In 1998, we purchased land in Southfield, Michigan for a cost of $3.2 million. In 2004, the construction of our corporate headquarters was completed on half of this land. In December 2004, we relocated to the new office building. This new building is approximately 72,000 square feet. The total construction cost of the building approximated $12.0 million, which was paid in full at the closing on January 19, 2005. Previously, we leased our corporate offices from an unaffiliated third party.
Since 2003, we have issued $30.9 million and $25.0 million in junior subordinated debentures and senior debentures, respectively. We received a total of $53.3 million in net proceeds from the issuances of these debentures, of which $26.2 million was contributed to the surplus of our Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes. These debentures are callable after five years
Our specialty risk management operations segment, which includes insurance company specialty programs and fee-for-service specialty programs, focuses on specialty or niche insurance business. Specialty risk management operations provide services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention, and reinsurance placement, along with various types of property and casualty insurance coverage, including workers’ compensation, commercial multiple peril, general liability, commercial auto liability, and inland marine. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of our agent-partners. We recognize revenue related to the services and coverages the specialty risk management operations provides within seven categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance placement, investment income, and net realized gains (losses).
The following table sets forth our net case and IBNR reserves for losses and LAE by line of business at December 31, 2007 (in thousands):
In developing claim and claim adjustment expense (loss(es)) reserve estimates, we perform a complete and detailed reserve analyses each quarter. To perform this analysis the data is organized at a “reserve category” level. A reserve category can be a line of business such as commercial automobile liability, or it may be a particular geographical area within a line of business such as Nevada workers’ compensation. The reserves within a reserve category level are characterized as either short tail or long tail. About ninety-eight percent of our reserves can be characterized as coming from long tail lines of business. For long tail business, several years may lapse between the time the business is written and the time when all claims are settled. Our long-tail exposures include workers’ compensation, commercial automobile liability, general liability, professional liability, products liability, excess, and umbrella. Short-tail exposures include property, commercial automobile physical damage, and inland marine. The analyses generally review losses both gross and net of reinsurance.
All of these methods are consistently applied to every reserve category where they are applicable and they create indications for each accident year. We use judgment selecting the best estimate from within these estimates or adjusted estimates. As such, no one method or group of methods is strictly used for any line of business or reserve category within a line of business. The individual selections by year are our best judgments based on the strengths and weaknesses of the method, indications, the inherent variability in the data and the specific modifications to selections for data characteristics.
The method assumes that only future losses will develop at the expected loss ratio level. The percent of paid loss to ultimate loss implied from the paid development method is used to determine what percentage of ultimate loss is yet to be paid. The use of the pattern from the paid development method requires consideration of all factors listed in the description of the paid development method. The estimate of losses yet to be paid is added to current paid losses to estimate the ultimate loss for each year. This method will react very slowly if actual ultimate loss ratios are different from expectations due to changes not accounted for by the expected loss ratio calculation.
Claims for short-tail lines of business settle more quickly than long-tail lines of business, and in general, loss development factors for short-tail lines are smaller than long-tail lines. For long-tail lines, we tend to rely on initial expected loss methods throughout the current accident year then move to development factor based methods for older accident years. Development methods on short-tail lines are generally reliable in the third and fourth quarter of the initial accident year and recorded loss ratios reflect a blend of the development and forecast methods. Short-tail lines represent two percent of our total reserves at December 31, 2007.
Actuarial judgment is required in selecting the patterns to apply to each segment of data being analyzed, and our views regarding current and future claim patterns are among the factors that enter into our establishment of the losses and LAE reserves at each balance sheet date. When short-term averages or external rate bureau analyses indicate the claims patterns are changing from historical company or industry patterns, the new or forecasted information typically is factored into the methodologies. When new claims emergence or payment patterns have appeared in the actual data repeatedly over multiple evaluations, those new patterns are given greater weight in the selection process.
Because some claims are paid over many years, the selection of claim emergence and payment patterns involves judgmentally estimating the manner in which recently occurring claims will develop for many years and at times, decades in the future. When it is likely the actual development will occur in the distant future, the potential for actual development to differ substantially from historical patterns or current projections is increased.
