ALPS PROPERTY & CASUALTY INSURANCE COMPANY, DBA ATTORNEYS LIABILITY PROTECTION SOCIETY, A RISK RETENTION GROUP (A

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1 , DBA ATTORNEYS LIABILITY PROTECTION SOCIETY, A RISK RETENTION GROUP FINANCIAL REPORT

2 C O N T E N T S PAGE INDEPENDENT AUDITOR S REPORT... 1 and 2 FINANCIAL STATEMENTS Statutory Statements of Admitted Assets, Liabilities, and Capital and Surplus... 3 and 4 Statutory Statements of Operations...5 Statutory Statements of Changes in Capital and Surplus... 6 and 7 Statutory Statements of Cash Flows... 8 and 9 Notes to Financial Statements...10 to 29 SUPPLEMENTARY INFORMATION Summary of Investments Schedule...30 Investment Risk Interrogatories and 32 Reinsurance Interrogatories and 34 APPENDIX Appendix I Independent Auditor s Qualification Letter...35 to 37

3 ANDERSON ZURMUEHLEN & CO., P.C. CERTIFIED PUBLIC ACCOUNTANTS & BUSINESS ADVISORS MEMBER: AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS MSI GLOBAL ALLIANCE INDEPENDENT MEMBER FIRM CO;:!; too ('I")() C':'lc (C)-' On: coo ~== ~--~ :;:!;!!: ~~ 0.. en en cn w ~ == L{) COL{) ('l")<:t N...j XN o,.._ cow c::)o a:'<~" x. if a: 0 go u.o :z:w t;:": _.-I U.N,.._ ' 10 t;;~ UJ.!!: ljj UJ I :::> z UJ ~ :r I => 0 en..-1 N IX)..-1 INDEPENDENT AUDITOR'S REPORT To the Board of Directors ALPS Property & Casualty Insurance Company DBA Attorneys Liability Protection Society, A Risk Retention Group Missoula, Montana We have audited the accompanying statutory financial statements of ALPS Property & Casualty Insurance Company (a wholly owned subsidiary of ALPS Corporation) which comprise the statutory statements of admitted assets, liabilities, capital and surplus as of, and the related statutory statements of operations, changes in capital and surplus, and cash flows for the years then ended, and the related notes to the financial statements. Management's Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these fmancial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of fmancial statements that are free from material misstatement, whether due to fraud or error. Auditor's Responsibility Our responsibility is to express an opinion on these fmancial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the fmancial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the fmancial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the fmancial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the fmancial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our adverse audit opinion. -1-

4 ANDERSON ZURMUEHLEN & CO., P.C. CERTIFIED PUBLIC ACCOUNTANTS & BUSINESS ADVISORS Basis for Adverse Opinion on U.S. General Accepted Accounting Principles As more fully described in Note 2 to the financial statements, the Company has prepared the financial statements in conformity with accounting practices prescribed or permitted by the Montana Commissioner of Securities and Insurance, which practices differ from general accepted accounting principles. The effects on the financial statements of the variances between statutory accounting practices and accounting principles generally accepted in the United States of America, although not reasonably determinable, are presumed to be material. Adverse Opinion on U.S. Generally Accepted Accounting Principles In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the financial statements referred to in the first paragraph do not present fairly, in accordance with accounting principles generally accepted in the United States of America, the financial position of ALPS Property & Casualty Insurance Company as of, or the results of its operations or its cash flows for the years then ended. Opinion on Regulatory Basis of Accounting In our opinion, the financial statements referred to in the first paragraph present fairly, in all material respects, the admitted assets, liabilities, and surplus of ALPS Property & Casualty Insurance Company as of, and the results of its operations and its cash flows for the years then ended, on the basis of the financial reporting provisions of National Association of Insurance Commissioners as described in Note 2. Report on Supplementary Information Our audits were conducted for the purpose of forming an opinion on the fmancial statements as a whole. The accompanying supplementary schedules titled Summary Investment Schedule and Supplemental Investment Risks Interrogatories are presented for purposes of additional analysis and are not a required part of the financial statements. Such information is the responsibility of management and was derived from and relates directly to the underlying accounting and other records used to prepare the financial statements. The information has been subjected to the auditing procedures applied in the audits of the financial statements and certain additional procedures, including comparing and reconciling such information directly to the underlying accounting and other records used to prepare the financial statements or to the financial statements themselves, and other additional procedures in accordance with auditing standards generally accepted in the United States of America. In our opinion, the Summary Investment Schedule and Supplemental Investment Risks Interrogatories are fairly stated in all material respects in relation to the financial statements as a whole. The Supplemental Reinsurance Interrogatories, which is the responsibility of management, is of a nonaccounting nature and has not been subjected to the auditing procedures applied in the audit of the financial statements. Accordingly, we do not express an opinion or provide any assurance on it. ~~ ~~.ev.-p.c_. Missoula, Montana April 3,

