This 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 management, including, but not limited to, those statements that use the words “believes,” “expects,” “anticipates,” “estimates,” or similar expressions. 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: actual loss and loss adjustment expenses exceeding our reserve estimates; competitive pressures in our business; the failure of any of the loss limitation methods we employ; a failure of additional capital to be available or only available on unfavorable terms; our geographic concentration and the business, economic, natural perils, man-made perils, and regulatory conditions within our most concentrated region; our ability to appropriately price the risks we underwrite; goodwill impairment risk employed as part of our growth strategy and the anticipated impact of the goodwill impairment charge recognized in the second quarter of 2013; efforts with regard to the review of strategic alternatives; actions taken by regulators, rating agencies or lenders, including the impact of the downgrade by A.M. Best of the Company’s Insurance Company Subsidiaries’ financial strength rating and lowering the outlook for this rating from “stable” to “negative” and A.M. Best’s downgrade of our issuer credit rating and any other future action by A.M. Best with respect to such ratings; increased risks or reduction in the level of our underwriting commitments due to market conditions; a failure of our reinsurers to pay losses in a timely fashion, or at all; interest rate changes; continued difficult conditions in the global capital markets and the economy generally; market and credit risks affecting our investment portfolio; liquidity requirements forcing us to sell our investments; a failure to introduce new products or services to keep pace with advances in technology; the new federal financial regulatory reform; our holding company structure and regulatory constraints restricting dividends or other distributions by our Insurance Company Subsidiaries; minimum capital and surplus requirements imposed on our Insurance Company Subsidiaries; acquisitions and integration of acquired businesses resulting in operating difficulties, which may prevent us from achieving the expected benefits; our reliance upon producers, which subjects us to their credit risk; loss of one of our core selected producers; our dependence on the continued services and performance of our senior management and other key personnel; our reliance on our information technology and telecommunications systems; managing technology initiatives and obtaining the efficiencies anticipated with technology implementation; a failure in our internal controls; the cyclical nature of the property and casualty insurance industry; severe weather conditions and other catastrophes; the effects of litigation, including the previously disclosed arbitration and class action litigation or any similar litigation which may be filed in the future; state regulation; and assessments imposed upon our Insurance Company Subsidiaries to provide funds for failing insurance companies.
For additional information with respect to certain of these and other factors, refer to “Risk Factors” above and subsequent filings made with the United States Securities and Exchange Commission. We are not under any obligation to (and expressly disclaim any obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise.
In certain circumstances, we are required to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an 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.
The reserves referenced in the above table related to our direct and assumed-directly managed business are established through transactions processed through our internal systems and related controls. Likewise, business assumed from Midwest Insurance Company is defined as assumed business related to our partial ownership of Midwest Financial Holding, LLC (“MFH”), where we have direct access to their paid and case reserve loss data. Accordingly, case reserves are established on a current basis, therefore, there is no delay or lag in reporting of losses from a ceding company, and IBNR is determined utilizing various actuarial methods based upon historical data. Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag between the date of the evaluation and the receipt of the estimate from the National Council on Compensation Insurance (“NCCI”), and include an estimated reserve determined based upon internal actuarial methods for this lag. Relative to assumed business from other sources, we receive case and paid loss data within a forty-five day reporting period and develop our estimates for IBNR based on both current and historical data.
The following table sets forth our net case and IBNR reserves for losses and LAE by line of business at December 31, 2013 (in thousands):
Since the method uses more data (case reserves in addition to paid losses) than the paid development method, the incurred development patterns may be less variable than paid patterns. However, selection of the incurred loss pattern requires analysis of all of the factors listed in the description of the paid development method. In addition, the inclusion of case reserves can lead to distortions if changes in case reserving practices have taken place and the use of case incurred losses may not eliminate the issues associated with estimating the incurred loss pattern subsequent to the most mature point available.
This method is used directly, and as an input to the Bornhuetter-Ferguson methods. Initial expected losses for an accident year are based on adjusting prior accident year projections to the current accident year levels using underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments specific to the line of business.
This method may be useful if loss development patterns are inconsistent, losses emerge very slowly, or there is relatively little loss history from which to estimate future losses. The selection of the expected loss ratio requires analysis of loss ratios from earlier accident years or pricing studies and analysis of inflationary trends, frequency trends, rate changes, underwriting changes, and other applicable factors.
