(1) The combined loss and expense ratio (or combined ratio), expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty insurance business. The combined ratio is a statutory (non-GAAP) accounting measurement, which represents the sum of (i) the ratio of losses and loss expenses to net premiums earned (loss ratio), plus (ii) the ratio of underwriting expenses to net premiums written (expense ratio). The combined ratios above have been modified to reflect GAAP accounting, as management evaluates the performance of our underwriting operations using the GAAP combined ratio. Specifically, the GAAP combined ratio is the sum of the loss ratio, plus the ratio of GAAP underwriting expenses (which include the change in deferred policy acquisition costs) to net premiums earned (expense ratio). When the combined ratio is under 100% underwriting results are generally considered profitable; when the combined ratio is over 100% underwriting results are generally considered unprofitable.
(2) The accident year combined ratio is a non-GAAP measure that excludes changes in net ultimate loss estimates from prior accident year loss reserves. The accident year combined ratio provides management with an assessment of the specific policy year’s profitability (which matches policy pricing with related losses) and assists management in their evaluation of product pricing levels and quality of business written. Management uses accident year combined ratio as one component to assess the Company's current year performance and as a measure to evaluate, and if necessary, adjust current year pricing and underwriting.
on-going basis based on a variety of factors. There can be no assurance, however, the actual results will not be materially different than our estimates and assumptions, and that reported results of operation will not be affected by accounting adjustments needed to reflect changes in these estimates and assumptions. We believe the following policies, along with those disclosed in Note 1 ~ Summary of Significant Accounting Policies, are the most sensitive to estimates and judgments.
We establish a liability for losses and LAE, which represents case based estimates of reported unpaid losses and LAE and actuarial estimates of IBNR and LAE. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the ultimate liability may be greater or less than the estimate. As of December 31, 2014 and 2013, we have accrued $1,590.4 million and $1,616.5 million of gross loss and LAE reserves, respectively.
The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, at December 31, 2014 (in thousands):
This method uses historical, cumulative paid losses by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment environment, and to the extent necessary supplemented by analyses of the development of broader industry data.
Claims for short-tail lines of business settle quicker 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 typically 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 2% of our total reserves at December 31, 2014.
An explicit assumption used in the analysis is the set of initial expected loss ratios (“IELRs”) used in the current accident year reserve projections and in some of the prior accident year ultimate loss indications. To estimate the sensitivity of the estimated ultimate loss to a change in IELRs, the actuarial department recast the loss reserve indications using a set of IELRs all one percent higher than the final IELRs. The overall impact of a one percent change in IELRs would be a corresponding one percent change in reserve adequacy or a $5.7 million effect on after tax net income. Often the loss ratios by line of business will vary from the IELR in different directions causing them to partially offset each other. A variance of this type would 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.
Our range of loss and LAE reserves table shows that presently we estimate them as going from favorable development of 10.9% to unfavorable of 10.9%. The range was evaluated based on the ultimate loss estimates from the actuarial methods described above.
The range of loss and LAE reserves at December 31, 2014 had a minimum reserve estimate of $953.8 million and a maximum reserve estimate of $1,187.8 million.
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 46% of our total reserves at December 31, 2014.
The sensitivity around our commercial multiple peril and general liability reserves primarily reflects the longer duration of reserves relating to our liability excess program, which started in 2003 and was terminated in 2012, and our construction defect exposure, which together represent approximately 34% of the $444.3 million reserves in this line of business as of December 31, 2014. These lines of business are subject to greater uncertainty and volatility than the remainder of our book of business.
reserves represent professional liability programs which tend to be claims-made, therefore reducing the volatility that is inherent in a smaller book of business. Another large portion represents property claims, which have a shorter reporting and payout pattern than liability and workers’ compensation claims.
In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, or on the portion of risk either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. We collateralize balances due from our risk-sharing partners through funds withheld trusts or stand-by letters of credit issued by highly rated banks. We have historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which may be in dispute. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. At December 31, 2014, we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of our risk-sharing partners to meet their obligations.
