The Company currently leases its corporate offices in Southfield, Michigan from 26600 Development Associates Limited Partnership. In 2001, the Company paid approximately $1.3 million in rent. The term of the lease for the offices in Southfield expires on September 30, 2004. The Company, through its subsidiaries, is also a party to various leases for locations in which such subsidiaries have offices. The Company does not consider any of these leases to be material.
Meadowbrook Insurance Group, Inc. (the “Company”) is a program-oriented risk management company specializing in alternative risk management solutions for agents, brokers, professional/trade associations, and insureds of all sizes. The Company provides a broad array of insurance products and services through its subsidiaries. The Company owns insurance carriers, which are an integral component of many of the Company’s programs. Management defines its business segments as agency and program business operations based upon differences in products and services.
The agency segment was formed in 1955 as the Company’s original business. The insurance agency produces principally commercial insurance, as well as personal, property, casualty, life and accident and health insurance, with more than 50 insurance carriers from which they earn commission income and contingencies. The agency segment has grown to be one of the largest agencies in Michigan and, with acquisitions, has expanded into California.
The program business segment is engaged primarily in developing and managing alternative risk management programs for defined client groups and their members. This includes providing services, such as reinsurance brokering, risk management consulting, claims handling, and administrative services, along with various types of property and casualty insurance coverage, including workers’ compensation, general liability and commercial multi-peril. Insurance coverage is primarily provided to associations or similar groups of members. A program is a set of coverages and services tailored to meet the specific requirements of a group of clients.
The Company categorizes its programs into three categories: managed, risk-sharing, and fully insured. In “managed programs”, the Company usually assumes no insurance risk and generates fee revenue through program management services. In “risk-sharing programs”, the Company participates with the client or producing agent in the operating results of the programs through a captive, rent-a-captive or similar insured vehicles. In “risk-sharing programs”, the Company derives revenues from net earned premiums and investment income. In addition, the Company benefits from the margin built into the ceding commissions for services it renders on behalf of the risk-sharing partner for the program. In “fully insured programs”, the Company provides commercial insurance coverage without a risk-sharing mechanism and derives revenue exclusively from net earned premiums and investment income. Fully-insured programs are developed in response to a specific market opportunity and generally when the Company believes there is potential to subsequently create a “risk-sharing program”.
In recent years, the Company derived its revenue from the following sources (in thousands):
The Company has received inquiries from various state regulators requesting information concerning Star’s financial condition. The losses, adverse trends and uncertainties discussed in this report have been and continue to be reviewed by the domiciliary state and other insurance regulators of the Company’s insurance subsidiaries. The Company had previously submitted a Business Plan to reduce its current leverage ratios and increase the risk-based capital (“RBC”) ratio level and continues to work closely with the Michigan Office of Financial and Insurance Services (“OFIS”) to monitor its progress. While the Company’s gross and net written premiums have declined steadily throughout 2001, it has not yet sufficiently reduced its premium leverage ratios nor complied with the required RBC level. In addition to continued reductions in premium writings, capital from sources outside the Company may also be necessary to make sufficient progress towards reducing its leverage ratios and increasing the RBC ratio. While the Company has retained an investment-banking firm to execute its selected capital raising alternative, there can be no assurance the Company will be successful in raising additional capital, or that proceeds therefrom which would be contributed to the Company’s insurance subsidiaries would result in sufficient progress towards reducing its leverage ratios and increasing the RBC ratio. If the regulators determine the Company has made insufficient progress towards reducing its leverage ratios and increasing the RBC ratio, they may take action at any time. While the regulators have taken no actions to date, regulators could require the Company to take steps to correct the capital deficiency, require a reduction in permitted premium writings, or implement some form of regulatory action.
The liability for losses and loss adjustment expenses “LAE” represents (1) case basis estimates of reported losses and LAE on direct business, (2) actuarial estimates of incurred but not reported losses and LAE, and (3) estimates received from ceding reinsurers on assumed business. Such liabilities, by necessity, are based upon estimates and, while management believes that the amount accrued is adequate, the ultimate liability may be greater or less than the amount provided. At December 31, 2001, loss and loss adjustment expenses were $394.6 million.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid loss and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of incurred but not reported losses and LAE. Such recoverables, by necessity, are based upon estimates and, while management believes that the amount accrued is collectible, the ultimate recoverable may be greater or less than the amount accrued. At December 31, 2001, reinsurance recoverables on paid and unpaid losses were $222.5 million.
The methods for making such estimates and for establishing the loss reserves and reinsurance recoverables are continually reviewed and updated. Certain information is incorporated by reference to Item 1 - Business - Reserves on pages 8-10.