To analyze the development patterns, we compile, to the extent available, long-term and short-term historical data for our Insurance Company Subsidiaries, organized in a manner which provides an indication of the historical development patterns. To the extent that the historical data may provide insufficient information about future patterns-whether due to environmental changes such as legislation or due to the small volume or short history of data for some segments of our business-benchmarks based on industry data, and forecasts made by industry rating bureaus regarding the effect of legislative benefit changes on such patterns, may be used to supplement, adjust, or replace patterns based on our Insurance Company Subsidiaries' historical data.
One implicit assumption underlying development patterns is that the claims inflation trends will continue into the future similar to their past patterns. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, our actuarial department derives expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2013 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. General inflation trends have been fairly stable over the past several years but there have been fluctuations of one to two percent over the past ten years and therefore we used a one percent annual inflation variance factor. The effect differed by line of business but overall was a four percent change in reserve adequacy or approximately $30.5 million effect on after tax net income. 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.
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 45% of our total reserves at December 31, 2013.
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 was cancelled in 2012, and our construction defect exposure, which together represent approximately 37% of the $460.0 million reserves in this line of business as of December 31, 2013. These lines of business are subject to greater uncertainty and volatility than the remainder of our book of business.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses 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 IBNR losses and LAE. Such recoverables, by necessity, are based upon estimates. Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded. Instead of being netted against the appropriate liabilities, ceded unearned premiums and reinsurance recoverables on paid and unpaid losses and LAE are reported separately as assets in our consolidated balance sheets. Reinsurance recoverable balances are also subject to credit risk associated with the particular reinsurer. In our selection of reinsurers, we continually evaluate their financial stability. While we believe our reinsurance recoverables are collectible, the ultimate ceded reserve recoverable may be greater or less than the amount accrued. At December 31, 2013 and 2012, reinsurance recoverables on paid and unpaid losses were $519.9 million and $395.5 million, respectively.
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, 2013, 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.
Statutory surplus is a non-GAAP measure with the most directly comparable financial GAAP measure being shareholders’ equity. The following is a reconciliation of statutory surplus to shareholders’ equity:
We use net operating (loss) income and net operating (loss) income per share as components to assess our performance and as measures to evaluate the results of our business. We believe these measures provide investors with valuable information relating to our ongoing performance that may be obscured by the net effect of realized gains and losses as a result of our market risk sensitive instruments, which primarily relate to fixed income securities that are available for sale and not held for trading purposes. Realized gains and losses may vary significantly between periods and are generally driven by external economic developments, such as capital market conditions. In 2013, realized gains before tax were $7.8 million, compared to $55.3 million of realized gains in 2012 that were generated by the sale of a large portion of our investment portfolio. Realized gains in 2011 were $3.0 million. Accordingly, net operating (loss) income excludes the effect of items that tend to be highly variable from period to period and highlights the results from our ongoing business operations and the underlying loss or profitability of our business. We believe that it is useful for investors to evaluate net operating (loss) income and net operating (loss) income per share, along with net (loss) income and net (loss) income per share, when reviewing and evaluating our performance.
On August 2, 2013, A.M. Best Company (“A.M. Best”) lowered Meadowbrook’s issuer credit rating, as well its financial strength ratings and downgraded the Company’s Insurance Company Subsidiaries’ financial strength rating from “A-” (Excellent) with a “negative” outlook to “B++” (Good) with a “stable” outlook.
The multiple line quota share reinsurance treaty entered into December 31, 2012 was terminated, by mutual agreement of the parties, in the third quarter for business effective October 1, 2013 and after. At December 31, 2013, we had ceded unearned premium of $20.3 million, which will be earned over the next nine months, based on the premium effective date. The total pre-tax costs remaining, are $1.4 million (7% of the $20.3 million in ceded unearned premium), or $0.03 per share.
Our GAAP combined ratio was 111.0% for the year ended December 31, 2013, compared to 111.4% in 2012. Excluding the impact of the quota share reinsurance treaty, the GAAP combined ratio was 107.9% for the year ended December 31, 2013. Our accident year combined ratio was 101.2% for the year ended December 31, 2013, compared to 101.4% in 2012. Excluding the impact of the quota share reinsurance treaty, the accident year combined ratio was 99.8% for the year ended December 31, 2013.