5 F I N A N C I A L S T A T E M E N T S

6 STATUTORY STATEMENTS OF ADMITTED ASSETS, LIABILTIES, AND CAPITAL AND SURPLUS ADMITTED ASSETS INVESTED ASSETS AND CASH Bonds $ 59,442,880 $ 55,915,771 Common stocks 12,414,616 15,312,349 Short-term investments 2,575,430 1,382,603 Mortgage loans 1,082,281 1,082,478 Other invested assets 4,246,558 5,449,916 Receivable for securities 45, ,704 Cash 7,438,133 3,683,992 Total invested assets and cash 87,245,764 82,932,813 OTHER ADMITTED ASSETS Premiums receivable 4,397,038 4,696,275 Accrued investment income 950, ,516 Reinsurance receivable 1,136,808 1,028,765 Ceded reinsurance premiums - 418,908 Deferred tax assets 2,123,069 1,550,058 Deductible receivable 195, ,261 Due from parent, subsidiaries and affiliates - 1,364,774 Total other admitted assets 8,802,408 10,091,557 TOTAL ADMITTED ASSETS $ 96,048,172 $ 93,024,370 The Notes to Financial Statements are an integral part of these statements. -3-

7 LIABILITIES, CAPITAL AND SURPLUS Reserve for loss and loss adjustment expense $ 42,759,706 $ 46,502,387 Unearned premiums 12,413,333 11,503,441 Reinsurance payable 2,370, ,254 Advanced premiums 1,859,462 2,443,491 Accrued taxes, licenses, and fees 620, ,036 Accounts payable and accrued expenses 705, ,522 Remittances and items not allocated 351,038 62,464 Due to parent, subsidiaries and affiliates 306,115 42,269 Amounts withheld or retained by Company for the account of others 8,592 16,806 Federal income tax payable 1,007, ,566 Total liabilities 62,402,359 62,300,236 CAPITAL AND SURPLUS Certificates of contribution 734, ,320 Common stock 5,000,000 5,000,000 Paid-in and contributed surplus 4,184,226 4,910,476 Surplus notes 11,414,258 11,543,921 Unassigned surplus 12,312,482 8,529,417 Total capital and surplus 33,645,813 30,724,134 TOTAL LIABILITIES, CAPITAL AND SURPLUS $ 96,048,172 $ 93,024,370-4-

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9 STATUTORY STATEMENTS OF OPERATIONS Years Ended Underwriting income Gross premiums written $ 40,497,695 $ 37,240,261 Reinsurance ceded (12,636,674) (11,197,397) Net premiums written 27,861,021 26,042,864 Change in unearned premiums (909,891) (73,851) Net premiums earned 26,951,130 25,969,013 Underwriting expenses Losses incurred 6,754,063 8,908,506 Loss adjustment expenses incurred 8,725,442 12,764,245 Other underwriting expenses, net of reinsurance ceding commission of $189,532 and $161,179, respectively 10,774,812 8,964,573 Total losses and underwriting expenses 26,254,317 30,637,324 Underwriting income (loss) 696,813 (4,668,311) Investment and other income, net of investment expense of $999,566 and $977,144, respectively: Realized gain (loss) on investments, net of income taxes of $244,820 and $167,591, respectively 454,665 (311,240) Other investment income 3,963,722 4,043,087 Net investment income 4,418,387 3,731,847 Income (loss) before federal income taxes 5,115,200 (936,464) Provision for federal income taxes (533,035) (172,488) Net income (loss) $ 4,582,165 $ (1,108,952) The Notes to Financial Statements are an integral part of these statements. -5-