The Company, and its subsidiaries, are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business as further disclosed in Note 15 ~ Commitments and Contingencies. Where appropriate, the Company vigorously defends such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by the policy of insurance at issue. We account for such activity through the establishment of unpaid loss and loss expense reserves. We also maintain errors and omissions insurance and extra-contractual coverage under reinsurance treaties related to the policy of insurance at issue or other appropriate insurance. In terms of any retentions or deductibles associated with such insurance, the Company has established accruals for such retentions or deductibles, when necessary, based upon current available information. In accordance with accounting guidance, if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is reasonably estimable; then an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets. Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income. Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, the Company does not believe that there is a reasonable possibility that, other than with regard to the arbitration disclosed in Note 15 ~ Commitments and Contingencies, any material
loss exceeding amounts already accrued, if any, will result from any of the claims, lawsuits and proceedings to which the Company is subject to, either individually, or in the aggregate.
Net operating income (loss) and net operating income (loss) per share are non-GAAP measures that represent net income (loss) excluding net realized gains, net of tax. The most directly comparable financial GAAP measures to net operating income (loss) and net operating income (loss) per share are net income (loss) and net income (loss) per share, respectively. Net operating income (loss) and net operating income (loss) per share are intended as supplemental information and are not meant to replace net income (loss) nor net income (loss) per share. Net operating income (loss) and net operating income (loss) per share should be read in conjunction with the GAAP financial results. The following is a reconciliation of net operating income (loss) to net income (loss), as well as net operating income (loss) per share to net income (loss) per share:
The accident year loss and LAE ratio is a non-GAAP measure and represents our net loss and LAE ratio excluding the impact of any changes in net ultimate loss estimates on prior year loss and LAE reserves. The most directly comparable financial GAAP measure to the accident year loss and LAE ratio is the net loss and LAE ratio. The accident year loss and LAE ratio is intended as supplemental information and is not meant to replace the net loss and LAE ratio. The accident year loss and LAE ratio should be read in conjunction with the GAAP financial results. The following is a reconciliation of the accident year loss and LAE ratio to the net loss and LAE ratio:
The transaction is subject to the approval of the Company’s shareholders as well as regulatory approvals and the satisfaction of other specified closing conditions. The transaction is expected to be completed in the second half of 2015.
Our GAAP combined ratio was 102.1% for the year ended December 31, 2014, compared to 111.0% in 2013. Excluding the impact of the Multiple Line Quota Share Treaty with Swiss Reinsurance America Corporation (“Swiss Re”), the GAAP combined ratio was 101.8% for the year ended December 31, 2014, compared to 107.9% for the year ended December 31, 2013. Our accident year combined ratio was 102.4% for the year ended December 31, 2014, compared to 101.2% in 2013.
The year to date 2014 results were impacted by the decrease in net ultimate loss estimates for 2013 and prior accident years, which reduced the GAAP combined ratio by 0.3 percentage points. The year to date 2013 results included an increase in net ultimate loss estimates for 2012 and prior accident years, which increased the GAAP combined ratio by 9.8 percentage points.
The net income for the year ended December 31, 2014 was $28.7 million, or $0.57 per dilutive share, compared to net loss of ($112.3 million), or ($2.25) per dilutive share, for the comparable period of 2013. Net operating income, a non-GAAP measure, for the year ended December 31, 2014 was $21.5 million, or $0.43 per diluted share, compared to net operating loss of ($117.9 million), or ($2.36) per diluted share for the year ended December 31, 2013. The 2013 net operating loss, excluding the goodwill impairment, was ($16.3 million), or ($0.33) per diluted share; there was no goodwill impairment in 2014. Refer to Note 14 - Goodwill and Other Intangible Assets of the Notes to the Consolidated Financial Statements, for additional information specific to the goodwill impairment. Total diluted weighted average shares outstanding for the year ended December 31, 2014, were 50,063,953, compared to 49,871,587 the comparable period in 2013. The increase primarily reflects the impact of share issuances pursuant to our 2013 long term incentive plan.
termination of, or premium volume reductions in certain programs where pricing and underwriting did not meet the Company’s underwriting standards and was offset by an overall 9.1% earned rate increase, which exceeded the Company’s estimated loss ratio trend of 1.9%.
Net commission and fee revenue increased $3.7 million, or 9.3%, to $43.2 million for the year ended December 31, 2014, from $39.5 million for the comparable period in 2013. This increase was driven primarily by commission revenues generated from our subsidiary US Specialty Underwriters (“USSU”) that are no longer considered intercompany and as a result are not eliminated in consolidation as they are now written by SNIC carriers. This increase did not impact the Company’s consolidated financial results as there is a corresponding increase in the expenses from net commission and fee operations. The remainder of the increase in commission and fee revenue was the result of increased agency commission revenue attributable to a recently acquired agency.