The year to date 2013 results were also impacted by the increase in net ultimate loss estimates for 2012 and prior accident years, which added 9.1 percentage points to the GAAP combined ratio. Full-year 2013 results also reflect the addition of 3.1 percentage points to the combined ratio related to the impact from the quota share reinsurance treaty that was entered into during the fourth quarter of 2012, and by an adverse interim final award from a reinsurance arbitration, which added 1.2 percentage points to the GAAP combined ratio.
Gross written premium decreased $122.6 million, or 11.5%, to $944.0 million in 2013, compared to $1,066.6 million in 2012. The decline in premium is attributed to the 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 12% rate increase, which exceeded the Company’s estimated loss ratio trend of 1.7%.
Net investment income decreased by $6.7 million, to $46.5 million for the year ended December 31, 2013, from $53.1 million for the comparable period in 2012. The decrease reflects the impact of lower reinvestment rates in 2013 from the proceeds of the fourth quarter 2012 sale of a portion of our bond portfolio offset by the investment of the proceeds from the cash convertible senior notes.
Net loss and loss adjustment expenses (“LAE”) decreased $128.6 million to $549.0 million for the year ended December 31, 2013, from $677.7 million for the same period in 2012. Our loss and LAE ratio was 78.7% for the year ended December 31, 2013 and 79.3% for the year ended December 31, 2012. The loss and LAE ratio for the year ended December 31, 2013 includes a 9.8 percentage point increase from net ultimate loss estimates for accident years 2012 and prior, whereas the 2012 results include a 10.0 percentage point increase from net ultimate loss estimates for accident years 2011 and prior. The accident year loss and LAE ratio was 68.9% for the year ended December 31, 2013, down from 69.3% in the comparable period in 2012. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section.
Net income for the year ended December 31, 2012 was $11.7 million, or $0.23 per dilutive share, compared to net income of $43.0 million, or $0.82 per dilutive share, for the comparable period of 2011. Net operating loss, a non-GAAP measure, for the year ended December 31, 2012 was ($28.4 million), or ($0.57) per diluted share, compared to net operating income of $40.3 million, or $0.77 per diluted share for the year ended December 31, 2011. Total diluted weighted average shares outstanding for the year ended December 31, 2012, were 50,177,484, compared to 52,404,377 for the comparable period in 2011. This decrease reflects the impact of our Share Repurchase Plan (the “Plan”).
Revenues for the year ended December 31, 2012, increased $159.6 million, or 19.1%, to $996.8 million, from $837.2 million for the comparable period in 2011. This increase primarily reflects overall growth within our net earned premiums.
Net earned premiums increased $106.7 million, or 14.3%, to $854.3 million for the year ended December 31, 2012, from $747.6 million in the comparable period in 2011. This growth primarily reflects rate increase in combination with the maturation of existing programs. This growth was partially offset by reductions in certain programs where pricing and underwriting did not meet our targets.
Net investment income decreased by $1.4 million, to $53.1 million for the year ended December 31, 2012, from $54.5 million for the comparable period in 2011. The decrease reflects the impact from the fourth quarter 2012 sale of a portion of our bond portfolio in order to generate realized gains, and lower yields on our existing portfolio.
Federal income tax benefit for the year ended December 31, 2012 was $8.1 million, or -794.3% of income before taxes, compared to an expense of $11.5 million, or 22.1% of income before taxes for the same period in 2011. Income tax expense on net capital gains and the change in our valuation allowance on deferred tax assets was $15.2 million for the year ended December 31, 2012, compared to income tax expense on net capital gains and the change in our valuation allowance on deferred tax assets of $0.3 million for the year ended December 31, 2011. The unusual 2012 tax rate is primarily due to the large tax benefit generated from underwriting losses resulting from adverse loss development and storm losses offset by the tax expense on net investment income and realized gains. The effective tax rate on net investment income was 25.7%, driven by the level of tax exempt investments, compared to 24.6% for the year ended December 31, 2011. The 2012 effective tax rate on underwriting results and profits from net commissions and fees was 34.3%, compared to 42.1% for the year ended December 31, 2011. The 2012 effective tax rate on realized gains, which includes the benefit from the removal of the valuation allowance on deferred tax assets relating to OTTI securities that were sold, was 27.4%, compared to 8.6% for the year ended December 31, 2011. The proportion of these three components of 2012 net income resulted in the -794.3% overall effective tax rate.
