s $20.0 millionissuance of trust preferred securities, has an effective date ofOctober 6, 2005 and ending date of September 16, 2010.The Company is required to make quarterly fixed rate payments toLaSalle calculated on a notional amount of $20.0 million,non-amortizing, based on a fixed annual interest rate of 8.34%.LaSalle is obligated to make quarterly floating rate payments tothe Company referencing the same notional amount, based on thethree-month LIBOR, plus 3.58%.     On November 1, 2005, the Company purchased the net assetsof a Florida-based insurance agency. In accordance withSFAS No. 141 *“Business Combinations,”*the Company will allocate the costs of the acquired businessto the assets acquired, including intangible assets andliabilities assumed, based on their estimated fair value at theacquisition date. Any costs in excess of the amount specificallyassigned to the assets acquired and liabilities assumed, will berecorded as goodwill. Subsequent to the acquisition, thegoodwill and other intangible assets will be accounted for inaccordance with SFAS No. 142 *“Goodwill andOther Intangible Assets.”*
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**ITEM 2****MANAGEMENT’S DISCUSSION AND ANALYSIS OF****FINANCIAL CONDITION AND RESULTS OF OPERATIONS****For the Periods ended September 30, 2005 and 2004*****Forward-Looking Statements***     *This quarterly report may provide information includingcertain statements which constitute forward-looking statementswithin the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. These include statementsregarding the intent, belief, or current expectations ofmanagement, including, but not limited to, those statements thatuse the words “believes”, “expects”,“anticipates”, “estimates”, or similarexpressions. You are cautioned that any such forward-lookingstatements are not guarantees of future performance and involvea number of risks and uncertainties, and results could differmaterially from those indicated by such forward-lookingstatements. Among the important factors that could cause actualresults to differ materially from those indicated by suchforward-looking statements are: the frequency and severity ofclaims; uncertainties inherent in reserve estimates;catastrophic events; a change in the demand for, pricing of,availability or collectibility of reinsurance; increased ratepressure on premiums; obtainment of certain rate increases incurrent market conditions; investment rate of return; changes inand adherence to insurance regulation; actions taken byregulators, rating agencies or lenders; obtainment of certainprocessing efficiencies; changing rates of inflation; generaleconomic conditions and other risks identified in our reportsand registration statements filed with the Securities andExchange Commission. We are not under any obligation to (andexpressly disclaim any such obligation to) update or alter ourforward-looking statements whether as a result of newinformation, future events or otherwise.***Description of Business**     We are a publicly traded specialty risk management company, withan emphasis on alternative market insurance and risk managementsolutions for agents, professional and trade associations, andinsureds of all sizes. The alternative market includes a widerange of approaches to financing and managing risk exposures,such as captives, rent-a-captives, risk retention and riskpurchasing groups, governmental pools and trusts, andself-insurance plans. The alternative market developed as aresult of the historical volatility in the cost and availabilityof traditional commercial insurance coverages, and usuallyinvolves some form of self-insurance or risk-sharing on the partof the client. We develop and manage alternative risk managementprograms for defined client groups and their members. We alsooperate as an insurance agency representing unaffiliatedinsurance companies in placing insurance coverages forpolicyholders. We define our business segments as specialty riskmanagement operations and agency operations.**Critical Accounting Estimates**     In certain circumstances, we are required to make estimates andassumptions that affect amounts reported in our consolidatedfinancial statements and related footnotes. We evaluate theseestimates and assumptions on an on-going basis based on avariety of factors. There can be no assurance, however, thatactual results will not be materially different than ourestimates and assumptions, and that reported results ofoperation will not be affected by accounting adjustments neededto reflect changes in these estimates and assumptions. Theaccounting estimates and related risks described in our annualreport on Form 10-K as filed with the United StatesSecurities and Exchange Commission on March 16, 2005, arethose that we consider to be our critical accounting estimates.For the three months and nine months ended September 30,2005, there have been no material changes in our policies withregard to any of our critical accounting estimates.
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**RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30,2005 AND 2004*****Executive Overview***     Our overall underwriting results continued to improve during thefirst nine months of 2005 in comparison to 2004. Thisimprovement is primarily the result of our controlled growth ofpremiums written and the impact of rate increases in 2004.Growth of net income continued to demonstrate our commitment tostrong underwriting discipline, our consistent focus on growingour profitable specialty and fee-for-service programs, alongwith our on-going plan to leverage fixed costs. As a result, ourgenerally accepted accounting principles (“GAAP”)combined ratio improved 2.1 percentage points to 98.8% forthe nine months ended September 30, 2005, from 100.9% inthe comparable period in 2004.     On April 19, 2005, we announced an upgrade from A.M. Bestof certain of our Insurance Company Subsidiaries from B+ (VeryGood), with a positive outlook to B++ (Very Good). The ratingsupgrade applies to Star Insurance Company (“Star”),Savers Property and Casualty Insurance Company, and WilliamsburgNational Insurance Company. Additionally, A.M. Bestreaffirmed the rating for Ameritrust Insurance Corporation as B+(Very Good), with a positive outlook.***Results of Operations***     Net income for the nine months ended September 30, 2005,was $13.0 million, or $0.44 per dilutive share, up 14.9%,compared to net income of $11.3 million, or $0.38 perdilutive share, for the comparable period of 2004. As previouslyindicated, this improvement is primarily the result of ourcontrolled growth of premiums written, the impact from rateincreases in 2004, overall expense initiatives, and thecontinued leveraging of fixed costs. These improvementsmanifested, despite the favorable effect in the third quarter of2004, from the acceleration of $3.5 million in deferredrevenue, less approximately $500,000 in expenses and$1.0 million in taxes, relating to the early termination ofa specific multi-state claims run-off contract. In addition, netincome was favorably impacted by approximately $928,000 fromprofit-sharing commissions received in the first nine months of2005, partially offset by continuing expenses primarily relatedto compliance with Section 404 of the Sarbanes-Oxley Act.     Revenues for the nine months ended September 30, 2005,increased $28.5 million, or 14.3%, to $227.9 million,from $199.4 million for the comparable period in 2004. Thisincrease reflects a $31.6 million, or 20.3%, increase innet earned premiums. The increase in net earned premiums is theresult of our controlled growth in written premiums. Thisincrease was attributable to growth in various existing programsand new programs implemented in 2004. The impact of an overall8.4% rate increase in 2004 also contributed to the increase innet earned premiums. Partially offsetting these increases inrevenue was an approximate $6.0 million decrease in managedfee revenue, which was primarily the result of an accelerationof $3.5 million in deferred claim fee revenue recognized inthe third quarter of 2004. This decrease in managed fee revenueand the acceleration of deferred claim fee revenue was theresult of the earlier than anticipated termination of twolimited duration administrative services and multi-state claimsrun-off contracts. These contracts had been terminated by theliquidator during the third quarter of 2004. Therefore, therevenues that we anticipated earning in the first nine months of2005 were accelerated into the third quarter of 2004. Inaddition, the increase in revenue reflects a $2.1 millionincrease in investment income, primarily the result of anincrease in average invested assets and a slight increase inyield.