By its nature, the estimate of ultimate loss and LAE is subject to variability due to differences between our assumptions and actual events in the future. Although many factors influence the actual cost of claims and our corresponding reserve estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors known to impact the cost of claims cannot be measured directly, such as the impact on claim costs due to economic inflation, coverage interpretations and jury determinations. In most instances, we rely on our historical experience or industry information to estimate the values for the variables that are explicitly used in our reserve analyses. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of the future effects of these factors. Where we have reason to expect a change in the effect of one of these factors, we perform analyses to perform the necessary adjustments.
typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.
Historic development as shown within the “Analysis of Loss and Loss Adjustment Expense Development” table has been three percent or less in the last two years but was ten to thirty-three percent in the years prior to the underwriting and reserving shift in 2002. At that time, we concentrated our efforts on eliminating underwriting relationships where we had substantial liabilities above an aggregate exposure retained by risk sharing associations and captives. For a large share of our business, we also accelerated the pace at which we brought the claim administration to our employees and away from outside third party administrators. This enabled us to rapidly recognize trends and underlying loss patterns, while being able to quickly set more accurate reserves.
Our range of estimates table shows that presently we evaluate it as going from favorable development of 7.8% to unfavorable of 6.1%. The range was evaluated based on the ultimate loss estimates from the actuarial methods described above.
The sensitivity around our workers’ compensation reserves primarily reflects the size and the maturity of the underlying book of business. Our workers’ compensation reserves represent 49% percent of our total reserves at December 31, 2007. Workers’ compensation was our first line of business and is still our largest.
The sensitivity around our commercial multiple peril/general liability reserves primarily reflects the longer duration of reserves relating to our liability excess program which started in 2003 and currently represents 49% of the $87.8 million reserves in this line of business, as of December 31, 2007.
Our investment securities are classified as available for sale. Investments classified as available for sale are available to be sold in the future in response to our liquidity needs, changes in market interest rates, tax strategies and asset-liability management strategies, among other reasons. Available for sale securities are reported at fair value, with unrealized gains and losses reported in the accumulated other comprehensive income component of shareholders’ equity, net of deferred taxes and, accordingly, have no effect on net income. However, if there is a decline in the fair value of an investment below its cost and the decline is considered other than temporary, the amount of decline below cost is charged to earnings.
impaired securities is to determine impairment based on analysis of, but not limited to, the following factors: (1) rating downgrade or other credit event (e.g., failure to pay interest when due); (2) financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology or discontinuance of a business segment; (3) prospects for the issuer’s industry segment; and (4) intent and ability to retain the investment for a period of time sufficient to allow for anticipated recovery in market value. We evaluate our investments in securities to determine other than temporary impairment, no less than quarterly. Investments that are deemed other than temporarily impaired are written down to their estimated net fair value and the related losses recognized in income. There were no impaired investments written down in 2007, 2006, and 2005. There can be no assurance, however, that significant changes in the above factors in relation to our investment portfolio, will not result in future impairment charges.
Assumed premium estimates are specifically related to the mandatory assumed pool business from the NCCI, or residual market business. The pools cede workers’ compensation business to participating companies based upon the individual company’s market share by state. The activity is reported from the NCCI to participating companies on a two quarter lag. To accommodate this lag, we estimate premium and loss activity based on historical and market based results. Historically, we have not experienced any material difficulties or disputes in collecting balances from NCCI; and therefore, no provision for doubtful accounts is recorded related to the assumed premium estimate.
the estimated life of the claims, or the estimated life of the contract. For those contracts that provide services beyond the contractually defined termination date of the related contracts, fees are deferred in an amount equal to an estimate of our obligation to continue to provide services.
Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. As required by SFAS No. 142 “Goodwill and Other Intangible Assets,” we no longer amortize goodwill and, at least annually, we test all existing goodwill for impairment using a fair value approach, on a reporting unit basis. Our annual assessment date for goodwill impairment testing is October 1st. We test for impairment more frequently if events or changes in circumstances indicate that there may be an impairment to goodwill. We carry goodwill on two reporting units within the agency operations segment in the amount of $6.5 million and three reporting units within the specialty risk management operations segment in the amount of $37.0 million. Based on our most recent evaluation of goodwill impairment, we determined that no impairment to goodwill exists.
Our overall results in 2007 continued to reflect growth of net income in comparison to prior year. These improvements reflect our commitment to selective growth, as well as our adherence to strict corporate underwriting guidelines and price adequacy. We continue to maintain strong underwriting discipline and growth within our profitable programs. Our generally accepted accounting principles (“GAAP”) combined ratio improved 1.4 percentage points to 95.4% in 2007 from 96.8% in 2006. We also continue to experience solid growth in our fee-based operations. Net operating income, excluding amortization, increased 32.1% to $29.8 million, or $0.90 per diluted share, compared to $22.6 million, or $0.76 per diluted share in 2006.