10 STATUTORY STATEMENTS OF CHANGES IN CAPITAL AND SURPLUS Years Ended PAID-IN AND COMMON STOCK CONTRIBUTED SHARES AMOUNT SURPLUS Balance, January 1, ,000,000 $ 5,000,000 $ 6,187,694 Net change in unrealized gains Surplus refunds Adjustment to paid-in surplus - - (1,277,218) Repayment of surplus notes Net change in provision for reinsurance Net change in nonadmitted assets Net change in deferred taxes Net loss Balance, December 31, ,000,000 5,000,000 4,910,476 Cumulative effect of change in accounting principle Net change in unrealized gains Surplus refunds Adjustment to paid-in surplus - - (726,250) Repayment of surplus notes Dividends paid Net change in provision for reinsurance Net change in nonadmitted assets Net change in deferred taxes Net income Balance, December 31, ,000,000 $ 5,000,000 $ 4,184,226 The Notes to Financial Statements are an integral part of these statements. -6-

11 CERTIFICATES OF SURPLUS UNASSIGNED CONTRIBUTION NOTES SURPLUS TOTAL $ 925,193 $ 11,219,183 $ 9,630,472 $ 32,962, (613,170) (613,170) (184,873) - - (184,873) - 1,277, (952,480) - (952,480) - - (20,400) (20,400) - - (491,227) (491,227) - - 1,132,694 1,132, (1,108,952) (1,108,952) 740,320 11,543,921 8,529,417 30,724, , , (529,823) (529,823) (5,473) - - (5,473) - 726, (855,913) - (855,913) - - (625,000) (625,000) - - (35,911) (35,911) , , (569,841) (569,841) - - 4,582,165 4,582,165 $ 734,847 $ 11,414,258 $ 12,312,482 $ 33,645,813-7-

12 STATUTORY STATEMENTS OF CASH FLOWS Years Ended CASH FROM OPERATING ACTIVITIES: Premiums collected, net of reinsurance $ 28,879,841 $ 25,930,641 Benefits and loss related payments (9,466,694) (7,896,766) Commissions and expenses paid (20,257,479) (19,468,138) Investment income (net of investment expense) 3,738,173 3,750,424 Miscellaneous income 375, ,333 Federal income taxes paid (41,509) (191,798) Net cash flows from operating activities 3,227,419 2,495,696 CASH FROM INVESTING ACTIVITIES: Proceeds from sale of bonds 9,342,534 11,076,160 Proceeds from sale of stocks 6,374,408 4,498,952 Proceeds from redemption of mortgage loans Purchase of bonds (13,032,323) (10,757,191) Purchase of stocks (3,473,704) (6,132,557) Purchase of other invested assets - (305,000) Proceeds from other invested assets 1,295, ,026 Miscellaneous proceeds (applications) 59,838 (209,960) Net cash flows from investing activities 566,485 (1,591,191) The Notes to Financial Statements are an integral part of these statements. -8-

13 CASH FROM FINANCING ACTIVITIES: Surplus notes, capital and surplus repaid (855,913) (952,480) Dividends to stockholders (625,000) - Miscellaneous proceeds (applications) 2,633,977 (1,840,548) Net cash flows from financing activities 1,153,064 (2,793,028) Net change in cash and short-term investments 4,946,968 (1,888,523) Cash and Short-term Investments Beginning of year 5,066,595 6,955,118 End of year $ 10,013,563 $ 5,066,595 Reconciliation to Statutory Statements of Admitted Assets, Liabilities, and Capital and Surplus: Cash $ 7,438,133 $ 3,683,992 Short-term investments 2,575,430 1,382,603 Total cash and short-term investments $ 10,013,563 $ 5,066,595 Non-cash Financing Activities: Increase in surplus notes $ 726,250 $ 1,277,218 Non-cash Investing Activities: Securities sold without payment $ (59,838) $ (105,704) -9-