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**Specialty Risk Management Operations**     The following table sets forth the revenues and results fromoperations for our specialty risk management operations (inthousands):            **For the Nine Months**  **Ended September 30,**     **2005** **2004**         Revenue:             Net earned premiums $187,356  $155,759      Management fees  12,624   12,557      Claims fees  5,317   11,427      Loss control fees  1,739   1,629      Reinsurance placement  563   301      Investment income  13,012   10,884      Net realized losses  (52)  (73)            Total revenue $220,559  $192,484            Pre-tax income             Specialty risk management operations(1) & (2) $21,942  $19,182  (1)     Our specialty risk management operations now exclude an    allocation of corporate overhead, which is attributable to our    agency operations. Prior to January 1, 2005, corporate    overhead was only reflected in the specialty risk management    operations segment. This reclassification for the allocation of    corporate overhead more accurately presents our segments as a    result of improved cost allocation information. As a result, the    segment information for the nine months ended September 30,    2004, has been adjusted to reflect this allocation. For the nine    months ended September 30, 2005 and 2004, the allocation of    corporate overhead from the specialty risk management operations    to the agency operations segment was $2.3 million and    $2.6 million, respectively. (2)     We reclassified 2004 revenues related to the conversion of a    west-coast commercial transportation program, which was    converted to a specialty risk program with one of our    subsidiaries, from the agency operations segment to the    specialty risk management operations segment. Accordingly, the    agency operations revenue and intersegment revenue have been    reclassified. In addition, the overall net income related to    this subsidiary was reclassified from the agency operations to    the specialty risk management operations segment. As a result,    pre-tax net income of $2.3 million related to this    subsidiary was reclassified to the specialty risk management    operations pre-tax income from the agency operations segment for    the nine months ended September 30, 2004.    Revenues from specialty risk management operations increased$28.1 million, or 14.6%, to $220.6 million for thenine months ended September 30, 2005, from$192.5 million for the comparable period in 2004.     Net earned premiums increased $31.6 million, or 20.3%, to$187.4 million in the nine months ended September 30,2005, from $155.8 million in the comparable period in 2004.This increase primarily reflects our controlled growth ofpremiums written.     Management fees were $12.6 million for the nine monthsended September 30, 2005, and remained consistent incomparison to 2004. Management fees were impacted by ananticipated shift in fee-for-service revenue previouslygenerated from a third party contract to internally generatedfee revenue from a specific renewal rights agreement that iseliminated upon consolidation. Due to the earlier thananticipated termination of this third party contract, therevenues that we anticipated earning in the first nine months of2005 were accelerated into the third quarter of 2004. Excludingrevenue generated from this third party contract, management feerevenue increased approximately $1.2 million in comparisonto 2004. This increase is primarily the result of a new Floridabased program implemented in the second quarter of 2005, as wellas growth in a specific existing New England based program.     Claim fees decreased $6.1 million, or 53.5%, to$5.3 million, from $11.4 million for the comparableperiod in 2004. This decrease reflects a similar anticipatedshifting of revenue previously generated from a multi-stateclaims run-off service contract, to internally generated feerevenue from a specific renewal rights agreement that iseliminated upon consolidation. As previously indicated, due tothe earlier than anticipated termination of this third partycontract, the revenues that we anticipated earning in the firstnine months of 2005 were
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accelerated into the third quarter of 2004. Excluding revenuegenerated from this third party contract, claim fee revenueincreased $392,000 in comparison to 2004. This increase isprimarily the result of growth in a specific workers’compensation fund program.     Net investment income increased $2.1 million, or 19.6%, to$13.0 million in 2005, from $10.9 million in 2004.Average invested assets increased $64.1 million, or 18.5%,to $410.0 million in 2005, from $346.0 million in2004. The increase in average invested assets reflects cashflows from underwriting activities and growth in gross writtenpremiums during 2004 and 2005, as well as net proceeds fromcapital raised in 2004 through the issuances of debentures. Theaverage investment yield for September 30, 2005, was 4.3%,compared to 4.2% for the comparable period in 2004. The currentpre-tax book yield was 4.2% and current after-tax book yield was3.0%. The investment yield reflects the accelerated prepaymentsin mortgage-backed securities and the reinvestment of cash flowsin municipal bonds.     Specialty risk management operations generated pre-tax income of$21.9 million for the nine months ended September 30,2005, compared to pre-tax income of $19.2 million for thecomparable period in 2004. This increase in pre-tax incomedemonstrates a continued improvement in underwriting results asa result of our controlled growth in premium volume and ourcontinued focus on leveraging of fixed costs. Offsetting aportion of this improvement, was a $3.0 million pre-taxbenefit, recognized in the third quarter of 2004, from thepreviously mentioned acceleration of revenue recognition, net ofexpenses, relating to the termination of a specific multi-stateclaims run-off contract. The GAAP combined ratio was 98.8% forthe nine months ended September 30, 2005, compared to100.9% for the same period in 2004.     Net loss and loss adjustment expenses (“LAE”)increased $16.1 million, or 16.6%, to $113.3 millionfor the nine months ended September 30, 2005, from$97.2 million for the same period in 2004. Our loss and LAEratio decreased 1.9 percentage points to 65.2% for the ninemonths ended September 30, 2005, from 67.1% for the sameperiod in 2004. This ratio is the unconsolidated net loss andLAE in relation to net earned premiums. This overall improvementin the loss and LAE ratio reflects the impact of earned premiumsfrom the controlled growth of profitable programs which have hadfavorable underwriting experience, as well as our intended shiftin the balance from workers’ compensation to the generalliability line of business. Historically, the general liabilityline of business has a lower loss ratio and a higher externalproducer commission. Additional discussion of our reserveactivity is described below within the *OtherItems — Reserves*section. In addition, therewas a 0.7 percentage point decrease in the net loss and LAEratio as a result of efficiencies realized within our claimshandling activities. This improvement was offset by developmenton prior accident year reserves, which added $4.5 million,or 2.4 percentage points, to net loss and LAE in 2005,compared to $1.7 million, or 1.1 percentage points in2004. This development on prior accident year reserves resultedin a 1.3 percentage point increase in the change in netultimate loss estimate for prior accident years in 2005 ascompared to 2004. The increase in the development on prioraccident years was the result of an increase of $900,000, or 0.5percentage points, related to one specific 2003 workers’compensation claim. This claim exceeded our then applicable$5.0 million per claimant limit in our 2003 workers’compensation treaty and is now reserved at $5.9 million. Inaddition, the development on prior accident years was alsoattributable to an increase to an exposure allowance of$618,000, specific to reinsurance recoverables for adiscontinued surety program. During the second quarter of 2005,we received updated financial information from the liquidator ofthe defunct reinsurer on that program. Based upon thisinformation, we increased the allowance to 100% of theuncollateralized exposure as of June 30, 2005. Our accidentyear loss ratio improved 3.3 percentage points to 62.7% forthe nine months ended September 30, 2005, from 66.0% forthe same period in 2004. The accident year loss and LAE ratio isthe unconsolidated GAAP loss and LAE ratio, excludingdevelopment on prior accident years.     Our expense ratio for the nine months ended September 30,2005 was 33.6%, compared to 33.8% for the same period in 2004.This ratio is the unconsolidated policy acquisition and otherunderwriting expenses in relation to net earned premiums. Ourexpense ratio was impacted by an anticipated increase in grossexternal commissions, due to the shift in the balance betweenworkers’ compensation and general liability. The generalliability line of business has a higher external producercommission rate and, as previously indicated, a lower lossratio. Offsetting these increases to the expense ratio was theimpact of the leveraging of fixed costs.
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**Agency Operations**     The following table sets forth the revenues and results fromoperations for our agency operations (in thousands):           **For the Nine**  **Months Ended**  **September 30,**     **2005** **2004**         Net commission(1) $8,859  $7,646     Pre-tax income(1) & (2) $2,669  $1,841  (1)     We reclassified 2004 revenues related to the conversion of a    west-coast commercial transportation program, which was    converted to a specialty risk program with one of our    subsidiaries, from the agency operations segment to the    specialty risk management operations segment. Accordingly, the    agency operations revenue and intersegment revenue have been    reclassified. As a result, $5.6 million was reclassified    within the agency operations segment and the intersegment    revenue for the nine months ended September 30, 2004. In    addition, the overall net income related to this subsidiary was    reclassified from the agency operations to the specialty risk    management operations segment. As a result, pre-tax net income    of $2.3 million related to this subsidiary was reclassified    to the specialty risk management operations pre-tax income from    the agency operations segment for the nine months ended    September 30, 2004. (2)     Our agency operations include an allocation of corporate    overhead, which includes expenses associated with accounting,    information services, legal, and other corporate services. The    corporate overhead allocation excludes those expenses specific    to the holding company. Prior to January 1, 2005, corporate    overhead was only reflected in the specialty risk management    operations segment. This reclassification for the allocation of    corporate overhead more accurately presents our segments as a    result of improved cost allocation information. As a result, the    segment information for the nine months ended September 30,    2004, has been adjusted to reflect this allocation. For the nine    months ended September 30, 2005 and 2004, the allocation of    corporate overhead to the agency operations segment was    $2.3 million and $2.6 million, respectively.    Revenue from agency operations, which consists primarily ofagency commission revenue, increased $1.2 million, or15.9%, to $8.8 million for the nine months endedSeptember 30, 2005, from $7.6 million for thecomparable period in 2004. This increase is primarily the resultof profit sharing commissions received in the first and thirdquarter of 2005. In addition, the agency operations experiencedan increase in new business and renewal retentions in comparisonto 2004, which was partially offset by a reduction in renewalrates.     Agency operations generated pre-tax income, after the allocationof corporate overhead, of $2.7 million for the nine monthsended September 30, 2005, compared to $1.8 million forthe comparable period in 2004. The improvement in the pre-taxmargin is primarily attributable to the overall increase incommissions and leveraging of fixed costs. Excluding fixed costsand the allocation of corporate overhead, all other expensesremained relatively consistent.**Other Items****     Reserves**     At September 30, 2005, our best estimate for the ultimateliability for loss and LAE reserves, net of reinsurancerecoverables, was $262.0 million. We established areasonable range of reserves of approximately$243.5 million to $279.1 million. This range wasestablished primarily by considering the various indications