Gross written premium increased $15.6 million, or 4.7%, to $346.5 million in 2007, compared to $330.9 million in 2006. Our existing underwritten business, which excludes residual market premium, was up $18.8 million, or 5.9% in comparison to 2006. This growth included business from new programs implemented in 2006. The growth in existing business was slightly offset by a reduction in residual market premiums that are assigned to us as a result of a decrease in the estimate of the overall size of the residual market.
In April 2007, we received an upgrade of our financial strength rating by A.M. Best Company to “A−” (Excellent), from “B++” (Very Good) for our Insurance Company Subsidiaries. This rating upgrade validates our commitment to create value through excellent underwriting and consistent operating performance. We are continuing to implement new insurance programs as a result of this upgrade from A.M. Best and other business development strategies. We have a comprehensive due diligence process that incorporates an entity wide risk analysis, as well as an operational review. While this process can be lengthy, we believe the initial work leads to long term relationships with solid longer term favorable underwriting performance. We believe we are in a good position to achieve our top-line and bottom-line growth objectives in 2008. In addition, subsequent to the A.M. Best upgrade, we have renewed policies formerly written on a fronted basis by a non-affiliated insurance company and assumed by our Insurance Company Subsidiaries in exchange for a 5.5% fronting fee. As this renewal process continues and we earn the premium previously fronted, we expect to see this reduction in cost reflected within our expense ratio.
In April 2007, we purchased certain business assets of U.S. Specialty Underwriters, Inc. (“USSU”) for a purchase price of $23.0 million. This purchase price was comprised of $13.0 million in cash and $10.0 million in our common stock. USSU is based in Cleveland, Ohio, and is a specialty program manager that produces fee based income by underwriting excess workers’ compensation coverage for a select group of insurance companies. The total shares issued for the $10.0 million portion of the purchase price was 907,935 shares. Under the terms of the Agreement, we acquired the excess workers’ compensation business and other related assets. In addition, we entered into a Management Agreement with the shareholders of USSU. Under the terms and conditions of the Management Agreement, the shareholders were responsible for certain aspects of the administration and management of the acquired business. The shareholders’ consideration for the performance of their duties was in the form of a Management Fee payable by us based on a share of net income before interest, taxes, depreciation, and amortization. In addition, we retained the option to terminate the Management Agreement, at our discretion, based on a multiple of the Management Fee calculated for the trailing twelve
In July 2007, we completed an offering of 6,437,500 additional shares of newly issued common stock at $9.65 per share. The gross proceeds of the offering were $62.1 million. The net proceeds were $58.6 million. The net proceeds from the offering are being utilized to support organic growth within our underwriting operations, to fund select acquisitions and for other general corporate purposes. Upon receipt of the net proceeds, we reduced our outstanding line of credit balance from $22.0 million to zero.
On February 20, 2008, we executed a definitive merger agreement with ProCentury Corporation (“ProCentury”) for a merger transaction valued at approximately $272.6 million in cash and stock to be paid to ProCentury shareholders. The combined entity will adopt and operate under the Meadowbrook name and will continue to trade on the NYSE under the ticker symbol “MIG”. Our Chief Executive Officer, Robert S. Cubbin, will continue in his current role in the post-merger combined entity and two ProCentury board members are expected to join Meadowbrook’s Board of Directors.
We expect to finance the cash portion of the purchase price through a combination of cash and debt. Completion of the transaction is subject to various closing conditions, including the receipt of required regulatory and shareholder approval. We expect to complete the merger in the third quarter of 2008.
Net income improved $6.0 million, or 27.0%, to $28.0 million, or $0.85 per diluted share, in 2007, from net income of $22.0 million, or $0.75 per diluted share, in 2006. This improvement primarily reflects growth in underwriting profits and an increase in net investment income. Net investment income increased primarily from an overall increase in average invested assets. Improvements in our overall underwriting results reflect continued favorable development on prior year losses and a slight reduction in the expense ratio. These improvements were partially offset by amortization of intangibles and interest expense associated with our acquisition of the USSU business.