14 NOTES TO FINANCIAL STATEMENTS NOTE 1. ORGANIZATION ALPS Property & Casualty Insurance Company (the Company ), DBA Attorneys Liability Protection Society, A Risk Retention Group, is a wholly owned subsidiary of ALPS Corporation. The Company is licensed as a property and casualty insurer in the state of Montana and underwrites lawyers professional liability insurance on a claims-made basis. ALPS Corporation and the Company are organized, structured, and operate in compliance with the federal Liability Risk Retention Act (the LRRA ) which restricts ownership of ALPS Corporation s shares. The LRRA provides that only insured policyholders of the Company can be shareholders of ALPS Corporation. Further, all shareholders of ALPS Corporation must be insured policyholders of the Company. The Company is currently registered to do business as a risk retention group in thirty-eight (38) states, the District of Columbia, the U.S. Virgin Islands, and the Commonwealth of the Northern Mariana Islands. The majority of the Company s premium revenue is concentrated in Virginia (22%), West Virginia (11%), South Carolina (9%), Montana (7%), Alaska (7%), and Idaho (6%). The Company conducts its insurance operations in conformity with the accounting practices and laws prescribed by the Montana Commissioner of Securities and Insurance. The Company writes professional liability insurance for attorneys on a claims made basis, including prior acts coverage for those attorneys who were previously insured by other companies. The Company also offers an extended reporting endorsement on policies issued to sole practitioners. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting: The accompanying financial statements have been prepared in conformity with accounting practices prescribed or permitted by the Montana Commissioner of Securities and Insurance, which requires the Company to prepare the financial statements in accordance with the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual (SAP). SAP differs in some respects from accounting principles generally accepted in the United States of America (GAAP). The following is a description of the principal differences: Policy acquisition costs, such as commissions and other items, are charged to current operations as incurred. Under GAAP, these costs are deferred and amortized over the period of premium recognition. Certain assets designated as nonadmitted are excluded from the statutory statement of admitted assets, liabilities and capital and surplus. The change in nonadmitted assets is credited directly to or charged directly against unassigned surplus. Under GAAP, these nonadmitted assets are included in the balance sheet. -10-

15 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Basis of Accounting (Continued): Deferred income taxes are limited as to the amount which can be recorded and admitted. Under GAAP, deferred income taxes (subject to valuation allowances) are recognized for all temporary differences between book and tax income and carry forwards. The income or expense related to changes in deferred income taxes is directly credited to or charged against unassigned surplus under statutory accounting principles. Under GAAP, all such changes are reflected in income for the year of change. Comprehensive income is not reflected in accordance with the requirements of GAAP. Instead, changes in unrealized gains and losses on investments are charged directly to unassigned surplus. Subordinated debentures and certain types of borrowed funds with repayment restrictions dependent upon surplus of the organization are classified as surplus. GAAP requires that these be classified as liabilities. Statutory financial statements are prepared in a form and using language and groupings substantially the same as the annual statements of the Company filed with the National Association of Insurance Commissioners (NAIC) and state regulatory authorities which differ from the presentation and disclosure of financial statements presented in accordance with GAAP. Accounting Estimates: The Company s management is required to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from these estimates. Revenue Recognition: Premiums are recognized as revenue on a pro rata basis over the policy period. Unearned premiums are established to cover the unexpired portion of premiums written and are computed on a pro rata method. Advanced premiums are deferred until the effective date of the policy at which time they are recognized as revenue on a pro rata basis over the term of the policy. Loss and Loss Adjustment Expenses: Reserves for loss and loss adjustment expense reserve estimates are established based upon accepted actuarial standards as adopted by the actuarial standards board. Changes in reserves from the continuous actuarial review process are reflected in current year income. Due to the inherent unpredictability of estimates of ultimate loss amounts, it is at least reasonably possible that the estimates will change within the near term. -11-

16 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Cash and Short-term Investments: The Company considers all highly liquid investments with a maturity of twelve months or less at the date of acquisition and all non-negotiable certificates of deposit to be part of cash and shortterm investments. The Company s non-interest bearing accounts are subject to unlimited coverage by the FDIC. From time to time, certain bank accounts that are subject to limited FDIC coverage exceed their insured limits. At, bank balances for these accounts exceeded insured limits by $7,277,098 and $2,838,603, respectively. Effective January 1, 2013, the coverage for non-interest bearing accounts reverted to $250,000. Investments: Short-term investments are stated at amortized value using the interest method. Non-investment grade short-term investments are stated at the lower of amortized cost or fair value. The retrospective adjustment method is used to value all loan-backed securities. Bonds not backed by other loans are stated at amortized value using the interest method. Noninvestment grade bonds are stated at the lower of amortized value or fair value. Prepayment assumptions for single class and multi-class mortgage-backed/asset-backed securities were obtained from broker dealer survey values or internal estimates. Common stocks, other than investments in stocks of subsidiaries and affiliates, and mutual funds are stated at fair value. Income Taxes: The Company has adopted SSAP Statement No. 101, Accounting for Income Taxes. Under Statement No. 101, the liability method, as described in ASC 740, is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between financial reporting and tax bases of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Certain net deferred tax assets are non-admitted assets in accordance with SSAP No In 2011, the Company accounted for income taxes under SSAP 10R Income Taxes. Montana Prescribed or Permitted Practices: The Company prepares its statutory financial statements in conformity with accounting practices prescribed or permitted by the Montana Commissioner of Securities and Insurance, which requires insurance companies domiciled in the state of Montana to prepare their statutory financial statements in accordance with the NAIC Accounting Practices and Procedures Manual, subject to any deviations prescribed or permitted by the Montana Commissioner of Securities and Insurance. There are currently no applicable deviations from the prescribed or permitted practices of the NAIC. -12-

