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Executives

Karen Spaun - Chief Financial Officer

Bob Cubbin - Chief Executive Officer

Analysts

Mark Hayden - KeyBanc

Mark Dwelle - Ferris, Baker Watts

Tom Spiro - Spiro Capital

Robert Paun - Sidoti & Co

Meadowbrook Insurance Group, Inc. (MIG) Q1 2008 Earnings Call April 29, 2008 9:00 AM ET

Operator

Greetings, ladies and gentlemen and welcome to the Meadowbrook Insurance Group Incorporated First Quarter 2008 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Karen Spaun, Chief Financial Officer for Meadowbrook Insurance Group Incorporated. Thank you, Ms. Spaun. You may now begin.

Karen Spaun - Chief Financial Officer

Thank you, and welcome to Meadowbrook's first quarter 2008 earnings conference call. I will lead our today's call with a review of our first quarter financial results. Bob Cubbin, our CEO will then follow with a review of our financial outlook and current market conditions. The call will be then completed with a question-and-answer session.

During this call, we may make certain statements related to future results and expectations. These statements constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. We therefore must state actual results may differ materially from those projected and may involve risks and uncertainties that are outlined in our Form 10-Q and 10-K that are filed with the SEC.

Please note Meadowbrook undertakes no obligation to update or revise any forward-looking statements. If you have not received a copy of our earnings release, it is currently available on our website meadowbrook.com or you may give me a call and I will be happy to fax a copy to you.

Now, for our results. We are pleased with growth in our net operating income excluding amortization, increasing 22% to $8.6 million, compared to $7.1 million in 2007. Our results, for the first quarter reflected improvements in our expense ratio primarily related to the benefit of the elimination of the fronting fees paid prior to receiving our AM Best Upgrade and the benefit, from our ability to further leverage fixed costs.

Our results also benefited from an increase in net investment income with positive operating cash flows and the net proceeds we received in our equity raise last year. In addition, we continue to see favorable development on prior year losses. Our results were impacted by a $1.4 million increase in amortization expense related to the acquisition of the USSU business in 2007 and 2008.

Along with an increase in other administrative expenses related to the management fee paid to the former owners of USSU. In addition our results reflect a one time $1.8 million reduction in written and earned premium, which was due to an adjustment in a premium accrual on a discontinued retrospectively rated policy with one of our former risk sharing partners.

Our commitment to strong underwriting discipline and our controls over price adequacy resulted in an increase in underwriting process to $4 million, compared to $2.5 million in 2007. And a 2.4 point improvement in our combined ratio, 2.9% compared to 96.3% in 2007.

On a fee-for-service side pre-tax income excluding amortization was $2.5 million or 10.9% margin in 2008, compared to $3.9 million or16.4% margin in 2007. A reduction in pre-tax income from total fee-for-service business was impacted by a $1.3 million reduction in intercompany commissions and fees, as we recognize a levering of fixed cost by reducing the management fees paid by insurance company subsidiaries to the management company subsidiary.

In addition the management fee paid to the former owners of the USSU business also contributed to this through this [fee credit]. The USSU management fee has been eliminated as of February 2008.

Excluding these two items the fee-for-service pre-tax income excluding amortization would have been $4.6 million with 20% margin. The reduction in the intercompany fees has the effect of reducing unconsolidated GAAP expense ratio and the margin on the unconsolidated fee-for-service income. It does not impact consolidated net income.

Please refer to the earnings release for further details on a line by line analysis of our first quarter consolidated income statement.

With that, I will turn the call over to Bob Cubbin our Chief Executive Officer. Bob.

Bob Cubbin - Chief Executive Officer

Thanks Karen. While there is some noise in the quarter caused by the $1.8 million premium adjustments and higher amortization expense, we are very pleased by the overall results.

Cash earnings were up 22%, loss reserves continued to develop favorably and normalized results were inline with expectation. We are starting to see some of the benefits of our AM Best Upgrade by eliminating the fronting fees and have implemented new programs where production is ramping up.

We are committed to maintaining appropriate levels of underwriting profitability and continued to invest in the growth of our business. While gross written premium was up only slightly in comparison to 2007 we remained confident on our ability to meet our full year premium guidance of 385 to 395 million. This growth will come from mainly new programs implemented in 2007 and during the first quarter of 2008, as well as organic growth in existing program.

Since our upgrade last year, we have been focusing on building new relationships and enhancing existing relationship to underwrite additional business. Despite the current and more competitive market, we remained confident that our growth plans for 2008 are achievable.

Our expense ratio is tracking at an even lower level than expected due to the reduction in the intercompany fees paid by our insurance company subsidiaries to the management company, as we were able to leverage fixed cost and share those savings with the insurance company.