Revenues increased $22.5 million, or 7.1%, to $340.7 million for the year ended December 31, 2007, from $318.2 million for the comparable period in 2006. This increase reflects a $13.3 million, or 5.2%, increase in net earned premiums. The increase in net earned premiums was the result of selective growth consistent with our corporate underwriting guidelines and our controls over price adequacy, partially offset by a reduction in residual market premiums that are assigned to us as a result of a decrease in the estimate of the overall size of the residual market. The increase in revenue was also due to an overall increase in fee-for-service revenue, primarily as a result of our acquisition of the USSU business. Total fees received in 2007 as a result of this acquisition were $5.5 million. In addition, the increase in revenue reflects a $4.3 million increase in investment income, primarily the result of overall positive cash flow, a slight increase in yield and to a lesser extent the cash received from our equity offering in July 2007.
Net income improved $4.1 million, or 23.0%, to $22.0 million, or $0.75 per diluted share, in 2006, from net income of $17.9 million, or $0.60 per diluted share, in 2005. This improvement was primarily the result of our selective growth consistent with our corporate underwriting guidelines and our controls over price adequacy. In addition, during 2005 we increased our retention levels on certain reinsurance treaties, which favorably impacted net earned premiums and net income for 2006, compared to 2005. Growth in our fee-for-service programs also contributed to the overall improvement in net income in comparison to 2005.
Specialty risk management operations generated pre-tax income of $47.9 million for the year ended December 31, 2007, compared to pre-tax income of $38.3 million for the year ended December 31, 2006. This increase in pre-tax income primarily reflects expansion of cash margins on our fee revenue, an increase in net investment income, increased underwriting profits, favorable development in prior accident year reserves, and a slightly lower expense ratio. The GAAP combined ratio was 95.4% for the year ended December 31, 2007, compared to 96.8% for the comparable period in 2006.
Net losses and loss adjustment expenses (“LAE”) increased $4.7 million, or 3.2%, to $151.0 million for the year ended December 31, 2007, from $146.3 million for the same period in 2006. Our loss and LAE ratio improved 1.1 percentage points to 61.2% for the year ended December 31, 2007, from 62.3% for the same period in 2006. This ratio is the unconsolidated net loss and LAE in relation to net earned premiums. This improvement reflects the impact of overall favorable development on prior accident year reserves of 1.5 percentage points from the December 31, 2006 reserves. The improvement was primarily within the workers’ compensation and professional liability lines of business, partially offset by an increase in the ultimate loss projections within the general liability line of business. The unfavorable development within the general liability line of business reflects a claim reserving process change for an excess liability program. Additional discussion of our reserve activity is described below within the Other Items - Reserves section.
Net earned premiums increased $4.9 million, or 2.0%, to $254.9 million for the year ended December 31, 2006, from $250.0 million in the comparable period in 2005. This increase was primarily the result of selective
Claim fees increased $1.7 million, or 23.4%, to $8.8 million, from $7.1 million for the comparable period in 2005. This increase was primarily the result of our 2006 entry into the self-insured workers’ compensation market in Nevada. In addition, this increase was the result of increases in revenue related to a specific Minnesota-based program, as well as a Florida-based program, which was implemented in the second quarter of 2005.
Specialty risk management operations generated pre-tax income of $38.3 million for the year ended December 31, 2006, compared to pre-tax income of $29.5 million for the year ended December 31, 2005. This increase in pre-tax income demonstrates a continued improvement in underwriting results as a result of our controlled growth in premium volume and our continued focus on leveraging of fixed costs. The GAAP combined ratio was 96.8% for the year ended December 31, 2006, compared to 98.7% for the comparable period in 2005.
we experienced approximately $1.3 million in adverse development related to allowances on reinsurance recoverables.
Our expense ratio for the year ended December 31, 2006 was 34.5%, compared to 33.5% in 2005. This ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premiums. The increase in our expense ratio in comparison to 2005 reflects a reduction in an accrual for estimated profit-based ceding commissions on an excess reinsurance treaty for a specific commercial transportation program. This decrease was the result of unfavorable loss development on a limited number of excess of loss claims from prior accident years and added $1.6 million to our expenses, or 0.6 percentage points to our expense ratio for the year, as compared to a favorable impact on the 2005 expense ratio of $1.1 million, or 0.5 percentage points. As of December 31, 2006, the remaining accrual was less than $150,000; therefore, we do not anticipate any further unfavorable adjustments. Offsetting this increase in the expense ratio was a reduction in insurance related assessments primarily related to the guaranty fund in Florida and Nevada.