At December 31, 2013, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $1.1 billion. We established a reasonable range of reserves of approximately $971.8 million to $1.2 billion. 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):
The key assumptions used in our selection of ultimate reserves included the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key methods remained consistent for the year ended December 31, 2013, and the year ended December 31, 2012. We reviewed the key assumptions that underlie the actuarial standard methods and made the appropriate adjustments to reflect the emergence of claim activity.
Our ultimate loss estimates are reduced by our estimated impact of California legislative system and benefit changes enacted with Senate Bill 863 effective in 2013. Many of the provisions of the bill are applicable to future payments and transactional costs, regardless of accident year; and therefore, affect the portfolio of held reserves.
The workers’ compensation residual market line of business had an increase in net ultimate loss estimate of $0.6 million, or 3.3% of net reserves. This increase reflects rises in the net ultimate loss estimates for various accident years. We record loss reserves as reported by the National Council on Compensation Insurance (“NCCI”), plus a provision for the reserves incurred but not yet analyzed and reported to us due to a two quarter lag in reporting. These changes reflect a difference between our estimate of the lag incurred but not reported and the amounts reported by the NCCI in the year.
The following combined ratios are before the impact of the Quota Share Reinsurance Treaty which was terminated as of October 1, 2013.
The accident year combined ratio provides management with an assessment of a specific accident period’s profitability (which matches policy pricing with related losses) and assists management in their evaluation of product pricing levels and quality of business written in individual years. The current accident year’s combined ratio plus the current calendar year development on prior accident year’s reserves (as a percent of net earned premium) equals the current calendar year’s combined ratio. Prior accident year development is thus appropriately assigned and added to the accident years that triggered such liability. Therefore, each accident year’s developed combined ratio includes all development adjustments that have been recorded in all calendar periods to-date. The net earned premium and expenses remain fixed in the calendar period in which they were recorded and thus the sole difference between the calendar and accident year combined ratio is the allocation of the Loss & LAE to appropriate accident year. The incurred Loss & LAE inception-to-date does not change in total, but only in such accident year allocation.
The table below shows accident year combined ratios in which the prior accident year development has been reallocated to the appropriate accident year:
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 $13.7 million for the year ended December 31, 2013.
Cash flows provided by operations decreased by $120.0 million in 2013 to $2.0 million for the year ended December 31, 2013 from $122.0 million for the year ended December 31, 2012. Excluding the quota share reinsurance agreement, there was a decrease in operating cash flow of $156.9 million in 2013 compared to 2012. The decrease was driven primarily by lower premiums received and higher paid losses, partially offset by higher commissions and fees and cash held in relation to the settlement terms of the SNIC agreement. While cash flows from operations were down in 2013 compared to 2012, we believe we maintain a strong balance sheet with geographic spread of risks, high quality reinsurance, and a high quality investment portfolio.
Under the Amendment, the term loan facility continues to have a four year term, along with no changes to the amortization period. As of December 31, 2013, the outstanding balance on our term loan facility was $22.5 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. The Amendment also established an amortization schedule for the revolving credit facility beginning on September 30, 2014. The Company has $20.0 million outstanding under its revolving credit facility as of December 31, 2013.The undrawn portion of the revolving credit facility, which was $10.0 million as of December 31, 2013, is available to finance working capital and for other general corporate purposes, including but not limited to, surplus contributions to our Insurance Company Subsidiaries to support premium growth or strategic acquisitions.
The principal amount outstanding under the Credit Facilities provides for interest at either the Alternative Base Rate (“ABR”) or the London interbank offered rate (“LIBOR”). ABR borrowings under the Credit Facilities will bear interest at the greatest of (a) the Administrative Agent’s prime rate, (b) the federal funds effective rate plus 0.5%, or (c) the adjusted LIBOR for a one month period plus 1.0%, in each case, plus a margin that is adjusted on the basis of our consolidated leverage ratio. Eurodollar borrowings under the Credit Facilities will bear interest at the adjusted LIBOR for the interest period in effect plus a margin that is adjusted on the basis of our consolidated leverage ratio. In addition, the Credit Facilities provide for an unused facility fee ranging between twenty-five basis points and thirty-seven and a half basis points, based on our consolidated leverage ratio as defined by the Credit Facilities. At December 31, 2013, the interest rate on our term loan was 2.75%, which consisted of a variable rate of 0.25%, plus an applicable margin of 2.50%. To reduce the exposure to changes in variable interest rates, we have entered into interest rate swaps as described in Note 7 ~ Derivative Instruments. At December 31, 2013, the interest rate on our revolving credit facility was 2.75%, which consisted of a variable rate of 0.25%, plus a 2.50% margin.