We continue to maintain our balanced business model and focus on sustainable profitable results with reduced exposure to the volatility usually associated with market underwriting cycles. Our focus on small average premium accounts with specific risk characteristics and the affiliation with an association or specialized agent allows us to provide customized and responsive services and other risk management services designed to minimize frequency of claims.

We protect ourselves against severity with the purchase of excess-of-loss through insurance and by geographic diversification. Three more competitive underwriting cycles with smaller accounts tend to be more stable, because we offer more predictable pricing in hard and soft markets, and due to the cost associated with moving blocks to smaller business.

While our current annualized return on beginning equity was 9.4% in the quarter, due to our capital raise and the increase in amortization expense. We remained committed to our long-term ROE goal of 14% to 16%. We see numerous ways that we will be able to increase our underwriting leverage through select revenue enhancement opportunity brought by Meadowbrook and ProCentury.

We will be able to increase our investment leverage through cash from operation, by lengthening duration of reserves and growth of invested asset. We will be able to increase fee-for-service income through new opportunities and as amortization runs-off. We will also see an increased ROE through the reduction and expenses by levering fixed costs over a larger revenue base.

Our ROE strategy focuses on balancing stable process of profit for the conservative investment strategy maintaining a solid fee-for-service business and limiting underwriting volatility through targeting specialty programs in smaller accounts with both the product and geographic diversification.

The merger with ProCentury should also help to accelerate our progress further we go. The merger with ProCentury is going well. On February 20, we announced the execution of a definitive merger agreement. The merger is expected to withstand and compliment our specialty line capabilities with ProCentury's insurance professionals and product expertise in the surplus lines market. We believe the transaction will be immediately accretive to earnings and book value.

The combination of our two companies create the diversified platform and gives both companies the size and product debt to compete at a level that couldn’t be achieved as separate entities. Upon completion of the merger the combined entities will for the most part continue to operate the respected insurance subsidiaries as they were operating prior to the merger, only better.

On April 11, 2008, we filed the S-4 Registration Statement in conjunction with the merger and have since received a no review letter from SEC. This enables us to continue to move forward for the finalization of the merger. As indicated in the initial announcement, we expect the finance, the cash portion of the purchase price through a combination of cash and debt. We are currently working with our banks on the finalization of the financing arrangement and anticipate finding the term sheet within the next few weeks and closing on the financing arrangements in June or July.

We have been working with the ProCentury team on new business initiatives and are excited by the opportunities of creating a larger marketing platform through our combined distribution network. We have also been concentrating on the integration of our operation. We look forward to the successful completion of the merger in the third quarter and the implementation of the growth strategies that are as hard as this combination.

Even before the closing, we should expect to see the new business opportunities emerge and gain attraction. We have already begun the process of bringing ProCentury's products to our distribution system, particularly in markets where they have been historically under represented. This business combination also gives us the ability to better and more effectively manage through the market cycles.

As I said we are confident that our full year 2008 guidance can be achieved and we expect to be able to show demand full evidence of the potential growth from the merger in the near term as the opportunities emerge and are implemented.

We thank you for your continued interest in Meadowbrook. At this time, we will open the call to questions. Operator.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now conduct a question-and-answer session. (Operator Instructions). Our first question comes from Mark Hayden with KeyBanc. Please proceed with your question.

Mark Hayden

Hi, I am actually calling in for Beth Malone, as well. My question has to do with the expense ratio. I am just wondering, if it is going to be sustainable at the level that it has or even if it will be going lower in the future?

Karen Spaun

Yes. Actually we believe it is sustainable. The driving forces of it are coming down or the elimination of the front fees and the leveraging of the fixed cost, so we believe that rather where it is right now is a current run rate.

Mark Hayden

And the other question, I think you addressed it earlier, I am not unsure, but with the gross written premiums with the guidance is being between 385 and 395 and it came in the quarter at $90 million are we to expect that the gross written premiums are going to accelerate within the next three quarters or in the second half of the year to reach the guidance?

Bob Cubbin

That’s correct Mark. We are going to see some acceleration in the growth of premium as the programs that we implemented last year and early this year start to see their production ramp up. So over the next few quarters you are going to see that go up dramatically. So historically, I think the second quarter was lower than the first quarter, but we really do not expect to see that this year.

Mark Hayden

Okay. Thank you very much.

Operator

(Operator Instructions). Our next question comes from Mark Dwelle with Ferris, Baker Watts. Please proceed with your question.

Mark Dwelle

Yeah, good morning.

Bob Cubbin

Go ahead Mark.

Mark Dwelle

Few questions. First, related to the acquisition. You had indicated the timing is sort of third quarter, can you be a little more precise, I mean the third quarter is kind of a big place, are we thinking more towards to July or more towards September or to soon to tell?