Net realized gains increased by $3.1 million, to a $10.9 million gain for the year ended December 31, 2014, from a $7.8 million gain for the comparable period in 2013. The increase in realized gains primarily relates to the rebalancing of the equity portfolio in accordance with the Company’s investment policy.
Policy acquisition and other underwriting expenses increased $10.8 million, to $236.3 million for the year ended December 31, 2014, from $225.5 million for the same period in 2013. Our expense ratio increased 4.4 percentage points to 36.7% for the year ended December 31, 2014, from 32.3% for the same period in 2013. Excluding the impact of the quota share surplus relief treaty, the year to date expense ratio was 37.0% for 2014
compared to 33.3% for 2013. The 3.7% increase primarily reflects the cost associated with the use of an unaffiliated “A” rated insurance company for policy issuance which added 1.7 percentage points; a shift in the mix of business which includes business with a higher average commission rate; deleveraging impact of the anticipated reduction in earned premium associated with the Company’s efforts to terminate unprofitable business; and the impacts of a special incentive bonus.
Federal income tax expense for the year ended December 31, 2014 was $4.0 million, or 13.8% of income before taxes, compared to a benefit of $31.1 million, or 21.3% of income before taxes for the same period in 2013. Income tax expense on net capital gains and the change in our valuation allowance on deferred tax assets was $3.8 million for the year ended December 31, 2014, compared to $2.1 million for the year ended December 31, 2013. The 2013 tax rate is primarily due to the large tax benefit generated from underwriting losses resulting from adverse loss development offset by the tax expense on net investment income and realized gains. The effective tax rate on net investment income in 2014 was 20.5%, driven by the level of tax exempt investments, compared to 20.8% for the year ended December 31, 2013. The 2014 effective tax rate on underwriting results and profits from net commissions and fees was 33.5% compared to 2013 of 21.5%. The 2014 effective tax rate on realized gains was 35.0% compared to 27.9% in 2013. The proportion of these three components of 2014 net income resulted in the 13.8% overall effective tax rate.
Net commission and fee revenue increased $5.5 million, or 16.0%, to $39.5 million for the year ended December 31, 2013, from $34.0 million for the comparable period in 2012. This increase was driven primarily by commission revenues generated from our subsidiary USSU that are no longer considered intercompany and as a result are not eliminated in consolidation, as they are now written by SNIC carriers. This increase did not impact the Company’s consolidated financial results as there is a corresponding increase in the expenses from net commission and fee operations.
For the year ended December 31, 2014, we reported a decrease in net ultimate loss estimates for accident years 2013 and prior of $1.7 million, or -0.2% of $1.1 billion of beginning net loss and LAE reserves at January 1, 2014. At December 31, 2013 we recorded the loss and LAE reserves at 1,111.1 million. At December 31, 2014, re-estimated loss and LAE reserves for December 31, 2013 were $1,109.3 million which was within our 2013 loss and LAE estimated reserve range. The change in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2014 that differed from the projected activity. The major components of this change in ultimates are as follows (in thousands):
The net ultimate loss estimates for accident years 2013 and prior in the workers' compensation line of business decreased $31.5 million, or 6.6%. This decrease, which was primarily related to the 2013 accident year, was led by the California-dominated business segments for which substantial rate and underwriting improvements have been enacted over the last few years.
The net ultimate loss estimates for accident years 2013 and prior in the commercial multi-peril/general liability line of business increased $18.5 million, or 4.0%. The increase was driven by a $15.1 million increase
The $8.2 million increase, or 6.9%, in net ultimate loss estimates for the commercial automobile line of business was primarily driven by the 2009-2012 accident years which developed unfavorably by $11.2 million. Of the 2009-2012 unfavorable development, 75% was on terminated business and almost 45% was on a single terminated transportation program.
The $4.2 million increase, or 12.8%, in net ultimate loss estimates in other lines of business is primarily from an increase in accident year 2012 related to a cancelled surety program.