At December 31, 2007, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $341.5 million. We established a reasonable range of reserves of approximately $314.7 million to $362.4 million. This range was established primarily by considering the various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business (in thousands):
For the year ended December 31, 2007, we reported a decrease in net ultimate loss estimates for accident years 2006 and prior of $7.1 million, or 2.3% of $302.7 million of net loss and LAE reserves at December 31, 2006. The decrease in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2007 that differed from the projected activity. There were no significant
The projected net ultimate loss estimate for the workers’ compensation line of business, excluding residual markets, decreased $11.4 million, or 8.3% of net workers’ compensation reserves. This net overall decrease reflects decreases of $1.1 million, $3.8 million, $2.9 million, $557,000, and $1.1 million in accident years 2006, 2005, 2004, 2003, and 2000, respectively. These decreases reflect better than expected experience for many of our workers’ compensation programs, including those in Nevada, Florida, and a multi-state association program. The actual losses on reported claims were less than the prior actuarial projections and, therefore, ultimate loss estimates were reduced. The change in ultimate loss estimates for all other accident years was insignificant.
The projected net ultimate loss estimate for the commercial automobile line of business increased $847,000, or 1.6% of net commercial automobile reserves. This net overall increase reflects increases of $2.3 million and $1.5 million in accident years 2005 and 2004, respectively. These increases primarily reflect higher than expected emergence of claim activity in a Southeast-based and West coast-based program. These increases were offset by a decrease of $2.5 million in accident year 2006. The decrease in this accident year reflects favorable development within a West coast-based program and a Southeast-based program. The change in ultimate loss estimates for all other accident years was insignificant.
The projected net ultimate loss estimate for the other lines of business decreased $6.0 million, or 27.4% of net reserves. This net decrease reflects decreases of $1.6 million, $2.2 million, $1.2 million, and $771,000, in the net ultimate loss estimate for accident years 2006, 2005, 2004 and 2003, respectively. These decreases were due to better than expected case reserve development during the calendar year in the professional liability programs. The change in ultimate loss estimates for all other accident years was insignificant.
Salaries and employee benefits increased $3.3 million, or 6.3%, to $54.6 million in 2006, from $51.3 million for the comparable period in 2005. This increase primarily reflects an increase in variable compensation. In addition, this increase was the result of an increase in staffing levels, primarily as a result of the additions of our Florida-based retail agency and our entry into the self-insured workers’ compensation market in Nevada. Excluding those additions, overall staffing levels for 2006 were slightly higher in comparison to 2005.
Other administrative expenses increased $3.5 million, or 12.0%, to $32.3 million in 2007, from $28.8 million in 2006. Other administrative expenses increased in comparison to 2006 as a result of our acquisition of the USSU business, primarily due to the management fee associated with this acquisition. In addition, this increase was the result of information technology initiatives. Offsetting the increases related to the USSU business were decreases related to policyholder dividends, as well as various decreases in other general operating expenses in comparison to 2006.
Interest expense for 2007, 2006, and 2005 was $6.0 million, $6.0 million, and $3.9 million, respectively. Interest expense is primarily attributable to our debentures, which are described within the Liquidity and Capital Resources section of Management’s Discussion and Analysis, as well as our line of credit. Interest expense for 2007 includes interest related to a temporary increase in our line of credit which was associated with borrowings to fund the cash portion of the USSU business acquisition. Upon receipt of the net proceeds from our capital raise in July, we reduced this outstanding balance to zero. The increase in interest expense in 2006, compared to 2005 was related to the issuance of the junior subordinated debentures issued in the third quarter of 2005, as well as an overall increase in the average interest rates.
The average outstanding balance on our line of credit was $8.8 million, $10.6 million, and $9.0 million in 2007, 2006, and 2005, respectively. The average interest rate, excluding our debentures, was approximately 6.7%, 6.5%, and 4.8%, in 2007, 2006, and 2005, respectively.
Regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2007, was $81.8 million, compared to $69.7 million for the comparable period in 2006. This increase is the result of growth in our underwritten business and timing of premium and reinsurance recoverable collections. In addition, an increase in investment income as a result of growth in our investment portfolio contributed to the increase. Partially offsetting these improvements was an increase in payments related to policy acquisition costs and insurance related assessments.