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derived from standard actuarial techniques and other appropriatereserve considerations. The following table sets forth thisrange by line of business (in thousands):               **Minimum** **Maximum**    **Reserve** **Reserve** **Selected****Line of Business** **Range** **Range** **Reserves**           Workers’ Compensation(1) $137,947  $157,836  $147,945     Commercial Multiple Peril/ General Liability  46,670   54,380   50,420     Commercial Automobile  39,837   45,276   43,299     Other  19,074   21,653   20,368               Total Net Reserves $243,528  $279,145  $262,032            (1)     Includes Residual Markets    Reserves are reviewed by internal and independent actuaries foradequacy on a quarterly basis. When reviewing reserves, weanalyze historical data and estimate the impact of numerousfactors such as (1) per claim information;(2) industry and our historical loss experience;(3) legislative enactments, judicial decisions, legaldevelopments in the imposition of damages, and changes inpolitical attitudes; and (4) trends in general economicconditions, including the effects of inflation. This processassumes that past experience, adjusted for the effects ofcurrent developments and anticipated trends, is an appropriatebasis for predicting future events. There is no precise methodfor subsequently evaluating the impact of any specific factor onthe adequacy of reserves, because the eventual deficiency orredundancy is affected by multiple factors.     The key assumptions used in our selection of ultimate reservesincluded the underlying actuarial methodologies, a review ofcurrent pricing and underwriting initiatives, an evaluation ofreinsurance costs and retention levels, and a detailed claimsanalysis with an emphasis on how aggressive claims handling maybe impacting the paid and incurred loss data trends embedded inthe traditional actuarial methods. With respect to the ultimateestimates for losses and LAE, the key assumptions remainedconsistent for the nine months ended September 30, 2005 andthe year ended December 31, 2004.     For the nine months ended September 30, 2005, we reportedan increase in net ultimate loss estimates for accident years2004 and prior to be $4.5 million, or 2.0% of$227.0 million of net loss and LAE reserves atDecember 31, 2004. The increase in net ultimate lossestimates reflected revisions in the estimated reserves as aresult of actual claims activity in calendar year 2005 thatdiffered from the projected activity. There were no significantchanges in the key assumptions utilized in the analysis andcalculations of our reserves during 2005. The major componentsof this change in ultimate loss estimates are as follows (inthousands):                                     **Incurred Losses** **Paid Losses**    **Reserves at**     **Reserves at**  **December 31,** **Current** **Prior** **Total** **Current** **Prior**   **September 30,****Line of Business** **2004** **Year** **Years** **Incurred** **Year** **Years** **Total Paid** **2005**                     Workers’ Compensation $112,086  $46,926  $842  $47,768  $4,862  $30,985  $35,847  $124,007     Residual Markets  19,391   9,409   674   10,083   3,147   2,389   5,536   23,938     Commercial Multiple Peril/General Liability  44,217   15,823   225   16,048   220   9,625   9,845   50,420     Commercial Automobile  33,235   25,574   1,677   27,251   5,627   11,560   17,187   43,299     Other  18,067   11,082   1,099   12,181   2,362   7,518   9,880   20,368                              Net Reserves  226,996  $108,814  $4,517  $113,331  $16,218  $62,077  $78,295   262,032                              Reinsurance Recoverable  151,161                           181,262                              Consolidated $378,157                          $443,294                          
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                 **Re-estimated** **Development**  **Reserves at** **Reserves at** **as a Percentage**  **December 31,** **September 30, 2005** **of Prior Year****Line of Business** **2004** **on Prior Years** **Reserves**           Workers’ Compensation $112,086  $112,928   0.8%    Commercial Multiple Peril/General Liability  44,217   44,442   0.5%    Commercial Automobile  33,235   34,912   5.0%    Other  18,067   19,166   6.1%              Sub-total  207,605   211,448   1.9%    Residual Markets  19,391   20,065   3.5%              Total Net Reserves $226,996  $231,513   2.0%          **Workers’ Compensation Excluding Residual Markets**     The projected net ultimate loss estimate for the workers’compensation line of business, excluding residual markets,increased $842,000, or 0.8% of net workers’ compensationreserves. This net overall increase reflects decreases of$1.4 million, $3.1 million, and $940,000 in theultimate loss estimate for accident years 2004, 2001, and 1999,respectively. The decrease in the ultimate loss estimatereflects better than expected experience on most of ourworkers’ compensation programs. Average severity onreported claims did not increase as much as anticipated in theprior actuarial projections; therefore ultimate loss estimateswere reduced. In addition, there was a reallocation of lossreserves of $2.8 million from accident year 2001 toaccident year 2000 to align the incurred by not reported(“IBNR”) reserves with case reserves for a specificTennessee program. These net overall decreases were more thanoffset by increases of $2.7 million, $936,000, and$2.3 million in accident years 2003, 2002, and 2000,respectively. These increases are the result of higher thanexpected emergence of claim activity primarily related to aspecific workers’ compensation claim, as well as theaforementioned reallocation in the Tennessee program. The changein ultimate loss estimates for all other accident years wasinsignificant.**Commercial Multiple Peril/General Liability**     The commercial multiple peril line and general liability line ofbusiness had an increase in net ultimate loss estimates of$225,000, or 0.5% of net commercial multiple peril and generalliability reserves. The net decrease reflects a reduction of$612,000 in the ultimate loss estimate for accident year 2004.The improvement in the accident year reflected better thanexpected claim emergence on several programs. The decreases inthe 2003 and 2002 accident years were $1.1 million and$321,000, respectively. The decreases in accident years 2003 and2002 reflect the impact of a reclassification from the generalliability line of business to the commercial automobile line ofbusiness. This reclassification totaled $1.2 million andwas the result of actual claims emergence on three commercialautomobile claims that are subject to our core casualtyreinsurance program. Prior to the actual claims emergence thereserves for this exposure were carried in the general liabilityreinsurance line of business as IBNR. These decreases wereoffset by increases of $919,000, $556,000, and $476,000, inaccident years 2001, 2000, and 1999, respectively. The increasein the 2001 accident year loss ratio reflects slightly higherthan expected emergence of claim activity in several differentprograms. The increases in the 2000 and 1999 accident yearsreflect slightly higher than expected emergence of claimactivity in two discontinued programs. The change in ultimateloss estimates for all other accident years was insignificant.**Commercial Automobile**     The projected net ultimate loss estimate for the commercialautomobile line of business increased $1.7 million, or 5.0%of net commercial automobile reserves. This net overall increasereflects increases of $682,000, $426,000, and $918,000, inaccident years 2003, 2002, and 2001, respectively. Theseincreases reflect the impact of the three claims mentioned inthe above commercial multiple peril and general liabilitysection, which also reflect a reallocation by accident year. Thereserves also reflect higher than expected
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emergence of claim activity in an inactive program. Theseincreases were partially offset by reductions of $487,000 and$259,000 in the ultimate loss estimates for accident years 2004and 2000, respectively. The accident year 2004 reductionreflected better than expected claim emergence from a truckingprogram in California. Average severity on reported claims didnot increase as much as anticipated in the prior actuarialprojections; therefore ultimate loss estimates were reduced. Theaccident year 2000 reduction reflects the reallocation in IBNRon a discontinued program mentioned above. The change inultimate loss estimates for all other accident years wasinsignificant.**Other**     The other lines of business had an increase in net ultimate lossestimates of $1.1 million, or 6.1% of net reserves on theother lines of business. This net increase reflects an increasein the exposure allowance for potential unrecoverablereinsurance of $618,000 related to a specific discontinuedsurety program. During the second quarter or 2005, we receivedupdated financial information from the liquidator of the defunctreinsurer on that program. Based upon this information, weincreased the allowance to cover 100% of the uncollateralizedexposure as of June 30, 2005. The net increase alsoreflects an increase of $370,000 in accident year 2003 fromhigher than expected emergence of claim activity in a fewdifferent programs. The change in ultimate loss estimates forall other accident years was insignificant.**Residual Markets**     The workers’ compensation residual market line of businesshad an increase in net ultimate loss estimates of $674,000, or3.5% of net reserves on the workers’ compensation residualmarket line of business. The change reflects an increase of$824,000 in accident year 2003, offset by a $238,000 decrease inaccident year 2002. We record loss reserves as reported by theNational Council on Compensation Insurance (“NCCI”),plus an estimate for the reserves incurred but not yet analyzedand reported to us due to a two quarter lag in reporting. Thesechanges reflect a difference between our estimate of the lagincurred but not reported and the amounts reported by the NCCIin the quarter. The change in ultimate loss estimates for allother accident years was insignificant.**     Salary and Employee Benefitsand Other Administrative Expenses**     Salary and employee benefits for the nine months endedSeptember 30, 2005, decreased $251,000, or 0.6%, to$39.2 million, from $39.4 million for the comparableperiod in 2004. This variance reflects both a slight decrease instaffing levels in comparison to 2004 as a result of our expensereduction initiatives, offset by an increase due to meritincreases for associates.     Other administrative expenses increased $501,000, or 2.6%, to$19.9 million, from $19.4 million for the comparableperiod in 2004. This increase is primarily attributable toconsulting and audit expenses associated with Section 404of the Sarbanes-Oxley Act, as well as increases in expenses asthe result of information technology enhancements. Offsettingthese increases was an overall decrease in bad debt expense as aresult of an approximate $368,000 refinement in our estimationfor allowances on bad debt. The increase in other administrativeexpenses was also offset by our overall expense controlinitiatives.     Salary and employee benefits and other administrative expensesinclude both corporate overhead and the holding company expensesincluded in the reconciling items of our segment information.**     Interest Expense**     Interest expense for the nine months ended September 30,2005, increased $998,000, or 65.3%, to $2.5 million, from$1.5 million for the comparable period in 2004. Interestexpense is primarily attributable to our debentures, which aredescribed within the *Liquidity and Capital Resources*section of Management’s Discussion and Analysis, aswell as our current lines of credit. Interest expense increased$1.0 million primarily as a result of the senior debenturesissued in the second quarter of 2004. Interest expense relatedto our lines of credit remained relatively consistent incomparison to 2004. This is the result of a decrease in theaverage outstanding balance, offset by an increase in theaverage interest rate. The average outstanding
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balance during the nine months ending September 30, 2005,was $10.4 million, compared to $15.6 million for thesame period in 2004. The average interest rate, excluding thedebentures, in 2005 was 4.6%, compared to 4.2% in 2004.**     Income Taxes**     Income tax expense, which includes both federal and state taxes,for the nine months ended September 30, 2005, was$6.3 million, or 32.5% of income before taxes. For the sameperiod last year, we reflected an income tax expense of$6.0 million, or 34.9% of income before taxes. Oureffective tax rate differs from the 35% statutory rate primarilydue to a shift towards increasing investments in tax-exemptsecurities in an effort to maximize after-tax investment yields.Our current taxes are calculated using a 35% statutory ratebased on taxable income greater than $18.3 million.Deferred taxes are calculated based on a 34% statutory rate.**     Other than TemporaryImpairments**     Our policy for the valuation of temporarily impaired securitiesis to determine impairment based on analysis of the followingfactors: (1) market value less than amortized cost for asix month period; (2) rating downgrade or other creditevent (e.g., failure to pay interest when due);(3) financial condition and near-term prospects of theissuer, including any specific events which may influence theoperations of the issuer such as changes in technology ordiscontinuance of a business segment; (4) prospects for theissuer’s industry segment; and (5) our intent andability to retain the investment for a period of time sufficientto allow for anticipated recovery in market value. We evaluateour investments in securities to determine other than temporaryimpairment, no less than quarterly. Investments which are deemedimpaired are written down to their estimated net fair value andthe related losses recognized in income.     At September 30, 2005, we held 246 securities of which werein an unrealized loss position. These investments all hadunrealized losses of less than ten percent. AtSeptember 30, 2005, nineteen of those investments, with anaggregate $17.7 million and $737,000 fair value andunrealized loss, respectively, have been in an unrealized lossposition for more than eighteen months. Positive evidenceconsidered in reaching our conclusion that the investments in anunrealized loss position are not other than temporarily impairedconsisted of: 1) there were no specific events which causedconcerns; 2) there were no past due interest payments;3) there has been a rise in market prices; 4) our abilityand intent to retain the investment for a sufficient amount oftime to allow an anticipated recovery in value; and 5) wealso determined that the changes in market value were considerednormal in relation to overall fluctuations in interest rates.     The fair value and amount of unrealized losses segregated by thetime period the investment has been in an unrealized lossposition is as follows (in thousands):                    **September 30, 2005**     **Less than 12 Months** **Greater than 12 Months**       **Fair Value of** **Gross** **Fair Value of** **Gross**  **Investments with** **Unrealized** **Investments with** **Unrealized**  **Unrealized Losses** **Losses** **Unrealized Losses** **Losses**         **Debt Securities:**                    Debt securities issued by U.S. government and agencies $23,325  $(269) $11,791  $(378)    Obligations of states and political subdivisions  68,771   (830)  16,714   (398)    Corporate securities  37,424   (732)  19,421   (672)    Mortgage and asset backed securities  58,193   (783)  16,179   (450)                  Totals $187,713  $(2,614) $64,105  $(1,898)             