17 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Annual Statement Presentation: In the 2011 annual statement, ceded reinsurance premiums of $418,098 are shown as a reduction in liabilities, which differs from the presentation in the audited financial statements. Accrued Investment Income: Investment income is accrued when it is legally due to be paid to the Company. The Company does not admit investment income due and accrued over 90 days past due. Subsequent Events: Management has evaluated subsequent events through April 3, 2013, the date which the financial statements were available for issue. Reclassifications: Certain reclassifications have been made to the December 31, 2011 financial statements to conform to the December 31, 2012 presentation. These reclassifications had no effect on previously reported net loss or capital and surplus. Accounting Changes: SSAP No. 101, Income Taxes, became effective January 1, 2012, and has been adopted by the Company in The cumulative effect of the change in accounting principle on prior years is reflected as an increase in beginning surplus in the amount of $508,003. NOTE 3. SURPLUS CONTRIBUTIONS The Company was originally organized as a mutual insurer and obtained its operating surplus through surplus contributions from its insured policyholders. The original surplus contributions were evidenced by Certificates of Surplus Contribution. Effective January 1, 2001, the Company demutualized and converted to a stock insurer. Under the Plan of Demutualization approved by the Company s Board of Directors and the Montana Commissioner of Securities and Insurance, each holder of a Certificate of Surplus Contribution elected to either (1) convert the Certificate to shares of Class A common stock; (2) donate the Certificate to a bar foundation designated by the holder; or (3) receive annual cash payments until the amount of the Certificate was repaid, without interest, with payments made only in years following a year in which the Company had positive net income. An exception to this, where payments may be made in years following a year in which the Company had a net loss, is in the event of death of the certificate holder or the certificate holder s retirement from the practice of law. The amount returned as cash refunds during 2012 and 2011 was $5,473 and $184,873, respectively. -13-

18 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4. INVESTMENTS At December 31, 2012, maturities on bond investments were as follows: BOOK VALUE FAIR VALUE Less than one year $ 8,794,455 $ 8,956,581 One year through five years 21,599,349 23,071,205 Over five years through ten years 26,555,073 29,830,929 Over ten years through twenty years 2,494,003 2,802,480 Total $ 59,442,880 $ 64,661,195 The Company periodically examines its investment portfolio to determine if any investments are permanently impaired. Acting upon the advice of its asset managers, the Company recorded losses totaling $60,000 and $297,500 for those investments that were determined to be permanently impaired as of, respectively. The Company asserts that it has the intent and ability to hold securities in an unrealized loss position long enough to allow the cost basis of these securities to be recovered. These conclusions are supported by a detailed analysis of each security by the Company s asset managers. It is possible that the Company could recognize other-than-temporary impairments in the future on some securities if future events, information, and the passage of time causes it to conclude that declines in value are other-than-temporary. The following summarizes investments in an unrealized loss position: -14-

19 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4. INVESTMENTS (CONTINUED) 2012 Fixed Income Securities: FAIR UNREALIZED COST VALUE LOSSES Bonds For 12 months or more $ 2,959,717 $ 2,388,751 $ (570,966) For less than 12 months 7,249,789 7,156,829 (92,960) $ 10,209,506 $ 9,545,580 $ (663,926) Equity Securities: Common Stock For 12 months or more $ 5,182,863 $ 3,484,881 $ (1,697,982) For less than 12 months 2,808,720 2,286,357 (522,363) $ 7,991,583 $ 5,771,238 $ (2,220,345) Total For 12 months or more $ 8,142,580 $ 5,873,632 $ (2,268,948) For less than 12 months 10,058,509 9,443,186 (615,323) $ 18,201,089 $ 15,316,818 $ (2,884,271) Fixed Income Securities: 2011 FAIR UNREALIZED COST VALUE LOSSES Bonds For 12 months or more $ 3,691,160 $ 3,255,692 $ (435,468) For less than 12 months 1,141,649 1,047,196 (94,453) $ 4,832,809 $ 4,302,888 $ (529,921) Equity Securities: Common Stock For 12 months or more $ 3,215,176 $ 1,777,389 $ (1,437,787) For less than 12 months 6,285,281 4,903,073 (1,382,208) $ 9,500,457 $ 6,680,462 $ (2,819,995) Total For 12 months or more $ 6,906,336 $ 5,033,081 $ (1,873,255) For less than 12 months 7,426,930 5,950,269 (1,476,661) $ 14,333,266 $ 10,983,350 $ (3,349,916) -15-