Non-regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2007, was $6.8 million, compared to $4.6 million for the comparable period in 2006. The increase in cash flow from operations is primarily the result of an increase in the collection of commission and fees due to the USSU business acquisition. This increase in cash flow was partially offset by variable compensation payments related to our long-term incentive plan, which were made in the first quarter of 2007 and related to 2006 performance and profitability.
The issuance costs associated with these debentures have been capitalized and are included in other assets on the balance sheet. As of June 30, 2007, these issuance costs were being amortized over a seven year period as a component of interest expense. The seven year amortization period represented management’s best estimate of the estimated useful life of the bonds related to both the senior debentures and junior subordinated debentures. Beginning July 1, 2007, we reevaluated our best estimate and determined a five year amortization period to be a more accurate representation of the estimated useful life. Therefore, this change in amortization period from seven years to five years has been applied prospectively beginning July 1, 2007.
Since the junior subordinated debentures issued in 2003 are callable in 2008, we will be reviewing the capital strategy associated with refinancing at lower costs through debentures or equity.
The second interest rate swap transaction, which relates to $20.0 million of our $20.0 million issuance of trust preferred securities, has an effective date of October 6, 2005 and ending date of September 16, 2010. We are required to make quarterly fixed rate payments calculated on a notional amount of $20.0 million, non-amortizing, based on a fixed annual interest rate of 8.34%. The counterparty is obligated to make quarterly floating rate payments to us, referencing the same notional amount, based on the three-month LIBOR, plus 3.58%.
In April 2007, we executed an amendment to our current revolving credit agreement with our bank. The amendments included an extension of the term to September 30, 2010, an increase to the available borrowings of up to $35.0 million, and a reduction of the variable interest rate basis to a range between 75 to 175 basis points above LIBOR. We use the revolving line of credit to meet short-term working capital needs. Under the revolving line of credit, we and certain of our non-regulated subsidiaries pledged security interests in certain property and assets of named subsidiaries.
The revolving line of credit provides for interest at a variable rate based, at our option, upon either a prime based rate or LIBOR-based rate. In addition, the revolving line of credit also provides for an unused facility fee of 15 basis points on any unused balance. On prime based borrowings, the applicable margin ranges from 75 to 25 basis points below prime. On LIBOR-based borrowings, the applicable margin ranges from 75 to 175 basis points above LIBOR. The margin for all loans is dependent on the sum of non-regulated earnings before interest, taxes, depreciation, amortization, and non-cash impairment charges related to intangible assets for the preceding four quarters, plus dividends paid or payable to us from subsidiaries during such period (“Adjusted EBITDA”). At December 31, 2007, we did not have any LIBOR-based borrowings outstanding. At December 31, 2006, the weighted average interest rate for LIBOR-based borrowings outstanding was 6.7%.
portfolio, at December 31, 2007, were 97.7% investment grade A− or above bonds as defined by Standard and Poor’s.
While our investment portfolio includes investments in mortgage-backed and agency-backed securities, we do not have any direct exposure to any sub-prime risks. Our asset-backed securities sector comprises only 4.2%, or $26.6 million of our investment portfolio. Within this sector, $2.8 million relates to home equity loans, of which $1.2 million is insured. The remaining $23.8 million primarily relates to credit cards, auto loans, and utility and equipment loans. These asset-backed securities are adequately collateralized, AAA- rated investment quality that we currently expect will continue to perform. Our mortgage-backed securities have no exposure to any sub-prime risks.
Shareholders’ equity increased to $301.9 million, or a book value of $8.16 per common share, at December 31, 2007, compared to $201.7 million, or a book value of $6.93 per common share, at December 31, 2006. This per share increase in book value primarily reflects the impact of our equity offering in July 2007, year-to-date earnings, and an increase in unrealized gains, net of deferred income tax, of $4.3 million. Return on beginning equity was 13.9% in 2007, compared to 12.4% in 2006.
On July 19, 2007, we completed a secondary offering of 6,437,500 additional shares of our common stock at a price of $9.65 per share. Including the underwriting discount associated with the offering and other related expenses, we received total net proceeds of approximately $58.6 million. These net proceeds are being utilized to support organic growth within our underwriting operations, to fund select acquisitions and for other general corporate purposes. Upon receipt of the net proceeds, we reduced our outstanding line of credit balance from $22.0 million to zero.