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     As of September 30, 2005, gross unrealized gains onsecurities were $4.6 million and gross unrealized losses onsecurities were $4.5 million.                    **December 31, 2004**     **Less than 12 Months** **Greater than 12 Months**       **Fair Value of** **Gross** **Fair Value of** **Gross**  **Investments with** **Unrealized** **Investments with** **Unrealized**  **Unrealized Losses** **Losses** **Unrealized Losses** **Losses**         **Debt Securities:**                    Debt securities issued by U.S. government and agencies $18,480  $(138) $4,871  $(150)    Obligations of states and political subdivisions  28,581   (257)  551   (14)    Corporate securities  23,323   (220)  7,450   (226)    Mortgage and asset backed securities  19,583   (167)  6,442   (129)                  Totals $89,967  $(782) $19,314  $(519)                  As of December 31, 2004, gross unrealized gains onsecurities were $8.6 million and gross unrealized losses onsecurities were $1.3 million.**RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDEDSEPTEMBER 30, 2005 AND 2004*****Results of Operations***     Net income for the three months ended September 30, 2005,was $4.7 million, or $0.16 per dilutive share, down$0.6 million, or 11.2%, compared to net income of$5.3 million, or $0.18 per dilutive share, for thecomparable period of 2004. This decrease in net income incomparison to 2004 is the result of the favorable effect in thethird quarter of 2004, from the acceleration of$3.5 million in deferred revenue, less approximately$500,000 in expenses and $1.0 million in taxes, relating tothe early termination of a specific multi-state claims run-offcontract. In addition, this decrease in comparison to 2004 isthe result of a reclassification recognized in the third quarterof 2004 relating to a reinsurance agreement amendment. Thereinsurance agreement was amended by revising premium rate andloss coverage terms. Therefore, instead of a deposit accountingtreatment, the new terms resulted in a transfer of risk to thereinsurer and reduced our net estimated reinsurance costs. Inconjunction with this reinsurance amendment, we recorded areduction of prior period estimated net reinsurance costs of$813,000, in the third quarter of 2004. These decreases weremore than offset by improved underwriting results, due to ourcontrolled growth of premiums written, the impact from rateincreases in 2004, overall expense initiatives, and ourcontinued leveraging of fixed costs. In addition, thesedecreases were partially offset by an increase in our managedfee revenue related to new programs.     Revenues for the three months ended September 30, 2005,increased $7.5 million, or 10.9%, to $77.0 million,from $69.5 million for the comparable period in 2004. Thisincrease reflects a $10.2 million, or 19.3%, increase innet earned premiums. The increase in net earned premiums is theresult of our controlled growth in written premiums. This growthwas attributable to growth in various existing programs, whichincluded new programs implemented in 2004 that had beenhistorically profitable. Partially offsetting these increases inrevenue was an approximate $3.8 million decrease in managedfee revenue, which included an acceleration of $3.5 millionin deferred claim fee revenue recognized in the third quarter of2004. As previously indicated, this decrease in managed feerevenue and the acceleration of deferred claim fee revenue wasthe result of the earlier than anticipated termination of twolimited duration administrative services and multi-state claimsrun-off contracts. These contracts had been terminated by theliquidator during the third quarter of 2004. Therefore, therevenues that we anticipated earning in 2005 were acceleratedinto the third quarter of 2004. In addition, the increase inrevenue reflects a $707,000 increase in investment income,primarily the result of an increase in average invested assets.
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**     Specialty Risk ManagementOperations**     The following table sets forth the revenues and results fromoperations for our specialty risk management operations (inthousands):            **For the Three Months**  **Ended September 30,**     **2005** **2004**         Revenue:             Net earned premiums $63,205  $52,963      Management fees  4,328   3,948      Claims fees  1,799   5,998      Loss control fees  611   552      Reinsurance placement  124   184      Investment income  4,458   3,751      Net realized gains  40   79             Total revenue $74,565  $67,475            Pre-tax income             Specialty risk management operations(1) & (2) $7,959  $8,799  (1)     Our specialty risk management operations now exclude an    allocation of corporate overhead, which is attributable to our    agency operations. Prior to January 1, 2005, corporate    overhead was only reflected in the specialty risk management    operations segment. This reclassification for the allocation of    corporate overhead more accurately presents our segments as a    result of improved cost allocation information. As a result, the    segment information for the three months ended    September 30, 2004, has been adjusted to reflect this    allocation. For the three months ended September 30, 2005    and 2004, the allocation of corporate overhead from the    specialty risk management operations to the agency operations    segment was $609,000 and $948,000, respectively. (2)     We reclassified 2004 revenues related to the conversion of a    west-coast commercial transportation program, which was    converted to a specialty risk program with one of our    subsidiaries, from the agency operations segment to the    specialty risk management operations segment. Accordingly, the    agency operations revenue and intersegment revenue have been    reclassified. In addition, the overall net income related to    this subsidiary was reclassified from the agency operations to    the specialty risk management operations segment. As a result,    pre-tax net income of $951,000 related to this subsidiary was    reclassified to the specialty risk management operations pre-tax    income from the agency operations segment for the three months    ended September 30, 2004.    Revenues from specialty risk management operations increased$7.1 million, or 10.5%, to $74.6 million for the threemonths ended September 30, 2005, from $67.5 millionfor the comparable period in 2004.     Net earned premiums increased $10.2 million, or 19.3%, to$63.2 million in the three months ended September 30,2005, from $53.0 million in the comparable period in 2004.This increase primarily reflects our controlled growth ofpremiums written, which included new programs implemented in2004.     Management fees increased $380,000, or 9.6%, to$4.3 million for the three months ended September 30,2005, from $3.9 million for the comparable period in 2004.This increase is primarily the result of a new Florida basedprogram implemented in the second quarter of 2005.     Claim fees decreased $4.2 million, or 70.0%, to$1.8 million, from $6.0 million for the comparableperiod in 2004. The decrease in claim fees reflects thepreviously mentioned $3.5 million in deferred revenuerecognized in the third quarter of 2004, as a result of theearlier than anticipated termination of the multi-state claimsrun-off contract. Excluding the recognition of the deferredrevenue and revenue previously generated from this contract,claim fee revenue increased $235,000, in comparison to 2004.This increase is primarily the result of growth in a specificworkers’ compensation fund program.     Net investment income increased $707,000, or 18.8%, to$4.5 million in 2005, from $3.8 million in 2004.Average invested assets increased $43.4 million, or 11.7%,to $412.7 million in 2005, from $369.3 million in2004. The increase in average invested assets reflects cashflows from underwriting activities and growth in gross writtenpremiums during 2004 and 2005, as well as net proceeds fromcapital raised in 2004 through the
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issuances of debentures. The average investment yield forSeptember 30, 2005, was 4.5%, compared to 4.1% for thecomparable period in 2004. The current pre-tax book yield was4.2% and current after-tax book yield was 3.0%. The investmentyield reflects the accelerated prepayments in mortgage-backedsecurities and the reinvestment of cash flows in municipal bonds.     Specialty risk management operations generated pre-tax income of$8.0 million for the three months ended September 30,2005, compared to pre-tax income of $8.8 million for thecomparable period in 2004. This increase in pre-tax incomedemonstrates a continued improvement in underwriting results asa result of our controlled growth in premium volume and ourcontinued focus on leveraging of fixed costs. Offsetting aportion of this improvement, was a $3.0 million pre-taxbenefit from the previously mentioned acceleration of revenuerecognition, net of expenses, relating to the termination of aspecific multi-state claims run-off contract, which wasrecognized in the third quarter of 2004. The GAAP combined ratiowas 99.8% for the three months ended September 30, 2005,compared to 99.5% for the same period in 2004.     Net loss and LAE increased $6.6 million, or 20.9%, to$38.4 million for the three months ended September 30,2005, from $31.8 million for the same period in 2004. Ourloss and LAE ratio increased 0.7 percentage points to 65.5%for the three months ended September 30, 2005, from64.8% for the same period in 2004. This ratio is theunconsolidated net loss and LAE in relation to net earnedpremiums. This increase to the loss and LAE ratio was the resultof development on prior accident year reserves which added$2.5 million, or 3.9 percentage points, compared tofavorable development of $749,000, which benefited the loss andLAE ratio in 2004 by 1.4 percentage points. Thisdevelopment on prior accident year reserves resulted in a5.3 percentage point increase to the change in net ultimateloss estimate for prior accident years in 2005 as compared to2004. The increase in the development on prior accident yearswas partially the result of an increase of $900,000, or1.4 percentage points, related to a specific 2003workers’ compensation claim. This claim exceeded our$5.0 million claim limit in our 2003 workers’compensation treaty and is now reserved at $5.9 million.There was a 0.5 percentage point decrease in the net lossand LAE ratio as a result of efficiencies within our claimshandling activities. This overall improvement in the loss andLAE ratio also reflects the impact of earned premiums from thecontrolled growth of profitable programs which have hadfavorable underwriting experience, as well as our intended shiftin the balance from workers’ compensation to the generalliability line of business. Historically, the general liabilityline of business has a lower loss ratio and a higher externalproducer commission. Our accident year loss ratio improved4.7 percentage points to 61.6% for the three monthsended September 30, 2005, from 66.3% for the same period in2004. The accident year loss and LAE ratio is the unconsolidatedGAAP loss and LAE ratio excluding development on prioraccident years.     Our expense ratio decreased 0.4 percentage points to 34.3%for the three months ended September 30, 2005, from34.7% for the same period in 2004. This ratio is theunconsolidated policy acquisition and other underwritingexpenses in relation to net earned premiums. This decrease toour overall expense ratio was the result of our continuedleveraging of fixed costs. In addition, ceding commissions weregreater primarily as a result of an adjustment in relation to aspecific west-coast trucking program profit sharing agreement.These decreases were partially offset by the anticipatedincrease in gross external commissions, due to the shift in thebalance between workers’ compensation and generalliability. The general liability line of business has a higherexternal producer commission rate and, as previously indicated,a lower loss ratio.