20 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4. INVESTMENTS (CONTINUED) Major categories of net investment income are summarized as follows: Fixed maturities $ 3,272,862 $ 3,357,978 Equity securities 1,501, ,127 Premium finance interest 375, ,328 Mortgage loans 93,271 77,336 Short-term investments 1,172 2,763 Other 174, ,459 5,417,953 4,708,991 Investment expenses: Surplus note interest 412, ,965 Other investment expense 587, , , ,144 Net investment income $ 4,418,387 $ 3,731,847 The Company carries its bonds at amortized cost unless they are downgraded in accordance with the NAIC Securities Valuation Office. The book value and fair value of the bonds held at are as follows: 2012 EXCESS BOOK FAIR OVER (UNDER) VALUE VALUE BOOK VALUE Mortgage-backed securities $ 16,219,049 $ 17,424,264 $ 1,205,215 U.S. Government securities 39,882,331 43,636,875 3,754,544 Industrial and miscellaneous 3,316,355 3,574, ,450 Other government bonds 25,145 25, $ 59,442,880 $ 64,661,195 $ 5,218, EXCESS BOOK FAIR OVER (UNDER) VALUE VALUE BOOK VALUE Mortgage-backed securities $ 10,586,365 $ 11,668,363 $ 1,081,998 U.S. Government securities 40,695,159 43,547,586 2,852,427 Industrial and miscellaneous 4,634,247 4,989, ,651 $ 55,915,771 $ 60,205,847 $ 4,290,

21 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4. INVESTMENTS (CONTINUED) Fixed maturities investment income includes $40,022 and $331,524 of realized losses and $140,694 and $190,157 of realized gains in 2012 and 2011, respectively. The Company has determined the fair value of its investments through the application of SSAP No. 100 Fair Value Measurements. Under SSAP No. 100, all of the Company s investments are measured using the market approach on a recurring basis using Level 1 or Level 2 inputs. Level 1 inputs are quoted prices in active markets as of the measurement date. Level 2 inputs are quoted market prices for similar assets in inactive markets as of the measurement date. At, all equity securities were measured with Level 1 inputs, with all special revenue bonds, industrial bonds, and miscellaneous bonds being measured with Level 2 inputs. The amortized cost and fair value of investment securities at December 31, 2012, are as follows: FAIR FAIR VALUE VALUE UNREALIZED COST (LEVEL 1) (LEVEL 2) GAINS/(LOSSES) Common Stock Industrial and miscellaneous $ 12,456,021 $ 11,908,478 $ - $ (547,543) 2012 Bonds U.S Political Subdivisions 1,075, ,565 (386,414) Special revenue bonds 1,485,183-1,437,245 (47,938) Industrial and miscellaneous 300, ,994 (12,006) 1,785,183-2,414,804 (446,358) Total $ 14,241,204 $ 11,908,478 $ 2,414,804 $ (993,901) The amortized cost and fair value of investment securities at December 31, 2011, are as follows: FAIR 2011 FAIR VALUE VALUE UNREALIZED COST (LEVEL 1) (LEVEL 2) GAINS/(LOSSES) Common Stock Industrial and miscellaneous $ 14,646,721 $ 14,297,837 $ - $ (348,884) Bonds Special revenue bonds 1,702,008-1,523,614 (178,394) Industrial and miscellaneous 400,098-98,286 (301,812) 2,102,106-1,621,900 (480,206) Total $ 16,748,827 $ 14,297,837 $ 1,621,900 $ (829,090) -17-