Bob Cubbin

Well that’s a big question Mark. There are open items with regulatory approvals and you have to kind of sequence some of these things. So the real issue that we don’t know, very closely is the regulatory responses of State Insurance Department, because we need three states to approve that. So, it's very difficult to predict, how quickly they might respond to that particularly during the summer months. So we are now still looking at a third quarter close. We are obviously hoping that it’s earlier in the quarter, rather than later in the quarter, but I think safer that is to assume later in the quarter.

Mark Dwelle

Okay. With respect to your financing, the implications from your comments, you said this will be entirely bank financed, its not going to be any type of public debt?

Bob Cubbin

That’s correct. There will be no public debt issue.

Mark Dwelle

Okay. And then finally related to the premium growth, I guess, I was frankly disappointed. I thought the growth rate would come through somewhat better than it did and could you just provide maybe some insight, is it a matter of pipeline, I know there is a one lead time on these or is it just a matter of pricing in adequate and the growth time where you would like them to be. Just something to help us understand kind of how you are going to get from here to there, because it’s a steep curve to still hit your guidance given way you are adding for the end of 1Q?

Bob Cubbin

That’s a good point. A couple of things, just to keep in mind. First of all we did have a reduction in the residual market, which is a favorable thing, as well as the 1.8 million adjustments that hit the growth and the net and the earn from – with respect to policies. So we would have been up around little over 3% without that. And really you hit it right on the head in terms of the lead time and the timing for ramping up the production and the new business. Once we get a new program signed up with an agent, we didn’t have to make sure that all the infrastructure is in place and all the rates in the forms are properly filed and so that does take them lead time. And then you have the roll over of the business, there is some cyclicality to some of the programs that we write, that is you have some months or some quarters that are heavy over middle months and others.

In the Workers' Compensation business, you do tend to see a higher level of renewals in the second half of the year or if you miss the first, the January first number, startup then you got to really look for the second half of the year. So there is a lot of that in both instances. So Mark, we are very confident that the programs that we have signed up are well priced and there was very strong long-term partners. So we are patient, when it comes to ramping these things up. I know, we would rather had a goal quicker rather than slower, but sometimes the market just doesn’t allow you to go as fast as you would like. We recognized the steepness of the curve in order to get that 385 to 395, but after having gone back through even after the first quarter results were known, with our operating staff and our branch managers we remained confident, we can achieve that target.

Mark Dwelle

Okay. And then just a touch on in terms of pricing, how was that coming through, in the past you have been kind of low single-digit declines, is that so relevant?

Bob Cubbin

Yes. We are still in low single-digit. Actually the pricing was a little bit softer than we would have liked, but that was really kind of very isolated. So we are still expecting rates to come down between 2 and 2.5% for the full year. So as we've said in the past, we are a little bit insulated from some of the big swings, particularly in our small average premium size business. When you are dealing with larger accounts, that does tend to be a little more competitive and we did see kind of at the higher end of some programs where we have higher average premiums that the pricing was a little bit softer than in the small segment where we are primarily focused. So overall, we are not seeing any kind of predatory pricing. I know looking at and reading other companies results and their reports, there is a great deal of competitive pressure out there, but so far we are have been able to kind of go below that.

Mark Dwelle

Okay. That’s helpful. Good luck for the rest of the year. And I will let somebody else, have a chance.

Bob Cubbin

Thanks Mark.

Operator

Our next question comes from Tom Spiro with Spiro Capital. Please proceed with your question.

Tom Spiro

Good morning.

Bob Cubbin

Good morning Tom.

Karen Spaun

Good morning.

Tom Spiro

As I recall, your Workers' Comp reinsurance treaty, renewed around April 1, of this year, if I am right, how did that go?

Bob Cubbin

Went fine. And actually, the renewal terms were pretty much inline with what we expected which was – because we are having favorable results in the Work Comp line, it has come down a little bit.

Tom Spiro

Is the softness in the Workers' Comp a primary markets carrying through to the reinsurance market or is it much too difference?

Bob Cubbin

I would say that reinsurance market is not as soft as some of states. We had mandatory rate changes in Nevada, Florida and Massachusetts, but those were primarily driven by better than expected results. And so, I think the reinsure on the more catastrophe type losses don’t see that same kind of benefit from a reduction in frequency. So we are not seeing dramatic changes in the reinsurance market at least with the markets that we have been dealing with.

Tom Spiro

Bob, you mentioned that you are still hopeful of hitting this year's gross written premium goal, you are still expect to get into that 385 to 395 range. As I recall there were several other targets, you were shooting for this year with respect to things like that, growth in fee income for your amortization and gross commission in fees EPS over 4 or 5 of them, generally that whole package of target is still in effect or you are modifying any of them?