On August 6, 1999, the Company acquired the assets of TPA Associates, Inc., all of the outstanding stock of TPA Insurance Agency, Inc. and Preferred Insurance Agency, Inc. and approximately 94% of the
outstanding stock of Preferred Insurance Company, Ltd., (collectively, “TPA”) at a purchase price of $16.2 million. This transaction resulted in goodwill of $12.9 million.
The remaining goodwill relates to acquisitions of other agency and fee-for-service operations.
At December 31, 2001 and 2000, the net goodwill was $28,997,000 and $35,946,000, respectively. Amortization expense for 2001, 2000 and 1999 was $2.3 million, $2.0 million and $1.6 million, respectively. These charges primarily reflect the amortization of goodwill associated with acquisitions in 1997, 1998, and 1999.
The Financial Accounting Standards Board (“FASB”) has issued Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142, for periods starting December 15, 2001 or thereafter, eliminates the amortization of goodwill. In addition, goodwill would be separately tested for impairment using a fair-value based approach. Upon implementation in 2002, the Company will no longer amortize goodwill. Goodwill amortization in 2001 was $2.3 million. Management has not yet evaluated the impact to goodwill as prescribed by SFAS No. 142. The overall market value of the Company as of March 22, 2002 was $26.7 million, or $3.14 per share, compared to book value of $80.3 million, or $9.44 per share.
The Company provides alternative risk management products and services to certain large client groups and associations and then markets them to their individual members. Within these groups, the Company targets small to medium sized accounts. In 2001, 2000, and 1999, the Company’s top four programs, collectively, accounted for 29.4%, 21.6% and 25.9%, respectively, of the Company’s total net earned premium. The loss or cancellation of any of the Company’s significant programs by the relevant client groups, or the general availability of commercial market coverage to members of such groups on more favorable terms than provided under the Company’s programs, could have a material adverse effect on the Company’s results of operations. Some of the Company’s clients may require its insurance companies to retain an “A-” (“Excellent”) or better A.M. Best rating. In August 2001, the Company’s rating was downgraded to “B” (“Fair”) by A.M. Best. While the Company has not yet experienced a material impact on its business to date, the impact of this downgrade may have a material adverse impact on its ability to market its insurance products. If the Company is unsuccessful in increasing its capital in the immediate future, and its rating remains at the current level, certain programs and insureds may seek other insurance carriers with higher ratings. While the Company has no reason to believe that any downward adjustment will be made, there can be no assurance that A.M. Best will not further reduce its rating of the Company’s insurance company subsidiaries in the future.
Commission and fee income are recorded on the later of the effective date or the billing date of the policies on which they were earned. The income effects of subsequent premium and fee adjustments are recorded when the adjustments become known.
The majority of claims processing fees are recognized as revenue over the estimated life of the claims. For those contracts that provide services beyond the contractually defined termination date of the related contracts, fees are deferred in an amount equal to management’s estimate of the Company’s obligation to continue to provide services.
In December 1996, Star entered into a five-year joint underwriting agreement with Connecticut Surety Company (“CSC”), whereby Star transferred the underwriting risk on the majority of the Company’s existing surety bond business. Effective June 1, 2000, CSC no longer assumes risk on new or renewal business from Star; however, one of CSC’s subsidiaries continues to act as a general agent for the Company. This new and renewal business is now 100% reinsured to unaffiliated reinsurers with an A.M. Best rating of “A” or better. Effective January 2002, CSC sold the renewal rights to the business of CSC and its subsidiaries to a third party, which will now underwrite all new and renewal business, excluding those bonds which Star must renew due to statutory requirements.
repayment terms are in accordance with the original terms between CSC and Fleet Bank. Other investors executed similar notes with CSC in varying amounts and also purchased a portion of the CSC loan with Fleet Bank.
As of September 30, 2001, CSC had capital and surplus of $5.0 million. On February 6, 2002, the Connecticut Insurance Department placed CSC into Rehabilitation.
The Company has alternative plans to mitigate the risk items described above. The Company has retained an investment-banking firm to file a registration statement with the Securities and Exchange Commission with respect to a public offering of its common stock. The Company executed an engagement letter with an investment-banking firm that will act as financial advisor and lead underwriter for the Company in selling its common stock to the public. The terms will be determined immediately prior to the offering, which is expected to commence in May or June 2002. The offering is subject to certain conditions and no underwriting agreement has yet been executed. If the capital raising is unsuccessful, management believes the Company has the ability to sell certain of its non-regulated subsidiaries to satisfy its debt obligations. There are no restrictions that prohibit the sale of non-regulated subsidiaries. Proceeds from the offering would be used to satisfy all or a portion of the Company’s debt obligations and add to the surplus of its insurance subsidiaries. However, there can be no assurance that these capital-raising efforts will be successful.