22 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4. INVESTMENTS (CONTINUED) Other invested assets consist of a collateral loan and an investment in an LLC. At December 31, 2012 and 2011, the collateral loan had an outstanding balance of $3,066,254 and $4,254,298, respectively. The investment in the LLC had an outstanding balance of $1,180,304 and $1,195,618 at, respectively. The Company also holds an investment in Lawyers Reinsurance, Co. totaling $506,138 and $1,014,512 as of, respectively, which is accounted for using the equity method of accounting. In 2012, the Company received a dividend from Lawyers Reinsurance, Co. in the amount of $625,367. The change in value of this investment from 2011 to 2012 is primarily attributable to the accounting treatment of the 2012 dividend under the equity method of accounting. The Company has disaffiliated with the organization and the investment is classified as common stock in the statement of admitted assets. NOTE 5. MORTGAGE LOANS During 2007 and 2008, the Company invested in mortgage loans with an initial principal amount of $1,640,000. The loans have annual percentage rates ranging from 6.5% to 13%. Principal repayments in the amount of $198 and $379 were received by the Company during 2012 and 2011, respectively. As of, the loans are recorded at a book value of $1,082,281 and $1,082,478, respectively. During 2012 and 2011, the Company did not reduce the interest rate on its commercial mortgage loans. The maximum percentage of any one loan to the value of the security at the time of the loan, exclusive of insurance, guarantee or any purchase money mortgages was 80%. There were no taxes or any other amounts advanced which have not been included in the mortgage loan balance. At, one of the three mortgage loans had interest in excess of 150 days past due. The overdue loan has an outstanding principal balance of $306,165 and $292,852 as of, of which the Company has recorded an allowance of $31,935 and $18,623, respectively. The Company does not accrue interest on overdue loans. NOTE 6. FEDERAL INCOME TAX The Company files a consolidated income tax return with its parent, ALPS Corporation, and other wholly owned subsidiaries of ALPS Corporation. ALPS Corporation charges or credits each of its subsidiaries for each subsidiary s proportionate share of taxable income or loss contributed to the consolidated group at the effective income tax rate paid each year. At, the income tax payable represents amounts owed to the Internal Revenue Service and other subsidiaries of ALPS Corporation for use of the other subsidiaries tax benefits. The Company is not subject to state income taxes. -18-

23 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6. FEDERAL INCOME TAX (CONTINUED) The Company follows the provisions of SSAP No. 101 Income Taxes. Under this method, deferred tax assets and liabilities are determined based on differences between statutory financial reporting and tax bases for assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. For 2012 and 2011, the income tax provision differed from that expected using statutory rates due to the temporary differences attributable to the loss reserve discount adjustment, unearned premiums, and disallowed accrued expenses which are not deductible until paid. The components of net deferred federal income tax assets are as follows for December 31: Gross deferred federal income tax assets Discounting unpaid losses $ 1,408,400 $ 1,550,500 Unearned premium reserve 999, ,285 AMT credit 1,682,312 1,682,312 NOL carryforward - 587,974 Other temporary differences 94,816 23,297 Investments 368, ,197 Total deferred federal income tax assets $ 4,553,489 $ 5,134,565 Gross deferred federal income tax liabilities Ordinary - (5,589) Investments (43,856) (49,502) Total deferred federal income tax liabilities (43,856) (55,091) Net deferred federal income tax asset 4,509,633 5,079,474 Deferred federal income tax assets nonadmitted (2,386,564) (3,529,416) Net admitted deferred federal income tax asset $ 2,123,069 $ 1,550,058 Increase (decrease) in deferred federal income tax assets nonadmitted $ (1,142,852) $ 482,636 Under SSAP No. 101 Income Taxes, the following thresholds were used in the calculations of admissibility: Percentage used to determine recovery period and threshold limitation amount 369% 337% Adjusted capital and surplus used to determine recovery period and threshold limitation $ 31,977,781 $ 29,174,