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**     Agency Operations**     The following table sets forth the revenues and results fromoperations for our agency operations (in thousands):           **For the Three Months**  **Ended September 30,**     **2005** **2004**         Net commission(1) $2,917  $2,657     Pre-tax income(1) & (2) $687  $239  (1)     We reclassified 2004 revenues related to the conversion of a    west-coast commercial transportation program, which was    converted to a specialty risk program with one of our    subsidiaries, from the agency operations segment to the    specialty risk management operations segment. Accordingly, the    agency operations revenue and intersegment revenue have been    reclassified. As a result, $1.8 million was reclassified    within the agency operations segment and the intersegment    revenue for the three months ended September 30, 2004. In    addition, the overall net income related to this subsidiary was    reclassified from the agency operations to the specialty risk    management operations segment. As a result, pre-tax net income    of $951,000 related to this subsidiary was reclassified to the    specialty risk management operations pre-tax income from the    agency operations segment for the three months ended    September 30, 2004. (2)     Our agency operations include an allocation of corporate    overhead, which includes expenses associated with accounting,    information services, legal, and other corporate services. The    corporate overhead allocation excludes those expenses specific    to the holding company. Prior to January 1, 2005, corporate    overhead was only reflected in the specialty risk management    operations segment. This reclassification for the allocation of    corporate overhead more accurately presents our segments as a    result of improved cost allocation information. As a result, the    segment information for the three months ended    September 30, 2004, has been adjusted to reflect this    allocation. For the three months ended September 30, 2005    and 2004, the allocation of corporate overhead to the agency    operations segment was $609,000 and $948,000, respectively.    Revenue from agency operations, which consists primarily ofagency commission revenue, increased $260,000, or 9.8%, to$2.9 million for the three months ended September 30,2005, from $2.7 million for the comparable period in 2004.This increase is primarily the result of profit sharingcommissions received in the third quarter of 2005.     Agency operations generated pre-tax income, after the allocationof corporate overhead, of $687,000 for the three months endedSeptember 30, 2005, compared to $239,000 for the comparableperiod in 2004. The improvement in the pre-tax margin isprimarily attributable to the overall increase in commissionsand leveraging of fixed costs. Excluding fixed costs and theallocation of corporate overhead, all other expenses remainedrelatively consistent.**Other Items****     Reserves**     For the three months ended September 30, 2005, we reportedan increase in net ultimate loss estimates for accident years2004 and prior to be $2.5 million, or 1.1% of$227.0 million of net loss and LAE reserves atDecember 31, 2004. There were no significant changes in thekey assumptions utilized in the analysis and calculations of ourreserves during 2005.**Salary and Employee Benefits and Other Administrative    Expenses**     Salary and employee benefits for the three months endedSeptember 30, 2005, decreased $1.4 million, or 9.6%,to $12.9 million, from $14.3 million for thecomparable period in 2004. This decrease primarily reflects botha decrease in variable compensation, which is directly relatedto performance and profitability, offset by merit increases forassociates. In addition, this decrease was partially due to aslight decrease in staffing levels in comparison to 2004 as aresult of our expense reduction initiatives.     Other administrative expenses decreased $765,000, or 11.3%, to$6.0 million, from $6.8 million for the comparableperiod in 2004. This decrease is primarily attributable to anoverall decrease in bad debt expense as a result of anapproximate $368,000 refinement in our estimation for allowanceson bad debt. In addition, this decrease reflects the 2004expenses associated with the previously mentioned accelerationof revenue
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related to the early termination of a specific multi-stateclaims run-off contract. Other administrative expenses were alsofavorably impacted in comparison to 2004 as the result ofoverall expense initiatives. These decreases were partiallyoffset by increases in expenses as a result of informationtechnology enhancements.     Salary and employee benefits and other administrative expensesinclude both corporate overhead and the holding company expensesincluded in the reconciling items of our segment information.**     Interest Expense**     Interest expense for the three months ended September 30,2005, increased $262,000, or 38.2%, to $948,000, from $686,000for the comparable period in 2004. Interest expense is primarilyattributable to our debentures, which are described within the*Liquidity and Capital Resources* section ofManagement’s Discussion and Analysis, as well as ourcurrent lines of credit. Interest expense increased $252,000primarily as a result of the senior debentures issued in thesecond quarter of 2004. Interest expense related to our lines ofcredit remained relatively consistent in comparison to 2004.This is the result of a decrease in the average outstandingbalance, offset by an increase in the average interest rate. Theaverage outstanding balance during the three months endingSeptember 30, 2005, was $9.8 million, compared to$15.0 million for the same period in 2004. The averageinterest rate, excluding the debentures, in 2005 was 4.9%,compared to 3.9% in 2004.**     Income Taxes**     Income tax expense, which includes both federal and state taxes,for the three months ended September 30, 2005, was$2.0 million, or 30.5% of income before taxes. For the sameperiod last year, we reflected an income tax expense of$2.5 million, or 32.6% of income before taxes. Oureffective tax rate differs from the 35% statutory rate primarilydue to a shift towards increasing investments in tax-exemptsecurities in an effort to maximize after-tax investment yields.Our current taxes are calculated using a 35% statutory ratebased on taxable income greater than $18.3 million.Deferred taxes are calculated based on a 34% statutory rate.
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**Liquidity and Capital Resources**     Our principal sources of funds, which include both regulated andnon-regulated cash flows, are insurance premiums, investmentincome, proceeds from the maturity and sale of invested assets,risk management fees, and agency commissions. Funds areprimarily used for the payment of claims, commissions, salariesand employee benefits, other operating expenses, shareholderdividends, share repurchases, and debt service. Our regulatedsources of funds are insurance premiums, investment income, andproceeds from the maturity and sale of invested assets. Theseregulated funds are used for the payment of claims, policyacquisition and other underwriting expenses, and taxes relatingto the regulated portion of net income. Our non-regulatedsources of funds are in the form of commission revenue, outsidemanagement fees, and intercompany management fees. Thesenon-regulated sources of funds are used to service debt,shareholder dividends, and other operating expenses of theholding company and non-regulated subsidiaries. The followingtable illustrates net income, excluding interest, depreciation,and amortization, between our regulated and non-regulatedsubsidiaries, which reconciles to our consolidated statement ofincome and statement of cash flows (in thousands):             **For the Nine Months**  **Ended September 30,**     **2005** **2004**         Net income $12,985  $11,304            Regulated Subsidiaries:              Net income $9,463  $5,297       Depreciation and amortization  —   —       Interest  —   —             Net income, excluding interest, depreciation, and amortization  9,463   5,297              Adjustments to reconcile net income to net cash provided by    operating activities  2,634   2,362       Changes in operating assets and liabilities  34,464   23,680             Total adjustments  37,098   26,042      Depreciation and amortization  —   —      Interest  —   —             Net cash provided by operating activities $46,561  $31,339            Non-regulated Subsidiaries:              Net income $3,522  $6,007       Depreciation and amortization  2,129   1,371       Interest  2,527   1,719             Net income, excluding interest, depreciation, and amortization  8,178   9,097              Adjustments to reconcile net income to net cash provided by    operating activities  3,027   3,182       Changes in operating assets and liabilities  (4,411)  2,816             Total adjustments  (1,384)  5,998      Depreciation and amortization  (2,129)  (1,371)     Interest  (2,527)  (1,719)            Net cash provided by operating activities $2,138  $12,005            Consolidated total adjustments  35,714   32,040            Consolidated net cash provided by operating activities $48,699  $43,344        
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             **For the Three Months**  **Ended September 30,**     **2005** **2004**         Net income $4,662  $5,252            Regulated Subsidiaries:              Net income $3,093  $2,281       Depreciation and amortization  —   —       Interest  —   —             Net income, excluding interest, depreciation, and amortization  3,093   2,281              Adjustments to reconcile net income to net cash provided by    operating activities  1,141   1,452       Changes in operating assets and liabilities  15,981   3,057             Total adjustments  17,122   4,509      Depreciation and amortization  —   —      Interest  —   —             Net cash provided by operating activities $20,215  $6,790            Non-regulated Subsidiaries:              Net income $1,569  $2,971       Depreciation and amortization  697   523       Interest  948   750             Net income, excluding interest, depreciation, and amortization  3,214   4,244              Adjustments to reconcile net income to net cash provided by    operating activities  1,073   1,806       Changes in operating assets and liabilities  2,821   5,478             Total adjustments  3,894   7,284      Depreciation and amortization  (697)  (523)     Interest  (948)  (750)            Net cash provided by operating activities $5,463  $10,255            Consolidated total adjustments  21,016   11,793            Consolidated net cash provided by operating activities $25,678  $17,045             Consolidated cash flow provided by operations for the ninemonths ended September 30, 2005, was $48.7 million,compared to consolidated cash flow provided by operations of$43.3 million for the comparable period in 2004.     Regulated subsidiaries’ cash flow provided by operationsfor the nine months ended September 30, 2005, was$46.6 million, compared to $31.3 million for thecomparable period in 2004. This increase is the result ofimproved underwriting results and an increase in investmentincome, offset by a tax benefit reduction from the utilizationof the net operating loss carryforward in 2004.     Non-regulated subsidiaries’ cash flow used in operationsfor the nine months ended September 30, 2005, was$2.1 million, compared to $12.0 million provided byoperations for the comparable period in 2004. The decrease innon-regulated cash flow from operations reflects the decrease innet income, which was primarily the result of the previouslymentioned acceleration of revenue, recognized in the thirdquarter of 2004. In addition, the decrease in net income was theresult of an increase in administrative costs related tocompliance with Section 404 of the Sarbanes-Oxley Act,offset by an increase in revenue associated with profit-sharingcommissions. In addition, the decrease in cash flow fromoperations is the result of variable compensation payments madein the first quarter of 2005, related to 2004 performance andprofitability and a decrease in cash as a result of tax payments.