On February 8, 2007, our Board of Directors and the Compensation Committee of the Board of Directors approved the distribution of our LTIP award for the 2004-2006 plan years, which included both a cash and stock award. The stock portion of the LTIP award was valued at $2.5 million, which resulted in the issuance of 579,496 shares of our common stock. Of the 579,496 shares issued, 191,570 shares were retired for payment of the participant’s associated withholding taxes related to the compensation recognized by the participant. Refer to Note 2 - Stock Options, Long Term Incentive Plan, and Deferred Compensation Plan for further detail. The retirement of the shares for the associated withholding taxes reduced our paid in capital by $1.8 million.
On October 26, 2007, our Board of Directors authorized management to purchase up to 1,000,000 shares, or approximately 3%, of our common stock in market transactions for a period not to exceed twenty-four months. Our prior plan expired on October 27, 2007. For the years ended December 31, 2007 and 2006, we did not repurchase any common stock under either plan. As of December 31, 2007, we have available up to 1,000,000 shares to be purchased.
On February 8, 2008, our Board of Directors declared a quarterly dividend of $0.02 per common share. The dividend is payable on March 31, 2008, to shareholders of record as of March 14, 2008. Our Board of Directors did not declare any dividends in 2007 or 2006. When evaluating the declaration of a dividend, our Board of Directors considers a variety of factors, including but not limited to, our cash flow, liquidity needs, results of operations and our overall financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from our subsidiaries. We did not receive any dividends from our Insurance Company Subsidiaries in 2007 or 2006.
In April 2007, we acquired the business of USSU for a purchase price of $23.0 million. Under the terms of the Agreement, we acquired the excess workers’ compensation business and other related assets. USSU is based in Cleveland, Ohio, and is a specialty program manager that produces fee based income by underwriting excess workers’ compensation coverage for a select group of insurance companies.
A significant portion of our consolidated assets represent assets of our Insurance Company Subsidiaries. The State of Michigan Office of Financial and Insurance Services (“OFIS”), restricts the amount of funds that may be transferred to us in the form of dividends, loans or advances. These restrictions in general, 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 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 surplus earnings of the company. Earned surplus balances are calculated on a quarterly basis. Since Star is the parent insurance company, its maximum dividend calculation represents the combined Insurance Company Subsidiaries’ surplus. At December 31, 2007, Star’s earned surplus position was positive $33.7 million. At December 31, 2006, Star had positive earned surplus of $13.2 million. Based upon Star’s statutory financial statements as of December 31, 2007, Star would have the potential to pay a dividend of up to $18.8 million without the prior approval of OFIS. No statutory dividends were paid during 2007 or 2006.
Our Insurance Company Subsidiaries are required to maintain certain deposits with regulatory authorities, which totaled $115.2 million and $148.8 million at December 31, 2007 and 2006, respectively.
The following table is a summary of our contractual obligations and commitments as of December 31, 2007 (in thousands):
We have established two variable compensation plans as an incentive for performance of our management team. They consist of an Annual Bonus Plan (“Bonus Plan”) and a Long-Term Incentive Plan (“LTIP”). The
At December 31, 2007, each of our Insurance Company Subsidiaries was in excess of any minimum threshold at which corrective action would be required.
The NAIC’s Insurance Regulatory Information System (“IRIS”) was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies thirteen industry ratios and specifies “usual values” for each ratio. Departure from the “usual values” on four or more ratios generally leads to inquiries or possible further review from individual state insurance commissioners. In 2007, our Insurance Company Subsidiaries did not generate any ratios that departed from the “usual value” range.
In regard to our excess-of-loss reinsurance, we manage our credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective or existing reinsurers. We generally do not seek collateral where the reinsurer is rated “A−” or better by A. M. Best, has $500 million or more in surplus, and is admitted in the state of Michigan. The following table sets forth information relating to our five largest unaffiliated excess-of-loss reinsurers based upon ceded premium as of December 31, 2007:
Balances related to three unaffiliated insurance companies, which are under regulatory liquidation or control, for which allowances have been established; all other admitted reinsurers have an A.M. Best rating of “A−” or better.
