Meadowbrook Insurance Group, Inc. (the "Company") provides alternative risk management programs and services primarily to industry, public entities, and trade/professional groups. Revenues are generated from four principal sources: fees from program management services, commissions earned on insurance placed by a subsidiary with other carriers, earned insurance premiums, and investment income. The subsidiaries of the Company that provide these services are Star Insurance Company ("Star"), Savers Property and Casualty Insurance Company ("Savers"), Florida Preferred Administrators, Inc. ("Florida Preferred"), Ameritrust Insurance Company ("Ameritrust"), Crest Financial Corporation ("Crest") and its wholly owned insurer Williamsburg National Insurance Company ("Williamsburg"), American Indemnity Insurance Company, Ltd. ("American Indemnity"), Association Self Insurance Services, Inc. ("ASI"), Meadowbrook of Saginaw, ("Saginaw") and Meadowbrook, Inc. ("Meadowbrook"), the risk management company and other subsidiaries.
Managed programs and agency activities are provided through Meadowbrook, the Company's risk management subsidiary. Meadowbrook was acquired by the Company in November, including their subsidiaries, in 1995. Prior to its acquisition, it was an affiliated company. Fee and commission revenues are generated through Meadowbrook and Crest Financial Services primarily from the following sources: retail insurance agency commissions, program management fees, claims handling and administration fees, loss prevention and control fees, and reinsurance brokerage commissions. Management fee revenue is also generated from the following services: program design and implementation, sales and marketing to members of a client group, captive formation and management, underwriting/risk selection, accounting and financial statement preparation, regulatory compliance, actuarial and loss reserve analysis. In addition to providing services to outside clients, Meadowbrook also provides services to the Company's insurance subsidiaries, which includes the management of their insurance operations.
In December of 1996, the Company entered into a five-year joint underwriting agreement with Connecticut Surety Company. The agreement provides for the transfer of the underwriting risk on the majority of the Company's existing surety bond business. In addition, Star will continue to write new surety
On July 31, 1998, the Company acquired Florida Preferred, a third party administrator, and Star acquired Southeastern Holding Corporation, the holding company of Ameritrust, both of which are located in Sarasota, Florida. Florida Preferred provides a broad range of risk management services to purchasers of workers' compensation insurance from Ameritrust as well as other insurance carriers.
Net earned premiums increased by $23.6 million, or 34.4%, to $92.1 million in 1998 from $68.5 million in 1997. This increase reflects the acquisition of Ameritrust, which contributed $7.5 million. Excluding the impact of the Ameritrust acquisition, net earned premium increased 23.5% reflecting growth in existing business primarily from programs initiated in 1997.
Net commissions and fees for Meadowbrook increased by $8.0 million, or 33.0%, from $24.4 million in 1997 to $32.4 million in 1998. Net commission and fees increased by $7.8 million, or 47.0%, to $24.4 million in
Net commissions and fees increased $7.8 million, or 47.0%, during 1997. The increase in risk management fees of $4.9 million primarily reflects additional management fees of $1.3 million and ASI claims fees of $3.2 million. The remaining increase resulted from Crest management fees of $0.5 million. The increase in Agency and sales commissions reflect additional commissions from Crest Financial of $2.1 million. The remaining increase resulted from growth in Meadowbrook's existing agency business.
Total expenses increased by $43.8 million, or 52.2%, to $127.5 million in 1998 from $83.7 million in 1997 and decreased by $14.6 million, or 14.8%, to $83.7 million in 1997 from $98.3 million in 1996. The expenses are as follows (in thousands):
Net losses and LAE incurred increased by $20.6 million, or 56.9%, to $56.7 million in 1998 from $36.1 million in 1997 and decreased by $5.1 million, or 12.4%, to $36.1 million in 1997 from $41.3 million in 1996. Analysis of losses and LAE utilizing insurance ratios, on an overall and non-surety basis, are reflected below.
The GAAP loss and LAE ratio increased to 65.0% in 1998 from 55.7% in 1997. This 9.3 point increase reflects a $7.3 million charge for reserve strengthening which added 7.9 points to the GAAP loss and LAE ratio. This reserve strengthening was required for three reasons: less favorable than anticipated development of prior year reserves, unexpected increases in recent claims activity on several large programs, and an increase in projected ultimate loss ratios for the most recent accident years due to pricing pressure experienced in the commercial property & casualty market. The remaining 1.4 point increase reflects increased expected loss ratios going forward to reflect these competitive market conditions.
The GAAP loss and LAE ratio was 55.7% and 52.1% in 1997 and 1996, respectively, a 3.6 point increase. On a pro forma basis, as if the Connecticut Surety reinsurance ceding arrangement on the surety program had occurred at the beginning of 1996, the GAAP loss and LAE ratio would have been 56.3% in 1996. This change reflects favorable claims experience primarily in workers compensation based programs and residual markets. This favorable experience was somewhat offset by adverse development relating to the run-off of the surety bond program which added 3.3 points in 1997.
Salaries and employee benefits increased by $9.5 million, or 34.4%, to $36.9 million in 1998 compared to $27.4 million in 1997. This increase reflects additional 1998 salary and employee expenses of $5.2 million from 1998 and full year 1997 acquisitions and the remaining increase reflects an increase in staff to handle information technology initiatives and growth in our existing and new business.
Interest expense for 1998 and 1997 was $2.0 million and $649,000, respectively. This interest expense relates to the use of the Company's line of credit. There was no interest expense recorded during 1996. The proceeds from the line of credit were used to fund the 1998 and 1997 acquisitions, as well as the stock repurchases in the fourth quarter of 1998.
Other operating expenses from the non-surety business increased $11.1 million, or 52.8%, to $32.0 million in 1998 from $20.9 million in 1997. This increase primarily reflects a $1.3 million write-off of uncollectible agency loans and premium receivables related to discontinued programs, contract service fees associated with the 1998 technology initiatives, as well as direct commissions and contingent commissions on risk bearing insurance programs.
Other operating expenses from the non-surety business decreased $1.1 million, or 4.8%, to $20.9 million in 1997 from $22.0 million in 1996. This decrease reflects a $3.3 million increase in ceding commission on risk sharing and fronted programs, reduction in technology costs incurred in 1996 and overall savings in administrative costs related to management's efforts to increase operating efficiencies. These reductions were offset by incremental costs of $3.1 million related to 1997 acquisitions.
Other operating expense from the surety business decreased $11.5 million to ($1.4) million in 1997 from $10.1 million in 1996. This decrease reflects the run-off of the surety business and the increase in ceding commissions.
The decrease in the effective tax rate in 1998 reflects an unusually low proportion of underwriting and fee based income in relation to net investment income. The increase in the effective tax rate in 1997 reflects the higher proportion of underwriting and risk management service income in relation to net investment income.
The principal sources of funds for the Company are insurance premiums, investment income, proceeds from the maturity and sale of invested assets, risk management fees and agency commissions. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, and other operating expenses. In addition, the Company has a high volume of intercompany transactions due to the payment of management fees by the insurance subsidiaries to the risk management subsidiaries. Such fees are subject to regulatory approval by state insurance departments.
Cash flow provided by operations for 1998 and 1996 was $10.3 million and $11.6 million, respectively. This compares to cash used by operations of $1.7 million in 1997. The unusual reduction in cash from operations during 1997 reflects significant written, but uncollected, premiums in the fourth quarter of 1997, the transfer of the surety bond program to Connecticut Surety and the payment of claims associated with the run-off of the surety bond program. The Company held $20.5 million in cash and cash equivalents at December 31, 1998.
The Company has one unsecured line of credit totaling $50.0 million, of which $38.1 million was outstanding at December 31, 1998. The line expires on July 1, 2001. The Company drew on this line of credit to meet cash flow needs, primarily to consummate the acquisitions made during 1997 and 1998.
In addition, a standby letter credit of $3,564,077 had been issued to an insurance subsidiary of the Company, under an agreement expiring with extensions granted on a yearly basis. This letter of credit is being used as security for the insurance subsidiary's obligations under a reinsurance agreement, and is added to the outstanding balance under the Company's $50.0 million unsecured line of credit to determine availability of funds under the line.
Shareholders' equity was $119.6 million, or $13.80 per common share, at December 31, 1998, compared to $115.4 million at December 31, 1997, or $13.33 per common share. The increase in shareholders' equity during 1998 reflects earnings, dividends, stock repurchases and an increase of $0.9 million in the fair values of available-for-sale debt and equity securities. Changes in shareholders' equity related to the unrealized values of underlying portfolio investments will continue to be volatile as market prices of debt securities fluctuate with changes in the interest rate environment.
In its risk-sharing programs, the Company is also subject to credit risk with respect to the payment of claims by its clients' captive insurers on the portion of risk exposure ceded to such captives. The capitalization and credit worthiness of prospective captive insurers is one of the factors considered by the Company in entering into and renewing risk-sharing programs. The Company secures reinsurance balances due from its non-admitted reinsurers through Funds Withheld Trusts or Letters of Credit.
programs by the relevant client groups, or the general availability of commercial market coverage to members of such groups on more favorable terms than provided under the Company's programs, could have a material adverse effect on the Company's results of operations. The Company has multiple year contracts with many of its clients and has maintained retention rates in the mid to high 90% range.
The "Year 2000" issue has come about as a result of computer programs that were written using two digits rather than four digits to define the year in a date record. If the Company's computer systems were not Year 2000 compliant, they may recognize a date using "00" as the year 1900 instead of 2000. This mistake could result in a system failure or miscalculations causing disruptions of operations, including, but not limited to, a temporary inability to process transactions, send policies or invoices or engage in other, similar business activity.
Substantial portions of the Year 2000 project are staffed with the company's internal resources. The Company has engaged outside contractors to assist with some Year 2000 problem identification and remediation. The Company is also engaging an outside contractor to re-assess the corrected systems, identify problem areas and assist in final testing for Year 2000 compliance. The Company is developing Departmental Contingency Plans for all critical business systems. The Company will continue to assess the need for formal contingency plans, based upon progress of Year 2000 efforts, and results of the final testing.
The Company works on Year 2000 compliance efforts with a priority based upon their significance to the operations of the Company. Those systems which are most critical to the Company are the focus of our current efforts. The Year 2000 Project team is aggressively addressing these issues to ensure that all critical functions operate after the Year 2000. However, some non-critical systems or systems beyond the control of the Company may potentially suffer some Y2K-related failures. The Company's efforts are designed to ensure that all of our critical business systems, and our ability to operate, will not be significantly effected by the Year 2000 issue.
The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, liquidity, and financial condition. Due to the general uncertainty inherent in the Year 2000 issue, resulting in part from the uncertainty of the Year 2000 readiness of third-party service providers and customers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's results. The Year 2000 Project is expected to significantly reduce the Company's level of uncertainty about the Year 2000 issue, as well as the readiness of its external agents. The Company believes that, with the implementation of new business systems, the remediation efforts, and completion of the Year 2000 Project as scheduled, the possibility of significant interruptions of normal operations should be reduced.
The Financial Accounting Standards Board ("FASB") has issued Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities" which is effective for fiscal quarters of all fiscal years beginning after June 15, 1999. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. As the Company does not use derivative instruments, the Management of the Company does not anticipate that the adoption of SFAS 133 will have an effect on the results of operations or financial position of the Company.