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     In addition to the changes described above in relation to ourcash provided by operations, we had an increase in cash used ininvesting activities as a result of an $11.6 million cashpayment for our new corporate headquarters in the first quarterof 2005. The proceeds from the 2004 issuance of debentures,which are described below, were used for the purchase of our newbuilding. On January 1, 2005, we entered into a leaseagreement for our furniture and phone system in relation to ournew building. As of September 30, 2005, the total liabilityin relation to this lease was $925,000. Total lease paymentsmade for the nine months and three months endedSeptember 30, 2005, were approximately $205,000 and$88,000, respectively.     We anticipate a temporary increase in cash outflows related toinvestments in technology as we continue to enhance ouroperating systems and controls.**Other Items**     In September 2003, an unconsolidated subsidiary trust issued$10.0 million of mandatory redeemable trust preferredsecurities (“TPS”) to a trust formed by aninstitutional investor. Contemporaneously, we issued$10.3 million in junior subordinated debentures, whichincludes our $310,000 investment in the trust. We received atotal of $9.7 million in net proceeds, after the deductionof approximately $300,000 of commissions paid to the placementagents in the transaction. These issuance costs have beencapitalized and are included in other assets on the balancesheet, which are being amortized over seven years as a componentof interest expense. We contributed $6.3 million of theproceeds to our Insurance Company Subsidiaries and the remainingbalance was used for general corporate purposes. The debenturesmature in thirty years and provide for interest at thethree-month LIBOR, plus 4.05%.     In April 2004, we issued senior debentures in the amount of$13.0 million. The senior debentures mature in thirty yearsand provide for interest at the three-month LIBOR, plus 4.0%,which is non-deferrable. The senior debentures are callable atpar after five years from the date of issuance. Associatedwith this transaction, we incurred $390,000 of commissions paidto the placement agents. These issuance costs have beencapitalized and are included in other assets on the balancesheet, which are being amortized over seven years as a componentof interest expense.     In May 2004, we issued senior debentures in the amount of$12.0 million. The senior debentures mature in thirty yearsand provide for interest at the three-month LIBOR, plus 4.2%,which is non-deferrable. The senior debentures are callable atpar after five years from the date of issuance. Associatedwith this transaction, we incurred $360,000 of commissions paidto the placement agents. These issuance costs have beencapitalized and are included in other assets on the balancesheet, which are being amortized over seven years as a componentof interest expense.     We contributed $9.9 million of the proceeds from the seniordebentures to our Insurance Company Subsidiaries in December2004. The remaining proceeds from the issuance of the seniordebentures may be used to support future premium growth throughfurther contributions to our Insurance Company Subsidiaries andgeneral corporate purposes.     In September 2005, an unconsolidated subsidiary trust issued$20.0 million of mandatory redeemable trust preferredsecurities to a trust formed by an institutional investor.Contemporaneously, we issued $20.6 million in juniorsubordinated debentures, which includes our $620,000 investmentin the trust. We received a total of $19.4 million in netproceeds, after the deduction of approximately $600,000 ofcommissions paid to the placement agents in the transaction.These issuance costs have been capitalized and are included inother assets on the balance sheet, which will be amortized overseven years as a component of interest expense. Wecontributed $10.0 million of the proceeds to our InsuranceCompany Subsidiaries and the remaining balance will be used forgeneral corporate purposes. The debentures mature in thirtyyears and provide for interest at the three-month LIBOR, plus3.58%.     The seven year amortization period in regard to the issuancecosts represents our best estimate of the estimated useful lifeof the bonds related to both the senior debentures and juniorsubordinated debentures described above.
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     In November 2004, we entered into a revolving line of credit forup to $25.0 million. The revolving line of credit replacedour former term loan and line of credit and expires in November2007. We had drawn approximately $9.0 million on this newrevolving line of credit to pay off our former term loan. We usethe revolving line of credit to meet short-term working capitalneeds. Under the revolving line of credit, we and certain of ournon-regulated subsidiaries pledged security interests in certainproperty and assets of named subsidiaries.     At September 30, 2005, we had no outstanding balance on therevolving line of credit. On December 31, 2004, we had anoutstanding balance of $9.0 million on the revolving lineof credit.     The revolving line of credit provides for interest at a variablerate based, at our option, upon either a prime based rate orLIBOR-based rate. On prime based borrowings, the applicablemargin ranges from 75 to 25 basis points below prime. OnLIBOR-based borrowings, the applicable margin ranges from 125 to175 basis points above LIBOR. The margin for all loans isdependent on the sum of non-regulated earnings before interest,taxes, depreciation, amortization, and non-cash impairmentcharges related to intangible assets for the preceding fourquarters, plus dividends paid or payable to us from subsidiariesduring such period (“Adjusted EBITDA”). For thethree month period ending September 30, 2005, theaverage interest rate for LIBOR-based borrowings was 4.7%.     Debt covenants consist of: (1) maintenance of the ratio ofAdjusted EBITDA to interest expense of 2.0 to 1.0,(2) minimum net worth of $130.0 million and increasingannually, commencing June 30, 2005, by fifty percentof the prior year’s positive net income, (3) minimumA.M. Best rating of “B”, and (4) on an annualbasis, a minimum Risk Based Capital Ratio for Star of 1.75 to1.00. As of September 30, 2005, we were in compliance withthese covenants.     In addition, our non-insurance premium finance subsidiarymaintains a line of credit with a bank, which permits borrowingsup to 75% of the accounts receivable, which collateralize theline of credit. At September 30, 2005, this line of credithad an outstanding balance of $2.3 million. OnApril 26, 2005, the terms of this line of credit weremodified. The modifications included a decrease in the line ofcredit from $8.0 million to $6.0 million. The interestterms of this line of credit provide for interest at the primerate minus 0.5%, or a LIBOR-based rate, plus 2.0%. AtSeptember 30, 2005, the LIBOR-based option was 5.6% and theaverage interest rate was 5.6%.     At September 30, 2005, shareholders’ equity was$174.0 million, or $6.05 per common share, compared to$167.5 million, or $5.76 per common share, atDecember 31, 2004.     In November 2004, our Board of Directors authorized us torepurchase up to 1,000,000 shares of our common stock inmarket transactions for a period not to exceed twenty-fourmonths. For the nine months and three months endedSeptember 30, 2005, we purchased and retired 634,900 and426,110 shares of common stock for a total cost of approximately$3.4 million and $2.3 million, respectively. We didnot repurchase any common stock during 2004. As ofSeptember 30, 2005, the cumulative amount we haverepurchased and retired under the current share repurchase planwas 634,900 shares of common stock for a total cost ofapproximately $3.4 million.     At our regularly scheduled board meeting on October 28,2005, our Board of Directors authorized us to purchase up to1,000,000 shares, or approximately 3%, of our common stock inmarket transactions for a period not to exceed twenty-fourmonths.     A significant portion of our consolidated assets representassets of our Insurance Company Subsidiaries that at this time,without prior approval of the State of Michigan Office ofFinancial and Insurance Services (“OFIS”), cannot betransferred to us in the form of dividends, loans or advances.The restriction on the transferability to us from the InsuranceCompany Subsidiaries is regulated by Michigan insurance statuteswhich, in general, are as follows: the maximum discretionarydividend that may be declared, based on data from the precedingcalendar year, is the greater of each insurance company’snet income (excluding realized
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capital gains) or ten percent of the insurance company’ssurplus (excluding unrealized gains). These dividends arefurther limited by a clause in the Michigan law that prohibitsan insurer from declaring dividends except out of surplusearnings of the company. Earned surplus balances are calculatedon a quarterly basis. Since Star is the parent insurancecompany, its maximum dividend calculation represents thecombined Insurance Company Subsidiaries’ surplus. Basedupon the 2004 statutory financial statements, Star may only paydividends to us during 2005 with the prior approval of OFIS.Star’s earned surplus position at December 31, 2004was negative $13.7 million. At September 30, 2005,earned surplus was negative $7.1 million. No dividends werepaid in 2004 or 2005.     Effective July 1, 2005, we made a $2.5 million loan,at an effective interest rate equal to the three month LIBOR,plus 5.2%, to an unaffiliated insurance agency. This agency hasbeen a producer for us for over ten years. Under the terms ofthe agreement, we may demand repayment of the principal, plusaccrued interest at any time. As security for the loan, theshareholder has pledged 100% of the common shares of theunaffiliated insurance agency and three other insuranceagencies, and has executed a personal guaranty.***Contractual Obligations and Commitments***     Except as described above with respect to the issuance of$20.6 million in junior subordinated debentures, there wereno material changes outside the ordinary course of our businessin relation to our contractual obligations and commitments forthe three months and nine months ended September 30, 2005.**Regulatory and Rating Issues**     The National Association of Insurance Commissioners(“NAIC”) has adopted a risk-based capital(“RBC”) formula to be applied to all property andcasualty insurance companies. The formula measures requiredcapital and surplus based on an insurance company’sproducts and investment portfolio and is used as a tool toevaluate the capital of regulated companies. The RBC formula isused by state insurance regulators to monitor trends instatutory capital and surplus for the purpose of initiatingregulatory action. In general, an insurance company must submita calculation of its RBC formula to the insurance department ofits state of domicile as of the end of the previous calendaryear. These laws require increasing degrees of regulatoryoversight and intervention as an insurance company’s RBCdeclines. The level of regulatory oversight ranges fromrequiring the insurance company to inform and obtain approvalfrom the domiciliary insurance commissioner of a comprehensivefinancial plan for increasing its RBC to mandatory regulatoryintervention requiring an insurance company to be placed underregulatory control in a rehabilitation or liquidation proceeding.     At December 31, 2004, all of our Insurance CompanySubsidiaries were in compliance with RBC requirements. Starreported statutory surplus of $120.7 million atDecember 31, 2004, compared to the minimum thresholdrequiring regulatory involvement of $56.9 million in 2004.At September 30, 2005, Star’s statutory surplusincreased $18.2 million from December 31, 2004, to$138.9 million. As previously mentioned, we contributed$10.0 million of the proceeds from our recent issuance ofjunior subordinated debentures to our Insurance CompanySubsidiaries.     Insurance operations are subject to various leverage tests (e.g.premium to statutory surplus ratios), which are evaluated byregulators and rating agencies. Our targets for gross and netwritten premium to statutory surplus are 3.0 to 1.0 and 2.5 to1.0, respectively. As of September 30, 2005, on a statutorycombined basis, gross and net premium leverage ratios were 2.4to 1.0 and 1.9 to 1.0, respectively.**     Reinsurance**     Intercompany pooling agreements are commonly entered intobetween affiliated insurance companies, so as to allow thecompanies to utilize the capital and surplus of all of thecompanies, rather than each individual company. Under poolingarrangements, companies share in the insurance business that isunderwritten and allocate the combined premium, losses andrelated expenses between the companies within the poolingarrangement. Effective January 1, 2005, the InsuranceCompany Subsidiaries entered into an Inter-Company ReinsuranceAgreement (the “Pooling Agreement”). This PoolingAgreement includes Star, Ameritrust