Due to the bifurcation, the debt component reflects an original issue discount (“OID”) of $12.9 million. The OID and deferred issuance costs of $3.7 million 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%. Interest expense, including amortization of deferred issuance costs, recognized on the Notes was $5.4 million for the year ended December 31, 2013, respectively.
In connection with the offering of the Notes, we 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 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.
We paid $12.9 million for the Note Hedges, which are exercisable upon conversion of the Notes. The Note Hedges are structured under the cash settlement method and are accounted for as a derivative asset.
We received $3.0 million for the Warrants sold to certain counter-parties. The Warrants have a strike price of $11.69 and will be net share settled; meaning we will issue a number of shares per Warrant corresponding to the difference between its share price on each Warrant exercise date and the exercise price. The Warrants meet the definition of derivatives under the guidance in ASC 815; however, because these instruments have been determined to be indexed to our own stock and meet the criteria for equity classification under ASC 815-40, the Warrants have been accounted for as an adjustment to our paid-in-capital.
We have entered into interest rate swap transactions to mitigate our interest rate risk on our existing debt obligations. These interest rate swap transactions have been designated as cash flow hedges and are deemed highly effective hedges. These interest rate swap transactions are recorded at fair value on the balance sheet and the effective portion of the changes in fair value are accounted for within other comprehensive income. The interest differential to be paid or received is accrued and recognized as an adjustment to interest expense.
As of December 31, 2013 and December 31, 2012, the recorded values of our investment portfolio, including cash and cash equivalents, were $1.7 billion and $1.7 billion, respectively.
In general, we believe our overall investment portfolio is conservatively invested. The effective duration of the investment portfolio at December 31, 2013 and 2012, was 5.0 years and 5.1 years, respectively. Our pre-tax book yield, excluding cash and cash equivalents at December 31, 2013 was 3.0% compared to 3.0% in 2012. The tax equivalent yield, excluding cash and cash equivalents was 3.7% at December 31, 2013, compared to 4.0% at December 31, 2012. Approximately 99.8% of our fixed income investment portfolio is investment grade.
At December 31, 2013, each of our Insurance Company Subsidiaries was in excess of any minimum threshold at which corrective action would be required. Refer to Note 8 ~ Regulatory Matters and Rating Issues for further details of RBC.
In 2013, our Insurance Company Subsidiaries generated ratios that varied from the “usual value” range. The Intercompany Pooling Reinsurance Agreement frequently causes large intercompany balance sheet amounts at period end that may adversely impact several of the IRIS ratio calculations. These balances are settled after period end. After considering the settlement these balances, the Adjusted Liabilities to Liquid Assets and Gross Agents’ Balances to Policyholders’ Surplus ratios fall into the usual values range. The Investment Yield ratio provides a usual value range of between 3.0% and 6.5%; however, this range has not been recently updated to consider the historically low yielding environment. Three other ratios, Two-Year Overall Operating Ratio, Two-Year Reserve Development to Policyholders’ Surplus and Change in Adjusted Policyholders’ Surplus, fell into the unusual value range due to the adverse prior year development, as previously discussed. The capital and surplus was $488.2 million at December 31, 2013, up 14.5% from December 31, 2012. The variations and additional details for the reasons are set forth below:
(4) Two-Year Reserve Development to Policyholders’ Surplus measures the deficiency/(redundancy) of reserves reported to date on loss/ALAE costs reported in the second prior year, in relation to ending policyholders’ surplus. Five of the six Insurance Subsidiaries generated Two-Year Reserve Development to Policyholders’ Surplus ratios greater than the usual value of 20%. Star was within the usual range, at 19%. The results of this ratio are driven by the adverse prior year development experienced in calendar years 2012 and 2013.
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, 2013:
Refer to Note 1 ~ Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements.