In 1998, Star purchased land in close proximity to its existing offices. The cost of the land was $3.2 million.
The GAAP combined ratio is the sum of the GAAP loss and loss adjustment expense ratio and the GAAP expense ratio. The GAAP loss and loss adjustment expense ratio is the unconsolidated net loss and loss adjustment expenses in relation to net earned premium. The GAAP expense ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premium.
The statutory combined ratio is the sum of the statutory loss and loss adjustment expense ratio and the statutory expense ratio. The statutory loss and loss adjustment expense ratio is the net loss and loss adjustment expenses in relation to net earned premium. The statutory expense ratio is the statutory policy acquisition and other underwriting expenses in relation to net written premium.
Meadowbrook Insurance Group, Inc. (the “Company”) is a specialty risk management company specializing in alternative market insurance and risk management solutions for agents, brokers, professional and trade associations, and insureds of all sizes. The alternative market includes a wide range of approaches to financing and managing risk exposures, such as captives, risk retention and risk purchasing groups, governmental pools and trusts, and self-insurance plans. The alternative market developed as a result of the historical volatility in the cost and availability of traditional commercial insurance coverages, and usually involves some form of self-insurance or risk-sharing on the part of the client. The Company develops and manages alternative risk management programs for defined client groups and their members. The Company also operates as an insurance agency representing policyholders in placing their insurance coverages with unaffiliated insurance companies. Management defines its business segments as specialty risk management operations and agency operations.
The agency segment was formed in 1955 as a retail insurance agency. The agency operations have grown to be one of the largest agencies in Michigan and, with acquisitions, have expanded into California. The agency operations primarily produce commercial insurance, as well as personal property, casualty, life and accident and health insurance, with more than fifty insurance carriers from which it earns commission income.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid loss and loss adjustment expenses (“LAE”), (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of incurred but not reported (“IBNR”) losses and LAE. Such recoverables, by necessity, are based upon estimates. While management believes that the amount accrued is collectible, the ultimate recoverable may be greater or less than the amount accrued. At December 31, 2002 and 2001, reinsurance recoverables on paid and unpaid losses were $202.2 million and $222.5 million, respectively.
When a claim is reported to one of the Insurance Company Subsidiaries, its claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the claims.
Programs with aggregate stop loss provisions, where the client’s risk-sharing is capped at a specified loss ratio; and
At December 31, 2002, the Company had a deferred tax asset of $19.1 million, $7.8 million of which is related to a net operating loss carryforward (“NOL”). Realization of the deferred tax asset is dependent on generating sufficient taxable income to absorb both the applicable reversing temporary differences and the NOL. At December 31, 2002, management concluded that the positive evidence supporting the generation of future taxable income sufficient to realize the deferred tax asset outweighed the negative evidence of the cumulative losses reported for the periods ended December 31, 1999, 2000, and 2001. This conclusion was based upon:
The current market conditions that supported the cumulative premium rate increases of 47% since the beginning of 2000 is expected to continue;
Alternative tax strategies, which could generate capital gains from the potential sale of assets and/or subsidiaries.
Effective January 1, 2002, the Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142, for periods starting December 15, 2001 or thereafter, eliminates the amortization of goodwill. In addition, the Company is required to test, at least annually, all existing goodwill for impairment using a fair value approach, on a reporting unit basis. Also pursuant to SFAS No. 142, the Company is required to test for impairment more frequently if events or changes in circumstances indicate that the asset might be impaired. Upon implementation of SFAS No. 142 in 2002, the Company is no longer amortizing goodwill.
The Company’s investment securities at December 31, 2002 and 2001 are classified as available for sale. Investments classified as available for sale securities are available to be sold in the future in response to the Company’s 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.
The Company’s policy on other than temporarily impaired securities is to determine impairment based on analysis of the following factors: market value consistently equal to or less than 80% of amortized cost for a six month period; rating downgrade or other credit event, e.g., failure to pay interest when due; 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; prospects for the issuer’s industry segment; intent and ability of the Company to retain the investment for a period of time sufficient to allow for anticipated recovery in market value. At December 31, 2002, the Company did not hold any securities in its investment portfolio that met the tests for impairment.
Results from operations improved $8.2 million from a net loss of ($6.5) million in 2001 to net income of $1.7 million in 2002. This improvement reflects the impact of the run-off of the previously mentioned unprofitable discontinued programs, an overall shift in the mix of business towards the workers’ compensation line of business and the impact of rate increases achieved in 2002 and 2001 of 15.7% and 18.2%, respectively. The workers’ compensation line of business had an accident year loss ratio of 67.4% in 2002 and represented 55.6% of net earned premium in 2002, compared to 42.4% of net earned premium in 2001. This improvement is the result of the continuing rate increases and expense management initiatives, which included reductions in salary and benefit levels of $6.5 million, or 14.8%, from $44.2 million in 2001, to $37.7 million in 2002. This improvement is also the result of the elimination of amortization of goodwill, which was $2.3 million in 2001. Other administrative expenses increased $238,000, or 1%, to $23.0 million in 2002, compared to $22.8 million in 2001. Salary and benefits and administrative expenses include both corporate overhead and the holding company expenses included in the reconciling items of the Company’s segment information.
Revenues from specialty risk management operations decreased $20.3 million, or 10.0%, to $183.7 million for the year ended December 31, 2002 from $204.0 million for the comparable period in 2001. This decrease reflects an $18.3 million, or 11.2%, decrease in net earned premiums to $145.4 million in the year ended December 31, 2002 from $163.7 million in the comparable period in 2001. This decrease is the result of a reduction in earned premium of $16.8 million related to programs discontinued in 1999 and a decrease of $40.4 million related to programs terminated for leverage ratio purposes. Offsetting this decrease is a $32.8 million reduction in ceded earned premium associated with the cancellation in 2002 of the surplus relief treaty relating to several workers’ compensation programs and growth in existing programs of $6.1 million, primarily due to rate increases achieved in 2002 and 2001 and growth in policy counts.
Management fees decreased $1.7 million, or 6.8%, to $23.7 million from $25.5 million. This decrease is the result of a one-time $1.6 million profit sharing fee recognized in 2001 and a $1.6 decrease in fees for a specific account for which the client moved the services in-house. Offsetting this decrease was net growth in existing programs of $1.4 million.
Specialty risk management operations generated a pre-tax loss of ($1.1) million for the year ended December 31, 2002 compared to a pre-tax loss of ($7.6) million for the comparable period in 2001. The Company’s loss and loss adjustment expense ratio improved by 9.0 points to 72.1% for the year ended December 31, 2002, from 81.1% for the comparable period in 2001. This improvement reflects the impact of the discontinued programs, an overall shift in the mix of business towards the workers’ compensation line of business, which had an accident year loss ratio of 67.4% in 2002 and represented 55.6% of net earned premium
For the year ended December 31, 2002, the Company reported net adverse development on loss and LAE of $6.1 million, or 3.1% of net loss and LAE reserves. The adverse development reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2002 that differed from the projected activity. There were no significant changes in the key assumptions utilized in the analysis and calculations of the Company’s reserves during 2002. The major components of this development are as follows:
The programs that were discontinued that had aggregate stop loss provisions, lack of risk sharing or proven actuarial experience, and the surety line of business accounted for $3.3 million of the adverse development on reserves of $33.3 million related to accident years 2001 and prior. This adverse development reflected higher than expected claims reported and paid in automobile liability of $1.5 million, $1.6 million in liability occurrence programs, and $291,000 in workers’ compensation.
The programs that were terminated in late 2000 and in 2001 to reduce leverage ratios accounted for $3.3 million of the adverse development on reserves of $61.5 million related to accident years 2001 and prior. This adverse development primarily reflects higher than expected claims reported and paid in automobile liability of $1.4 million, $1.3 million in general liability, and $1.2 million in claims made liability. This adverse development was partially offset by favorable development on workers’ compensation programs of $861,000.
At December 31, 2002, the Company recorded management’s best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, which was $193.1 million. Reserves are reviewed by both internal and independent actuaries for adequacy on a periodic basis. When reviewing reserves, the Company analyzes historical data and estimates the impact of various factors such as (i) per claim information; (ii) Company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends
The key assumptions used in management’s 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 assumptions remained consistent for the years ended December 31, 2002, 2001, and 2000.
Specialty risk management operations generated a pre-tax loss of ($7.6) million for the year ended December 31, 2001 compared to a pre-tax loss of ($24.3) million for the comparable period in 2000. This was the result of a decrease in the Company’s loss and loss adjustment expenses and operating expenses on specialty risk management operations. The Company’s loss and loss adjustment expense ratio was 81.1% for the year ended December 31, 2001 compared to 90.9% for the comparable period in 2000. The net loss in 2001 reflects the impact of adverse development of $14.4 million on net reserves. The adverse development reflects $5.2 million related to unprofitable discontinued programs, $4.5 million related to the provision for uncollectible reinsurance on CSC and HIH, and the remaining development related to claims activity on the automobile liability line of business. The 2000 results reflected significant adverse development related to the discontinued programs mentioned above.
Revenue from agency operations, which consists primarily of agency commission revenue, decreased $1.4 million, or 8.8%, to $14.3 million for the year ended December 31, 2002 from $15.7 million for the comparable period in 2001. This decrease reflects the sale of a Florida-based agency, effective July 1, 2001. Excluding revenue related to this agency for the twelve months ended December 31, 2001, revenues for the agency operations would have increased 4.6%.
Revenue from agency operations decreased $1.5 million, or 8.9%, to $15.7 million for the year ended December 31, 2001 from $17.2 million for the comparable period in 2000. This decrease reflects the sale of a Florida-based agency effective, July 1, 2001. Excluding revenue related to this agency for both periods, agency revenue would have decreased 2.2%. This decrease in agency commissions primarily relates to the sale of business to a former employee, for which there was a corresponding reduction in salary and administrative costs.
Federal income tax expense for 2002 was $431,000, or 20.7% of income before taxes. For 2001 and 2000, the Company reflected a federal income tax benefit of $3.6 million and $10.1 million, or 35.6%, and 36.7% of loss before taxes, respectively. The Company’s effective tax rate differs from the 34% statutory rate primarily due to tax-exempt investment income. Changes in the effective rate over prior periods are related to changes in the proportion of tax-exempt investment income to total underwriting results and elimination of goodwill amortization.
Interest expense for 2002, 2001, and 2000 was $3.0 million, $4.5 million, and $5.1 million, respectively. This interest expense relates primarily to the Company’s line of credit. The average debt outstanding was approximately $44 million, $54 million, and $51 million in 2002, 2001, and 2000, respectively. The average interest rate was approximately 7%, 8%, and 9%, in 2002, 2001, and 2000, respectively.
The principal sources of funds for the Company and its subsidiaries 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, other operating expenses, shareholder dividends, and debt service. The Company generates 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 $10.0 million in 2002. These earnings were available for debt service, including interest.
On September 25, 2002, the Company successfully executed a revised credit agreement with its existing bank. The revised agreement includes a $20.0 million term loan and a revolving line of credit for up to $8.0 million. The term loan calls for quarterly amortization of the principal beginning on October 1, 2002 until July 1, 2006, at which time the term loan will be paid in full. The quarterly amortization requires payments of $1.2 million on October 1, 2002 and January 1, 2003; $1.0 million on April 1, 2003 and July 1, 2003; $1.5 million on October 1, 2003; and $1.2 million for the remaining quarterly amortization payments in 2004, 2005, and 2006, with a final payment of $1.5 million on July 1, 2006. The revolving line of credit will expire on July 1, 2004, and is thereafter renewable on an annual basis. At December 31, 2002, the Company had an outstanding balance of $18.8 million and $5.3 million on the term loan and revolving line of credit, respectively.
Pursuant to the terms of the loan agreement, the Company made a principal payment of $1.2 million on October 1, 2002. Subsequent to December 31, 2002, the Company paid in full the amount outstanding on the revolving line of credit. In addition, the Company paid the $1.2 million principal payment due on January 1, 2003, pursuant to the terms of the loan agreement.
Both the term loan and revolving line of credit provide for interest at a variable rate based, at the Company’s option, upon either the prime rate or eurocurrency rate. The applicable margin, which ranges from 200 to 300 basis points above eurocurrency rates, is determined by the level of the fixed charge coverage ratio. The most restrictive covenant is the fixed charge coverage ratio. The fixed coverage ratio, as defined by the credit facility, is the ratio of the non-regulated earnings before interest and taxes for the four preceding fiscal quarters to the sum of fixed charges which include interest expense, principal payments payable, stock repurchases, and dividends declared during the period. Any unused portion of the revolving credit as of the date of determination reduces the sum of these fixed charges. This ratio at December 31, 2002, was 2.9 to 1.0, compared to the covenant minimum of 1.2 to 1.0.
In addition, the Company had an outstanding subordinated promissory note payable in the amount of $3.5 million, due June 30, 2003, which bore interest at a rate of 6.673% plus a Eurocurrency margin. As of December 31, 2002, the Eurocurrency margin was 1.25%. On January 14, 2003, the Company paid in full the $3.5 million subordinated promissory note.
The Board of Directors of the Company did not declare a dividend in 2002. The Board of Directors considers whether a dividend will be declared based on a variety of factors, including but not limited to, the Company’s cash flow, liquidity needs, results of operations and financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from its subsidiaries. The Company did not receive any dividends from its regulated insurance subsidiaries in 2002.
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. The Company’s targets for gross and net written premium to statutory surplus are 3.0 to 1 and 2.0 to 1, respectively. As previously indicated, the Company contributed $37.5 million to the surplus of Star during the second quarter of 2002. The premium leverage ratios as of December 31, 2002, on a statutory consolidated basis, were 2.0 to 1 and 1.5 to 1 on a gross and net written premium basis, respectively.
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory
The 2001 RBC ratio for Star was within Company Action Level and the Company was required to submit a Business Plan to OFIS outlining how it intended to achieve compliance. The Business Plan was approved by OFIS. The Company complied with the Business Plan when it sold 21,275,000 shares of newly issued common stock at $3.10 per share in a public offering in June 2002. Of the $60.5 million in total net proceeds, $37.5 million was contributed to the surplus of Star as of June 30, 2002. As a result, at December 31, 2002, each of the Insurance Company Subsidiaries’ RBC is above the minimum threshold requirement.
In 2002, the Insurance Company Subsidiaries generated certain ratios that varied from the “usual value” range. The variations and reasons for these variations are set forth below:
While this ratio showed improvement from 151% at 2001 to 116% at 2002, it continues to be negatively impacted by the exclusion of the value of affiliated common stocks, as the value of affiliated common stocks is not considered in the ratio.
The Two-year Reserve Development to Surplus Ratio reflects development in 2001 on unprofitable programs, which have been discontinued. Excluding the 2001 adverse development on discontinued programs, the ratio would have been within the usual range at 9%.
The growth in the net written premium on Williamsburg was high for the year primarily due to three growing programs: one workers’ compensation and two general liability programs. These programs generated $1,469,000 of the total $1,643,000 increase in net written premium for 2002, creating the high ratio for the year.
The primary factor contributing to the high value of the Two-Year Overall Operating Ratio was incurred loss development and a net increase in expenses related to discontinued business. Excluding discontinued
This ratio was impacted by the cancellation of a surplus relief reinsurance treaty. Excluding the effect of the cancellation of this treaty, the Change in Net Writings would have been within the usual range at -27%.
Reinsurance does not legally discharge an insurer from its primary liability for the full amount of risks assumed under insurance policies it issues, but it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, the Company is subject to credit risk with respect to the obligations of its reinsurers. In its selection of reinsurers, the Company evaluates the financial stability of its prospective reinsurers. To date, the Company has not, in the aggregate, experienced material difficulties in collecting reinsurance recoverables other than those balances related to CSC and HIH, as discussed previously, and for which allowances have been established. No assurance can be given regarding the future ability of any of the Company’s reinsurers to meet their obligations. The following table sets forth information relating to the Company’s five largest reinsurers (other than client captive quota-share reinsurers) as of December 31, 2002:
In its risk-sharing programs, the Company is also subject to credit risk with respect to the payment of claims by its clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure 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 considered by the Company in entering into and renewing risk-sharing programs. The Company collateralizes balances due from its risk-sharing partners through funds withheld trusts or letters of credit. At December 31, 2002, the Company had
risk exposure in excess of collateral in the amount of $11.6 million on these programs, of which the Company has an allowance of $6.8 million related to these exposures. The Company has historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. Management believes this allowance is adequate. To date, the Company has not, in the aggregate, experienced material difficulties in collecting balances from its risk-sharing partners. No assurance can be given, however, regarding the future ability of any of the Company’s risk-sharing partners to meet their obligations.