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Insurance Corporation (“Ameritrust”), Savers Propertyand Casualty Insurance Company (“Savers”) andWilliamsburg National Insurance Company(“Williamsburg”). Pursuant to the Pooling Agreement,Savers, Ameritrust and Williamsburg have agreed to cede to Starand Star has agreed to reinsure 100% of the liabilities andexpenses of Savers, Ameritrust and Williamsburg, relating to allinsurance and reinsurance policies issued by them. In return,Star agrees to cede and Savers, Ameritrust and Williamsburg haveagreed to reinsure Star for their respective percentages of theliabilities and expenses of Star. The Pooling Agreement wasfiled with the applicable regulatory authorities. Any changes tothe Pooling Agreement must be submitted to the applicableregulatory authorities.**     Off-Balance SheetArrangements**     In June 2003, we entered into a guaranty agreement with a bank.We are guaranteeing payment of a $1.5 million term loanissued by the bank to an unaffiliated insurance agency. In theevent of default on the term loan by the insurance agency, weare obligated to pay any outstanding principal (up to a maximumof $1.5 million), as well as any accrued interest on theloan, and any costs incurred by the bank in the collectionprocess. In exchange for our guaranty, the president and memberof the unaffiliated insurance agency pledged 100% of the commonshares of two other insurance agencies that he wholly owns. Inthe event of default on the term loan by the unaffiliatedinsurance agency, we have the right to sell any or all of thepledged assets (the common stock of the two insurance agencies)and use the proceeds from the sale to recover any amounts paidunder the guaranty agreement. Any excess proceeds would be paidto the shareholder. As of September 30, 2005, no liabilityhas been recorded with respect to our obligations under theguaranty agreement, since the collateral is in excess of theguaranteed amount.     In addition, refer to the discussion below under the caption*“Subsequent Events”*for additional informationin regard to our off-balance sheet arrangements.**Recent Accounting Pronouncements**     In December 2004, the Financial Accounting Standards Board(“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 123 (revised 2004),*“Share-Based Payment”*(“SFAS 123(R)”), which replacesSFAS No. 123, *“Accounting for Stock Issued toEmployees.”*SFAS 123(R) requires all share-basedpayments to employees to be recognized in the financialstatements based on their fair values. The pro forma disclosurespreviously permitted under SFAS 123, will no longer be analternative to financial statement recognition. Commencing inthe first quarter of 2003, we began expensing the fair value ofall stock options granted since January 1, 2003 under theprospective method. Under SFAS 123(R), we must determinethe appropriate fair value model to be used for valuingshare-based payments, the amortization method for compensationcost and the transition method to be used at the date ofadoption. The transition methods include prospective andretroactive adoption options. Under the retroactive options,prior periods may be restated either as of the beginning of theyear of adoption or for all periods presented. The prospectivemethod requires that compensation expense be recorded at thebeginning of the first quarter of adoption of SFAS 123(R)for all unvested stock options and restricted stock based uponthe previously disclosed SFAS 123 methodology and amounts.The retroactive methods would record compensation expensebeginning with the first period restated for all unvested stockoptions and restricted stock. On April 14, 2005, theSecurities and Exchange Commission adopted a new rule thatdelays the compliance dates for SFAS 123(R). Under the newrule, SFAS 123(R) is effective for public companies forannual, rather than interim periods, that begin afterJune 15, 2005. Therefore, we are required to adoptSFAS 123(R) in the first quarter of 2006, or beginningJanuary 1, 2006. We have evaluated the requirements ofSFAS 123(R) and have determined the impact on our financialstatements related to existing stock options is immaterial.     In May 2005, the FASB issued SFAS No. 154,*“Accounting Changes and Error Corrections, a replacementof APB Opinion No. 20 and FASB StatementNo. 3.”* SFAS No. 154 replaces thementioned pronouncements and changes the requirements for theaccounting and reporting of a change in an accounting principle.This Statement applies to all voluntary changes in accountingprinciple, as well as changes required by an accountingpronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions. However, when apronouncement includes specific transition provisions, thoseprovisions
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should be followed. SFAS No. 154 requiresretrospective application to prior period financial statementsfor changes in accounting principle, unless it is impracticableto determine either the period-specific effects or thecumulative effect of the change. SFAS No. 154 alsorequires that retrospective application of a change inaccounting principle be limited to the direct effects of thechange. Indirect effects of a change in accounting principleshould be recognized in the period of the accounting change.SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning afterDecember 15, 2005. However, early adoption is permitted foraccounting changes and corrections of errors made in fiscalyears beginning after the date this Statement was issued. We arerequired to adopt the provisions of SFAS No. 154, asapplicable, beginning in 2006. We believe the adoption ofSFAS No. 154 will not have a material impact on ourconsolidated financial statements.     In July 2005, the FASB issued an exposure draft of a proposedinterpretation on accounting for uncertain tax positions underSFAS No. 109 *“Accounting for IncomeTaxes.”*If adopted as proposed, the pronouncement willbe effective December 31, 2005 and only those tax benefitsthat meet the probable recognition threshold may be recognizedor continue to be recognized as of the effective date. We haveevaluated the impact this proposed interpretation will have onour financial statements and do not expect it to have a materialimpact.**Subsequent Events**     On October 4, 2005, we entered into two interest rate swaptransactions with LaSalle Bank (“LaSalle”) to mitigateour interest rate risk on $5.0 million and$20.0 million of our senior debentures and trust preferredsecurities, respectively. We will recognize these transactionsin accordance with SFAS No. 133 *“Accountingfor Derivative Instruments and Hedging Activities,”*assubsequently amended. This interest rate swap transaction hasbeen designated as a cash flow hedge and is deemed a highlyeffective transaction under SFAS No. 133. Inaccordance with SFAS No. 133, these interest rate swaptransactions will be recorded at fair value on the balance sheetand any changes in their fair value will be accounted for withinother comprehensive income. The interest differential to be paidor received will be accrued and will be recognized as anadjustment to interest expense.     The first interest rate swap transaction, which relates to$5.0 million of our $12.0 million issuance of seniordebentures, has an effective date of October 6, 2005 andending May 24, 2009. We are required to make certainquarterly fixed rate payments to LaSalle calculated on anotional amount of $5.0 million, non-amortizing, based on afixed annual interest rate of 8.925%. LaSalle is obligated tomake quarterly floating rate payments to us referencing the samenotional amount, based on the three-month LIBOR, plus 4.20%.     The second interest rate swap transaction, which relates to$20.0 million of our $20.0 million issuance of trustpreferred securities, has an effective date of October 6,2005 and ending September 16, 2010. We are required to makequarterly fixed rate payments to LaSalle calculated on anotional amount of $20.0 million, non-amortizing, based ona fixed annual interest rate of 8.34%. LaSalle is obligated tomake quarterly floating rate payments to us referencing the samenotional amount, based on the three-month LIBOR, plus 3.58%.     On November 1, 2005, we purchased the net assets of aFlorida-based insurance agency. In accordance withSFAS No. 141 *“Business Combinations,”*we will allocate the costs of the acquired business to theassets acquired, including intangible assets and liabilitiesassumed, based on their estimated fair value at the acquisitiondate. Any costs in excess of the amount specifically assigned tothe assets acquired and liabilities assumed, will be recorded asgoodwill. Subsequent to the acquisition, the goodwill and otherintangible assets will be accounted for in accordance withSFAS No. 142 *“Goodwill and Other IntangibleAssets.”***Item 3.*****Quantitative and Qualitative Disclosures About Market    Risk***     Market risk is the risk of loss arising from adverse changes inmarket rates and prices, such as interest rates as well as otherrelevant market rate or price changes. The volatility andliquidity in the markets in which the underlying assets aretraded directly influence market risk. The following is adiscussion of our primary risk exposures and how those exposuresare currently managed as of September 30, 2005. Our marketrisk sensitive