For the table above, the calendar year combined ratios increased to over 100% in calendar year 2012 and 2013, primarily driven by adverse development on prior accident year Loss & Loss Adjustment Expense (“LAE”). The 2014 combined ratio, which includes $1.7 million of favorable development, is also over 100%. This is due in part to the expense ratio which includes a policy issuance expense associated with use of an A-rated insurance carrier. This prior year development is shown allocated to the related accident years in the following table:
Allocation of Loss & LAE to accident year is a more appropriate match of revenue (net earned premium) and expenses (Loss & LAE) than calendar year. Accident year combined ratios furthermore allow management to monitor changes over time in the profitability of the business written year-over-year and the impact of operational changes such as rate increases, underwriting actions, etc.
The developed (to ultimate) accident year combined ratio measurement allows management to observe profitability associated with business earned in each year and take appropriate actions. Management records its best estimate of reserves at each accounting date.
We also generate operating cash flow from non-regulated subsidiaries in the form of commission revenue, outside management fees, and intercompany management fees. These sources of income are used to meet debt service, shareholders’ dividends, and other operating expenses of the holding company and non-regulated subsidiaries. Earnings before interest, taxes, depreciation, and amortization from non-regulated subsidiaries were approximately $11.2 million for the year ended December 31, 2014.
Based on our subsidiaries’ membership in the Federal Home Loan Bank of Indianapolis (“FHLBI”), we have the ability to borrow on a collateralized basis at relatively low borrowing rates, providing a source of liquidity. As of December 31, 2014 and December 31, 2013, we had borrowed $30.0 million from the FHLBI. The proceeds were used to fund purchases of high quality bonds with maturities that match the maturity of the FHLBI credit facility. We have the ability to increase our borrowing capacity through additional investments and pledging additional securities.
Cash flows used in operations were $11.5 million for the year ended December 31, 2014. Cash provided by operations were $2.0 million for the year ended December 31, 2013. The decrease in operating cash flows reflects a decrease in premium collected related to the termination of, or premium volume reductions in, certain programs where pricing and underwriting did not meet the Company’s underwriting standards.
On September 19, 2013, the Company amended the Credit Facilities pursuant to a Second Amendment to Credit Agreement and Waiver (the “Amendment”). Under the Amendment, the term loan facility continues to have a four year term and the same amortization period. As of December 31, 2014, the outstanding balance on the Company’s term loan facility was $16.5 million. The Amendment reduced available borrowing under the revolving credit facility from $100.0 million to $30.0 million with further periodic reductions to $21.0 million as of March 31, 2016, less any optional reductions to the revolving commitments. The Amendment also established an amortization schedule for the revolving credit facility beginning on September 30, 2014. The Company has $15.0 million outstanding under its revolving credit facility and $0.1 million in letters of credit as of December 31, 2014. The undrawn portion of the revolving credit facility, which was $8.4 million as of December 31, 2014, is available to finance working capital and for other general corporate purposes, including but not limited to, surplus contributions to its Insurance Company Subsidiaries to support premium growth or strategic acquisitions. On December 30, 2014, in connection with the proposed transaction with Fosun, the parties to the Credit Agreement entered into a letter agreement amending the definition of “Change of Control” therein by removing from such definition the entry by Meadowbrook into a contract that would result in an acquisition of Meadowbrook.
(3) maximum permitted consolidated leverage ratio of 0.35 to 1.00 at any time on or after September 30, 2014, (4) minimum consolidated fixed charge coverage ratio of 1.25 to 1.00, and (5) minimum A.M. Best rating of “B++” for all Insurance Company Subsidiaries. As of December 31, 2014, the Company was in compliance with these debt covenants.
Due to the bifurcation, the debt component reflects an original issue discount (“OID”) of $12.9 million which will be amortized into interest expense over the term of the Notes. After considering the contractual interest payments and amortization of the OID, the Notes’ effective interest rate is 7.4%.
The following table shows the amounts recorded for the debt component of the Notes as of December 31, 2014 and December 31, 2013 (in thousands):
In connection with the offering of the Notes, the Company also entered into cash convertible senior notes hedge transactions (the “Note Hedges”) and warrant transactions (the “Warrants”) with respect to its common stock with certain counter-parties. Upon conversion, the Note Hedges are intended to offset potential cash payments in excess of the principal amount of the Notes. The Note Hedges and Warrants are separate transactions, entered into by the Company with certain counter-parties and are not part of the terms of the Notes.
(ASC) 815; however, because these instruments have been determined to be indexed to the Company’s own stock and meet the criteria for equity classification under ASC 815-40, the Warrants have been accounted for as an adjustment to the Company’s paid-in-capital.
If the market value per share of the Company’s common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on the Company’s net income per share and the Company will use the “treasury stock” method in calculating the dilutive effect on earnings per share.
As of December 31, 2014 and December 31, 2013, the recorded values of our investment portfolio, including cash and cash equivalents, were $1.7 billion for both years.
(5) Relates to the junior subordinated debentures acquired in conjunction with the ProCentury Merger.
(6) For a description of our term loan and its interest rate terms, as well as actual rates in accordance with our interest rate swap transaction, refer to Note 6 ~ Debt and Note 7 ~ Derivative Instruments.
(7) Consists of rental obligations under real estate leases related to branch offices. In addition, includes amounts related to equipment leases.
Our variable compensation plans have been established as an incentive for performance of our management team and consist of an Annual Bonus Plan (“Bonus Plan”) and a Long-Term Incentive Plan (“LTIP”). The Bonus Plan is a discretionary cash bonus plan premised upon a targeted growth in net after-tax earnings on a year over year basis. Each year, the Compensation Committee and our Board of Directors establish new targets based upon prior year performance and the forecasted performance levels anticipated for the following year. The amount of the bonus pool is established by aggregating the individual targets for each participant, which is a percentage of salary. An employee’s actual bonus may be plus or minus his or her target based upon the Company and individual’s performance at the end of the year. The Compensation Committee and the Board of Directors review our performance in relation to performance targets and then establish the total bonus pool to be utilized to pay cash bonuses to the management team based upon overall corporate and individual participant goals.
Following the release of our 2013 fourth quarter results, on February 21, 2014, A.M. Best downgraded the issuer credit rating for our Insurance Company Subsidiaries to “bbb” from “bbb+” while affirming their
financial strength rating of B++ (Good). A.M. Best also downgraded Meadowbrook’s issuer credit rating to “bb” from “bb+” and revised the outlook for the Insurance Company Subsidiaries to “negative” from “stable”.
On January 5, 2015, A.M. Best placed under review with positive implications the issuer credit rating of “bb” of Meadowbrook, and also placed the financial strength rating of B++ (Good) and the ICRs of “bbb” under review with positive implications for our Insurance Company Subsidiaries. Our results of operations could be materially and adversely impacted a negative rating change.
Departure from the “usual values” on four or more ratios, at an individual company, generally leads to inquiries or possible further review operations and financial condition from state insurance commissioners. In reviewing the financial information in the Statutory Annual Statements in coordination with the IRIS ratio results, a state regulator may determine that a company's departure from “usual values” is significant enough to indicate a strong concern with the financial condition of a company. When such a determination is made, state regulatory requirements may include but not be limited to: specific restrictions on premium writings and surplus levels of a company, additional analysis of other key financial ratios of a company, or requiring an action plan be filed by the Company with specific actions outlined to bring the ratios back into the usual range.
(2) The Adjusted Liabilities to Liquid Assets evaluates an entity’s ability to meet obligations as they become due. While all liabilities are included in the ratio, only assets considered “liquid” by NAIC definition are included in the denominator of the ratio. For 2014, this ratio is outside the usual range on Star, primarily as a result of our Intercompany Reinsurance Pooling Agreement. The Adjusted Liabilities include the gross amount of reinsurance payables related to the pool and does not allow an offset to those payables for any reinsurance recoverables related to the pool. In addition, the reinsurance recoverables are not included in the Liquid Assets portion of the formula. This causes the ratio results to appear much higher due to the timing of the settlement of the pool balances. Pool balances between the entities are settled subsequent to year-end. Once the balances are settled, the ratio is below 100% for Star and within the usual value.
In regard to our risk-sharing partners (client captive or rent-a-captive quota-share non-admitted reinsurers), we manage credit risk on reinsurance recoverables by reviewing the financial stability, capitalization, and credit worthiness of prospective or existing reinsurers or partners. We customarily collateralize reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks. To date, we have not, in the aggregate, experienced material difficulties in collecting reinsurance recoverables.