Bob Cubbin

Well we haven’t modified any of them. Presently, we are seeing a little bit more amortization than we had expected. We have to shoot it on a [publicated] the book of business in the fourth quarter of last year that we didn’t have in our budget. But we are amortizing some of that. And then bottom line really is where we are primarily focused on and we do expect to be able hit those bottom line numbers. As you know, that’s obviously, the most important things to maintain profitability.

Tom Spiro

Sure, agreed. On the ProCentury side, as I understand it Bob, much of the appeal of the ProCentury deal is really revenue will grow fast, its more of a revenue story than a cost story, as I understand. A part of the opportunity here is that we will be able to sell some of our products through the ProCentury systems, that’s pretty accurate description?

Bob Cubbin

Absolutely, plus they will be able to sell their product through our system and actually a number of the initiative that are already underway are geared towards getting three or four of our top program agents, administrators, partners to sign up as ProCentury wholesalers and particularly in areas where they are under represented, and we are making some very significant headway there. So we feel very confident that those growth opportunities will emerge and start to gain some traction even before we close down on the merger in the third quarter. So those remained very much in front of our planing, as well as are being able to provide to ProCentury's distribution system admitted product, which again we just met with their agents at their annual agents meeting and we were well received and we were very optimistic coming out of their -- that the opportunities that we foresaw before the transaction was consummated will start to come to provision.

Tom Spiro

But I just had second part for a moment here, I wish, I think there can be a lot of products through the ProCentury system, they are focusing on for example Workers' Comp or Commercial Auto, which I know are both important to us. How much Workers' Comp or how much Commercial Auto is the ProCentury system, their agents in such, how much are they just selling now, that’s written on somebody else, that is what's the sort of the size of the opportunity we are looking at?

Bob Cubbin

Well they have about a 150 wholesale agents and we are in the process of completing the survey of those agents in order to determine the order of magnitude, but a few of the agents that we have talked to already have very, very substantial block of business that we maybe interested in. Obviously, there won't be for everybody and within the amount of the rate off practice or all hazards of Workers' Comp. So we are going above that in a very conservative way to move it forward, but at the same time we want to be cautious that we are not accepting business that doesn’t fit underwriting criteria. So it’s a very substantial opportunity, but we have got to be proactive in what we pick. So we are not trying to be offerings all people as we don’t in any of our programs, and so as we get more information for them and we develop that information you know, we will look to sign up some of those agents who have the qualifications and the quality of business that we are looking for.

Tom Spiro

Okay. Many thanks.

Bob Cubbin

Okay, Tom. Thank you.

Operator

Our next question comes from Robert Paun with Sidoti & Co. Please proceed with your question.

Robert Paun

Good morning.

Bob Cubbin

Good morning Robert.

Robert Paun

Going back to gross written premiums, can you remind us why premiums were light in the second quarter last year?

Bob Cubbin

I think that’s just cyclical. Yeah I don’t think there is anything significant in the second quarter that I recall. Karen do you recall any specifics.

Karen Spaun

No.

Bob Cubbin

I know it’s just a cyclical nature of the business.

Robert Paun

And you don’t expect that to happen this….?

Bob Cubbin

No, we don’t. Because we have got additional programs that we implemented at the second half of last year and even in the beginning of this year that we think will overcome that normal cyclical downturn in the second quarter. As I mentioned Workers' Compensation tends to have kind of heavy January renewal and heavy July renewal and so that’s probably historically as where we have seen that kind of dip. But now we are expecting that just this year.

Robert Paun

Okay. And can you give us some more color on what you are seeing in terms of pricing and competition in fee service business? I know net commission and fees were up in the quarter primarily due to the acquisition of US specialty, but it seems from your comments that you are experiencing increased competition, is that true?

Bob Cubbin

Yeah, in a couple of isolated areas Robert, that agency in Michigan have had you know, due to its commissions levels drop as pricing on there kind of middle market and up have seen reductions in the premiums, so the commissions were down. The other area is in particularly in our TPA operation in Massachusetts, the reduction in prices there have or mandated by the state, have translated in a few of our programs, where we are on a percentage of premium basis to lower commission levels. But we are making efforts there to fortify that. Other than in those two areas we haven’t seen substantial decreases in the commission or the fee rate.

Robert Paun

Okay, great. Thank you.

Bob Cubbin

Thank you, Robert.

Operator

There are no further questions in queue, at this time. I would like to turn it back over to management for closing comments.

Bob Cubbin

Thank you very much. Karen and I will be available for follow-up, if anybody has any other information that we can provide, we would be happy to do so. Thank you very much.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Meadowbrook Insurance Group, Inc. Q1 2008 Earnings Call Transcript
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