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instruments are primarily related to fixed income securities,which are available for sale and not held for trading purposes.     Interest rate risk is managed within the context of an asset andliability management strategy where the target duration for thefixed income portfolio is based on the estimate of the liabilityduration and takes into consideration our surplus. Theinvestment policy guidelines provide for a fixed incomeportfolio duration of between three and five years. AtSeptember 30, 2005, our fixed income portfolio had amodified duration of 3.49, compared to 3.46 at December 31,2004.     At September 30, 2005, the fair value of our investmentportfolio was $382.3 million. Our market risk to theinvestment portfolio is interest rate risk associated with debtsecurities. Our exposure to equity price risk is notsignificant. Our investment philosophy is one of maximizingafter-tax earnings and has historically included significantinvestments in tax-exempt bonds. During 2003 and 2004, we beganto increase our holdings of tax-exempt securities based on ourreturn to profitability and our desire to maximize after-taxinvestment income. For our investment portfolio, there were nosignificant changes in our primary market risk exposures or inhow those exposures are managed compared to the year endedDecember 31, 2004. We do not anticipate significant changesin our primary market risk exposures or in how those exposuresare managed in future reporting periods based upon what is knownor expected to be in effect.     A sensitivity analysis is defined as the measurement ofpotential loss in future earnings, fair values, or cash flows ofmarket sensitive instruments resulting from one or more selectedhypothetical changes in interest rates and other market rates orprices over a selected period. In our sensitivity analysismodel, a hypothetical change in market rates is selected that isexpected to reflect reasonable possible near-term changes inthose rates. “Near term” means a period of up to oneyear from the date of the consolidated financial statements. Inour sensitivity model, we use fair values to measure ourpotential loss of debt securities assuming an upward parallelshift in interest rates to measure the hypothetical change infair values. The table below presents our model’s estimateof changes in fair values given a change in interest rates.Dollar values are rounded and in thousands.               **Rates Down** **Rates** **Rates Up**  **100bps** **Unchanged** **100bps**           Market Value $397,068  $382,251  $367,487     Yield to Maturity or Call  3.34%  4.34%  5.34%    Effective Duration  3.71   3.82   3.93      The other financial instruments, which include cash and cashequivalents, equity securities, premium receivables, reinsurancerecoverables, lines of credit and other assets and liabilities,when included in the sensitivity model, do not produce amaterial loss in fair values.     Our debentures are subject to variable interest rates. Thus, ourinterest expense on these debentures is directly correlated tomarket interest rates. At September 30, 2005, we haddebentures of $55.9 million. At this level, a100 basis point (1%) change in market rates would changeannual interest expense by $559,000. At December 31, 2004,we had debentures of $35.3 million. At this level, a100 basis point (1%) change in market rates would havechanged annual interest expense by $353,000.     In addition, our revolving line of credit under which we canborrow up to $25.0 million is subject to variable interestrates. Thus, our interest expense on the revolving line ofcredit is directly correlated to market interest rates. AtSeptember 30, 2005, we had no outstanding balance on thisrevolving line of credit. At December 31, 2004, we had$9.0 million outstanding. At this level, a 100 basispoint (1%) change in market rates would have changed interestexpense by $90,000.**Item 4.*****Controls and Procedures*****Evaluation of Disclosure Controls and Procedures.**     Our disclosure controls and procedures (as defined inRule 13a-15(e) under the Securities Exchange Act of 1934,the “Exchange Act”), which we refer to asdisclosure controls, are controls and procedures that are
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designed with the objective of ensuring that informationrequired to be disclosed in our reports filed under the ExchangeAct, such as this Form 10-Q, is recorded, processed,summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.Disclosure controls are also designed with the objective ofensuring that such information is accumulated and communicatedto management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate to allow timely decisionsregarding required disclosure. There are inherent limitations tothe effectiveness of any control system. A control system, nomatter how well conceived and operated, can provide onlyreasonable assurance that its objectives are met. No evaluationof controls can provide absolute assurance that all controlissues and instances of fraud, if any, have been detected.     As of September 30, 2005, an evaluation was carried outunder the supervision and with the participation of ourmanagement, including our Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design andoperation of disclosure controls. Based upon our evaluation, ourChief Executive Officer and Chief Financial Officer concludedthat the design and operation of our disclosure controls wereeffective in recording, processing, summarizing, and reporting,on a timely basis, material information required to be disclosedin the reports we file under the Exchange Act and is accumulatedand communicated, as appropriate to allow timely decisionsregarding required disclosure.**Changes in Internal Control over Financial Reporting**     There were no significant changes in our internal control overfinancial reporting during the three month period endedSeptember 30, 2005, which have materially affected, or arereasonably likely to materially affect, our internal controlover financial reporting.
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**PART II — OTHER INFORMATION****Item 1.*     LegalProceedings***     The information required by this item is included underNote 6 — *Commitments and Contingencies*ofthe Notes to the Consolidated Financial Statements of theCompany’s Form 10-Q for the nine months endedSeptember 30, 2005, which is hereby incorporated byreference.**Item 2.*****Unregistered Sales of Equity Securities and Use of    Proceeds***     In November 2004, the Company’s Board of Directorsauthorized management to repurchase up to 1,000,000 sharesof its common stock in market transactions for a period not toexceed twenty-four months. For the three months endedSeptember 30, 2005, the Company purchased and retired426,110 shares of common stock for a total cost ofapproximately $2.3 million.                         **Maximum**      **Total Number** **Number of**      **of Shares** **Shares that may**      **Purchased as** **yet be**      **Part of Publicly** **Repurchased**  **Total** **Average** **Announced** **Under the**  **Number of** **Price Paid** **Plans or** **Plans or****Period** **Shares** **Per Share** **Programs** **Programs**             July 1 — July 31, 2005  155,120  $5.25   155,120   636,090     August 1 — August 31, 2005  75,830  $5.35   75,830   560,260     September 1 — September 30, 2005  195,160  $5.48   195,160   365,100                  Total  426,110  $5.37   426,110                  **Item 6.*     Exhibits***     The following documents are filed as part of this Report:     **Exhibit**  **No.** **Description**    4.1     Junior Subordinated Indenture between Meadowbrook Insurance    Group, Inc. and LaSalle Bank National Association, dated as of    September 16, 2005 (incorporated by reference to    Exhibit 4.1 to Form 8-K filed on September 22,    2005). 10.1     Second Amendment to Credit Agreement between Meadowbrook    Insurance Group, Inc. and Standard Federal Bank National    Association, dated September 8, 2005. 10.2     Purchase Agreement among Meadowbrook Insurance Group, Inc.,    Meadowbrook Capital Trust II, and Merrill Lynch    International, dated as of September 16, 2005 (incorporated    by reference to Exhibit 10.1 to Form 8-K filed on    September 22, 2005). 10.3     Amended and Restated Trust Agreement among Meadowbrook Insurance    Group, Inc., LaSalle Bank National Association, Christiana    Bank & Trust Company, and The Administrative Trustees    Named Herein, dated as of September 16, 2005 (incorporated    by reference to Exhibit 10.2 to Form 8-K filed on    September 22, 2005). 10.4     Guarantee Agreement between Meadowbrook Insurance Group, Inc.,    and LaSalle Bank National Association, dated as of    September 16, 2005 (incorporated by reference to    Exhibit 10.3 to Form 8-K filed on September 22,    2005). 31.1     Certification of Robert S. Cubbin, Chief Executive Officer    of the Corporation, pursuant to Securities Exchange Act    Rule 13a-14(a). 31.2     Certification of Karen M. Spaun, Senior Vice President and    Chief Financial Officer of the Corporation, pursuant to    Securities Exchange Act Rule 13a-14(a).
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     **Exhibit**  **No.** **Description**    32.1     Certification pursuant to 18 U.S.C. Section 1350, as    adopted pursuant to Section 906 of the Sarbanes-Oxley Act of    2002, signed by Robert S. Cubbin, Chief Executive Officer    of the Corporation. 32.2     Certification pursuant to 18 U.S.C. Section 1350, as    adopted pursuant to Section 906 of the Sarbanes-Oxley Act    of 2002, signed by Karen M. Spaun, Senior Vice President    and Chief Financial Officer of the Corporation.
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**SIGNATURES**     Pursuant to the requirements of the Securities and Exchange Actof 1934, the Registrant has duly caused this Report to be signedon its behalf by the undersigned, thereunto duly authorized. Meadowbrook Insurance    Group, Inc.     By:     /s/ Karen M. Spaun       *Senior Vice President and* *Chief Financial Officer*Dated: November 7, 2005
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**EXHIBIT INDEX**     **Exhibit**  **No.** **Description**    4.1     Junior Subordinated Indenture between Meadowbrook Insurance    Group, Inc. and LaSalle Bank National Association, dated as of    September 16, 2005 (incorporated by reference to    Exhibit 4.1 to Form 8-K filed on September 22, 2005). 10.1     Second Amendment to Credit Agreement between Meadowbrook    Insurance Group, Inc. and Standard Federal Bank National    Association, dated September 8, 2005. 10.2     Purchase Agreement among Meadowbrook Insurance Group, Inc.,    Meadowbrook Capital Trust II, and Merrill Lynch    International, dated as of September 16, 2005 (incorporated    by reference to Exhibit 10.1 to Form 8-K filed on    September 22, 2005). 10.3     Amended and Restated Trust Agreement among Meadowbrook Insurance    Group, Inc., LaSalle Bank National Association, Christiana    Bank & Trust Company, and The Administrative Trustees    Named Herein, dated as of September 16, 2005 (incorporated    by reference to Exhibit 10.2 to Form 8-K filed on    September 22, 2005). 10.4     Guarantee Agreement between Meadowbrook Insurance Group, Inc.,    and LaSalle Bank National Association, dated as of    September 16, 2005 (incorporated by reference to    Exhibit 10.3 to Form 8-K filed on September 22, 2005). 31.1     Certification of Robert S. Cubbin, Chief Executive Officer    of the Corporation, pursuant to Securities Exchange Act    Rule 13a-14(a). 31.2     Certification of Karen M. Spaun, Senior Vice President and    Chief Financial Officer of the Corporation, pursuant to    Securities Exchange Act Rule 13a-14(a). 32.1     Certification pursuant to 18 U.S.C. Section 1350, as    adopted pursuant to Section 906 of the Sarbanes-Oxley Act    of 2002, signed by Robert S. Cubbin, Chief Executive    Officer of the Corporation. 32.2     Certification pursuant to 18 U.S.C. Section 1350, as    adopted pursuant to Section 906 of the Sarbanes-Oxley Act of    2002, signed by Karen M. Spaun, Senior Vice President and    Chief Financial Officer of the Corporation.