Intercompany pooling or reinsurance agreements are commonly entered into between affiliated insurance companies, so as to allow the companies to utilize the capital and surplus of all of the companies, rather than each individual company. Under pooling arrangements, companies share in the insurance business that is underwritten and allocate the combined premium, losses and related expenses between the companies within the pooling arrangement. The Insurance Company Subsidiaries entered into an Inter-Company Reinsurance Agreement (the “Pooling Agreement”). This Pooling Agreement includes Star, Ameritrust Insurance Corporation (“Ameritrust”), Savers Property and Casualty Insurance Company (“Savers”) and Williamsburg National Insurance Company (“Williamsburg”). Pursuant to the Pooling Agreement, Savers, Ameritrust and Williamsburg have agreed to cede to Star and Star has agreed to reinsure 100% of the liabilities and expenses of Savers, Ameritrust and Williamsburg, relating to all insurance and reinsurance policies issued by them. In return, Star agreed to cede and Savers, Ameritrust and Williamsburg have agreed to reinsure Star for their respective percentages of the liabilities and expenses of Star. Annually, we examine the Pooling Agreement for any changes to the ceded percentage for the liabilities and expenses. Any changes to the Pooling Agreement must be submitted to the applicable regulatory authorities for approval.
In December 2005, we entered into a $6.0 million convertible note receivable with an unaffiliated insurance agency. The effective interest rate of the convertible note is equal to the three-month LIBOR, plus 5.2% and is due December 20, 2010. This agency has been a producer for us for over ten years. As security for the loan, the borrower granted us a security interest in its accounts, cash, general intangibles, and other intangible property. Also, the shareholder then pledged 100% of the common shares of three insurance agencies, the common shares owned by the shareholder in another agency, and has executed a personal guaranty. This note is convertible upon our option based upon a pre-determined formula, beginning in 2008. The conversion feature of this note is considered an embedded derivative pursuant to SFAS No. 133, and therefore is accounted for separately from the note. At December 31, 2007, the estimated fair value of the derivative is not material to the financial statements.
instrument-by-instrument basis as of specified election dates. This election is irrevocable. The objective of SFAS No. 159 is to improve financial reporting and reduce the volatility in reported earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We did not elect the fair value option for existing eligible items under SFAS No. 159; therefore there will be no impact to our consolidated financial condition or results of operations.
At December 31, 2007 and 2006, respectively, we held an $870,000 and $871,000 note receivable, including $209,000 of accrued interest at December 31, 2007, from one of our executive officers. Accrued interest at December 31, 2006 was $210,000. This note arose from a transaction in late 1998 in which we loaned the officer funds to exercise 64,718 common stock options to cover the exercise price and the taxes incurred as a result of the exercise. The note bears interest equal to the rate charged pursuant to our revolving credit agreement and is due on demand any time after January 1, 2002. As of December 31, 2007, the rate was 6.2%. The loan is partially collateralized by 64,718 shares of our common stock under a stock pledge agreement. For the years ended December 31, 2007 and 2006, $43,800 and $31,500, respectively, have been paid against the accrued interest on the loan. On June 1, 2001, the officer entered into an employment agreement which provides the note is a non-recourse loan and our sole legal remedy in the event of a default is the right to reclaim the shares pledged under the stock pledge agreement. As of December 31, 2007, the cumulative amount that has been paid against this loan was $162,800. Refer to Note 16 - Related Party Transaction for further information.
In April 2007, we entered into an agreement to acquire the excess workers’ compensation business of U.S. Specialty Underwriters, Inc. (“USSU”) for a purchase price of $23.0 million. In addition, we entered into a Management Agreement with the former owners of USSU. Under the terms the Management Agreement, the former owners were responsible for certain aspects of the daily administration and management of the USSU business. Their consideration for the performance of these duties was in the form of a management fee payable by us based on a share of net income before interest, taxes, depreciation, and amortization. We retained the option to terminate the Management Agreement, at our discretion, based on a multiple of the management fee calculated for the trailing twelve months.
Effective January 31, 2008, we exercised this option to purchase the remainder of the economics related to the acquisition of the USSU business, by eliminating the Management Agreement for a payment of $21.5 million, which now completes the transaction. As a result of this purchase, we recorded an increase to other intangible assets of approximately $11.4 million and an increase to goodwill of approximately $10.1 million.
On February 20, 2008, we executed a definitive merger agreement with ProCentury Corporation (“ProCentury”) for a merger transaction valued at approximately $272.6 million in cash and stock to be paid to ProCentury shareholders. The combined entity will adopt and operate under the Meadowbrook name and will continue to trade on the NYSE under the ticker symbol “MIG”.
We expect to finance the cash portion of the purchase price through a combination of cash and debt. Completion of the transaction is subject to various closing conditions, including the receipt of required regulatory and shareholder approvals. The transaction is expected to be completed in the third quarter of 2008.