Over the past three years, the Company took actions to eliminate seven specific unprofitable programs that were not aligned with its historic and present alternative risk management strategy. The Company also established strict corporate program guidelines that identify the following criteria as unacceptable:
On April 30, 1998, the Company acquired the business of Villari & Associates, Inc. and operated the agency as Meadowbrook-Villari Agency. The purchase price was $5.6 million comprised of $4.5 million in cash and 33,433 shares of common stock of the Company, resulting in goodwill of $5.6 million. The
Results from operations, excluding the cumulative effect of accounting change, deteriorated $9.6 million from a net loss of $7.8 million in 1999 to a net loss of $17.5 million in 2000. The 2000 results reflect a $28.0 million pre-tax, or $18.5 million after-tax charge, for loss and loss adjustment expense related items. This charge reflects $20.2 million of adverse development on prior accident years, $2.0 million for accelerated amortization of deferred acquisition costs, $3.0 million for additional reinsurance costs on the Company’s adjustable rate casualty reinsurance treaty, and $2.8 million associated with loss-based assessments and other indirect claims expenses. The adverse development was primarily from discontinued programs. The adverse development of $15.9 million in 1999 was primarily related to programs no longer being underwritten by the Company, which includes discontinued programs.
Revenues from program business increased $19.3 million, or 10.5%, to $204.0 million for the year ended December 31, 2001 from $184.7 million for the comparable period in 2000. This increase reflects 12.1%
Program business generated a pre-tax loss of ($7.6) million for the year ended December 31, 2001 compared to a pre-tax loss of ($24.3) million for the comparable period in 2000. This was the result of a decrease in the Company’s loss and loss adjustment expenses and operating expenses on program business. The Company’s loss and loss adjustment expense ratio was 81.1% for the year ended December 31, 2001 compared to 90.9% for the comparable period in 2000. The net loss in 2001 reflects the impact of adverse development of $14.4 million on net reserves. The adverse development reflects $5.2 million related to unprofitable discontinued programs, $4.5 million related to the provision for uncollectible reinsurance on CSC and HIH, and the remaining development related to claims activity on the auto liability line of business. The 2000 results reflected significant adverse development related to the discontinued programs mentioned above.
The Company’s expense ratio was 36.0% for the year ended December 31, 2001 compared to 35.9% for the comparable period in 2000.
Program business in 2000 generated a pre-tax loss of ($24.3) million compared to a pre-tax loss of ($11.9) million in 1999. The 2000 results reflect a $28.0 million pre-tax, or $18.5 million after-tax, charge for loss and loss adjustment expense reserve related items. This charge reflects $20.2 million of adverse development on prior accident years, $2.0 million for accelerated amortization of deferred acquisition costs, $3.0 million for additional reinsurance costs on the Company’s adjustable rate casualty reinsurance treaty, and $2.8 million associated with loss-based assessments and other indirect claims expenses. The adverse development in 2000 was primarily from discontinued programs. The adverse development of $15.9 million in 1999 was primarily relating to programs no longer being underwritten by the Company, which includes discontinued programs.
Agency commissions increased $843,000, or 5.1%, to $17.2 million in 2000 from $16.4 million in 1999. Agency operations pre-tax income increased $476,000, or 13.1%, to $4.1 million in 2000 from $3.6 million in 1999. This improvement in pre-tax income reflects the combination of growth in commission revenues and the impact of expense reductions taken in late 1999.
The provision for income taxes resulted in a benefit of $3.6 million, $10.1 million, and $6.2 million in 2001, 2000, and 1999 with a negative effective tax rate of 35.6%, 36.7% and 44.2%, respectively. The tax rate in 1999 deviated significantly from the 34% corporate rate due to the Company’s investment portfolio being weighted in tax-exempt securities. During 2000, because of the Company’s current tax position, the Company shifted more of its investment portfolio to taxable securities, bringing the effective tax rate closer to the corporate tax rate of 34%.
Interest expense for 2001, 2000 and 1999 was $4.5 million, $5.1 million and $3.6 million, respectively. This interest expense relates primarily to the Company’s line of credit. The average debt outstanding was approximately $54 million, $51 million, and $44 million in 2001, 2000 and 1999, respectively. The average interest rate was approximately 8%, 9%, and 8% in 2001, 2000 and 1999, respectively.
At December 31, 2001, the Company had a bank line of credit that permits borrowings up to $47.5 million. The Company drew on this line of credit primarily to consummate the acquisitions made during 1997 through 1999. The Company also used the line of credit to fund operating expenses of the non-regulated subsidiaries and to make investments with the regulated subsidiaries.
and the Company pledged the stock of its non-regulated subsidiaries as collateral. In the event of default, the banks would have the right to sell the Company’s non-regulated subsidiaries and apply the proceeds to the balance on the line of credit.
A non-insurance premium finance subsidiary of the Company maintains a line of credit with a bank, which permits borrowings up to 80% of the accounts receivable, which collateralize the line. The line will expire on May 14, 2002 and management intends to renew this line of credit. The line bears interest at 1% under the Prime Rate, which was 4.75% and 9.50% at December 31, 2001 and 2000, respectively. At December 31, 2001 and 2000, $3.8 million and $2.5 million, respectively, were outstanding under this line.
In addition, the Company has an outstanding subordinated promissory note payable in the amount of $3.5 million, due June 30, 2003, which bears interest at a rate of 6.673% plus a Eurocurrency margin. As of December 31, 2001, the Eurocurrency margin was 1.7%. Proceeds of this borrowing were used to reduce the outstanding balance on the bank line of credit.
There were no letters of credit open as of December 31, 2001. One letter of credit in the amount of $14,200,000 which had previously been provided as collateral for two insurance subsidiaries’ obligations under a reinsurance agreement, was drawn on in full by the beneficiary. This amount earns interest payable to the Company on the drawn balance at 4.5%. This agreement expires September 1, 2006.
Shareholders’ equity was $80.3 million, or $9.44 per common share, at December 31, 2001, compared to $86.0 million at December 31, 2000, or $10.10 per common share. The decrease in shareholders’ equity during 2001 primarily reflects the Company’s second quarter net loss. Changes in shareholders’ equity related to the unrealized values of underlying portfolio investments has been and will continue to be volatile as market prices of debt securities fluctuate with changes in the interest rate environment.
A significant portion of the Company’s consolidated assets represent assets of the Company’s insurance subsidiaries that at this time cannot be transferred to the holding company in the form of dividends, loans or advances. The restriction on the transferability to the holding company from its insurance subsidiaries is dictated by Michigan regulatory guidelines, which are as follows: The maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of each insurance company’s net income (excluding realized capital gains) or ten percent of the insurance company’s policyholders’ surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law that prohibits an insurer from declaring dividends except out of earned surplus of the company. Earned surplus balances are calculated on a quarterly basis. Since Star Insurance Company (“Star”) is the parent of the domestic insurance company subsidiaries, its maximum dividend calculation represents the combined insurance companies’ surplus. Based upon the 2001 statutory financial statements, Star may not pay any
dividends to the Company during 2002 without prior approval of OFIS. Star’s earned surplus position at December 31, 2001 was negative $29.1 million. No statutory dividends were paid in 2001 or 2000.
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidating proceeding.
The “Company Action Level” is triggered 	if a company’s total adjusted capital is less than 200% but 	greater than or equal to 150% of its risk-based capital. At the 	“Company Action Level,” a company must submit a 	comprehensive plan to the regulatory authority that discusses 	proposed corrective actions to improve its capital position. A 	company whose total adjusted capital is between 250% and 200% of 	its risk-based capital is subject to a trend test. A trend test 	calculates the greater of any decrease in the margin (i.e. the 	amount in dollars by which a company’s adjusted capital 	exceeds it risk-based capital) between the current year and the 	prior year and between the current year and the average of the 	past three years, and assumes that the decrease could occur 	again in the coming year. If a similar decrease in margin in the 	coming year would result in a risk-based capital ratio of less 	than 190%, then “Company Action Level” regulatory 	action would be triggered.
The “Regulatory Action Level” is 	triggered if a company’s total adjusted capital is less 	than 150% but greater than or equal to 100% of its risk-based 	capital. At the “Regulatory Action Level,” the 	regulatory authority will perform a special examination of the 	company and issue an order specifying corrective actions that 	must be followed.
The “Authorized Control Level” is 	triggered if a company’s total adjusted capital is less 	than 100% but greater than or equal to 70% of its risk-based 	capital, at which level the regulatory authority may take any 	action it deems necessary, including placing the company under 	regulatory control.
At December 31, 2001, all of the Company’s insurance subsidiaries were in compliance with RBC requirements, with the exception of Star. Star reported statutory surplus of $51.6 million and $56.2 million at December 31, 2001 and 2000, respectively. The calculated RBC was $29.7 million in 2001 and $27.0 million in 2000 and the threshold requiring the minimum regulatory involvement was $59.5 million in 2001 and $53.9 million in 2000. The 2001 RBC ratio for Star was within Company Action Level. The Company is required to submit an RBC Plan outlining how it intends to achieve compliance. The Company is preparing the RBC Plan which includes, but is not limited to, the actions outlined below in the Business Plan. The RBC Plan is due by April 15, 2002.
The growth in Star’s net written premium 	reflects the conversion of two commercial auto programs to 	fully-insured programs from risk-sharing programs. As part of 	the plan to reduce both gross and net leverage ratios, the 	Company has cancelled these programs effective December 31, 	2001. In addition, to reduce the Company’s overall excess 	reinsurance costs, Star assumed premium that was previously 	assumed by Preferred Insurance Company, Ltd. (“PICL”). 	Excluding these items, Star’s Change in Net Writings ratio 	would have been within the usual range at 4.3%.
The Surplus Aid to Surplus ratio was impacted by 	the purchase of a significant quota share reinsurance treaty for 	several of the Company’s workers’ compensation 	programs, as well as the overall reduction in statutory surplus 	as a result of the net losses in 2001 and 2000.
In 2001, the Change in Net Writings for Williamsburg National Insurance Company (“Williamsburg”), another insurance subsidiary, was 116%. The growth in the net written premium on Williamsburg was unusually high for the year primarily due to two new workers’ compensation programs. These two new programs generated an additional $383,000 of net written premium for 2001. Excluding the impact of this new business, the ratio would have been within the usual range at 18%.
The Company has received inquiries from various state regulators requesting information concerning Star’s financial condition. The losses, adverse trends and uncertainties discussed in this report have been and continue to be reviewed by the domiciliary state and other insurance regulators of the Company’s insurance subsidiaries. The Company had previously submitted a Business Plan to reduce its current leverage ratios and
Reinsurance does not legally discharge an insurer from its primary liability for the full amount of risks assumed under insurance policies it issues, but it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, the Company is subject to credit risk with respect to the obligations of its reinsurers. In its selection of reinsurers, the Company evaluates the financial stability of its prospective reinsurers. To date, the Company has not, in the aggregate, experienced any material difficulties in collecting reinsurance recoverables other than those balances related to CSC and HIH, as discussed previously, and for which allowances have been established. No assurance can be given regarding the future ability of any of the Company’s reinsurers to meet their obligations. The following table sets forth information relating to the Company’s five largest reinsurers on the basis of reinsurance premium ceded (other than client captive quota-share reinsurers) as of December 31, 2001 (in thousands):
exposure to uncollectibility. Management believes that this allowance is adequate. To date, the Company has not, in the aggregate, experienced material difficulties in collecting balances from its risk-sharing partners. No assurance can be given, however, regarding the future ability of any of the Company’s risk-sharing partners to meet their obligations.
FASB has issued SFAS No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142, for periods starting December 15, 2001 or thereafter, eliminates the amortization of goodwill. In addition, goodwill would be separately tested for impairment using a fair-value based approach. Upon implementation in 2002, the Company will no longer amortize goodwill. Goodwill amortization in 2001 was $2.3 million. Management has not yet evaluated the impact to goodwill as prescribed by SFAS No. 142. The overall market value of the Company as of March 22, 2002 was $26.7 million, or $3.14 per share, compared to book value of $80.3 million, or $9.44 per share.
FASB has issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144, for periods starting January 1, 2002 or thereafter, clarifies and revises existing guidance on accounting for impairment of plant, property, and equipment, amortized intangibles, and other long-lived assets not specifically addressed in other accounting literature. Management does not expect the adoption of this standard to have a significant impact on the Company’s 2002 financial results. SFAS No. 144 also broadens the presentation of discontinued operations to include a component of an entity (rather than only a segment of a business).
In March 1998, NAIC voted to adopt its Codification of Statutory Accounting Principles project (referred to hereafter as “codification”). Codification is a modified form of statutory accounting principles that will result in a change to the current NAIC Accounting Practices and Procedures Manual applicable to insurance enterprises. The Company’s insurance subsidiaries adopted codification effective January 1, 2001. The adoption of codification increased consolidated statutory surplus by $5.8 million as of January 1, 2001.
This annual report may provide information including certain statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These include statements regarding the intent, belief, or current expectations of the Company’s management. You are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks and uncertainties, and results could differ materially from those indicated by such forward-looking statements. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are: the frequency and severity of claims; uncertainties inherent in reserve estimates; catastrophic events; a change in the demand for, pricing of, availability or collectibility of reinsurance; increased rate pressure on premiums; obtainment of certain rate increases in current market conditions; investment rate of return; changes in and adherence to insurance regulation; actions taken by