24 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6. FEDERAL INCOME TAX (CONTINUED) Components of the total income tax provision charged to operations for the years ended December 31 are as follows: U.S. federal $ 768,470 $ (8,376) Foreign 9,385 13,273 Subtotal 777,855 4,897 Federal income tax on net capital (gains) losses (244,820) 167,591 Total federal and foreign tax $ 533,035 $ 172,488 The differences between the total provision for income taxes and income taxes computed using the U.S. federal income tax rate is as follows: Amount computed using statutory rate $ 1,876,006 $ (386,419) Increase (reduction) in tax resulting from: Premium deficiency reserve adjustment (17,150) 17,150 Tax reserves adjustment (90,136) 49,208 Unearned premiums 22,810 6,290 Tax exempt interest (84,589) (168,751) Dividends received deduction (261,836) (221,636) Travel and entertainment Other than temporary impairments 21, ,125 Utilization of capital loss carryforwards (97,997) - Deferred compensation 94,799 - NOL deduction (574,847) - Other/AMT adjustments 19,656 11,463 Subtotal 908,179 (587,975) Tax agreement allocation - 579,599 Adjustment to prior year estimate (239,442) - AMT tax expense 99,733 - Foreign income tax 9,385 13,273 Income tax expense $ 777,855 $ 4,

25 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6. FEDERAL INCOME TAX (CONTINUED) At December 31, 2011, the Company had a net operating loss carry forward of $1,679,927 that that was used to reduce taxable income in At December 31, 2012, the Company did not have an operating loss carry forward available to offset against future taxable income. At, the Company had alternative minimum tax credits of $1,682,312 available for recoupment in the event of future net income. NOTE 7. REINSURANCE The Company controls its exposure to large claims through the use of reinsurance. These contracts limit the Company s liability to $350,000 per claim for policies written after June 30, 2010; $337,500 per claim for policies written between June 30, 2009 and June 30, 2010; $312,500 per claims for policies written between June 30, 2007 and June 30, 2009; $500,000 per claim for policies written between April 1, 2002 and June 30, 2007; $350,000 for policies written between April 1, 1999 and March 31, 2002; and $250,000 for policies written between October 1, 1994 and March 31, Certain reinsurance agreements contain a provision for contingent profit sharing to be paid to the Company based on actual favorable loss experience. Contingent profit sharing is recorded when the experience is known and then reviewed on an annual basis. The Company s reinsurance treaties have no aggregate caps on claims submitted to reinsurers. Risks reinsured would become the liability of the Company only to the extent any reinsurer is unable to fulfill obligations under the agreement. Additionally, the reinsurers obligations under the Company s reinsurance treaties continue in the event of the Company s insolvency. The Company holds letters of credit in the amount of approximately $19,215,000 and $20,791,000 at, respectively, to secure recoverable balances from unauthorized reinsurers. -21-

26 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7. REINSURANCE (CONTINUED) The Company has unsecured aggregate recoverable for losses, paid and unpaid, loss adjustment expenses and unearned premium with the following individual reinsurers, authorized or unauthorized, exceeding 3% of policyholders surplus at December 31: Allied World Assurance Co. Ltd. $ 1,297,000 $ 1,223,000 American Safety Reinsurance Ltd. 7,679,000 8,593,000 Aspen Insurance 2,120,000 1,750,000 AXA RE 1,328,000 - Everest Reinsurance Co. 1,688,000 1,464,000 JRG Reinsurance Co. 4,043,000 2,839,000 Lawyer's Reinsurance Co. 1,716,000 1,942,000 Lloyd's LIB ,583,000 2,287,000 Paris Re - 1,677,000 Transatlantic Reinsurance Co. 1,980,000 1,694,000 $ 23,434,000 $ 23,469,000 The Company has commission equity in the amount of $70,076 and $59,692 on ceded unearned premiums of $5,579,500 and $4,688,364 as of, respectively. No accrual has been made for additional or return commissions based on actual loss experience of the reinsured business at. -22-

27 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 8. LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVES The following table provides a reconciliation of the beginning and ending reserve balances for losses and loss adjustment expenses (LAE), net of reinsurance recoverable, for 2012 and 2011: Reserve for losses and LAE, beginning of year (net of reinsurance recoverable of $24,307,414 and $21,123,039, in 2012 and 2011, respectively) $ 46,502,387 $ 43,945,002 Add provision (reduction) for losses and LAE, net of reinsurance, applicable to claims reported in: Current year 18,505,000 22,478,000 Prior years (3,025,495) (805,249) Total incurred losses during the current year 15,479,505 21,672,751 Payments for losses and LAE, net of reinsurance, reported in: Current year 5,532,852 5,815,098 Prior years 13,689,334 13,300,268 Net claim payments during the year 19,222,186 19,115,366 Reserve for losses and LAE, end of year (net of reinsurance recoverable of $25,254,926 and $24,307,414 in 2012 and 2011, respectively) $ 42,759,706 $ 46,502,387 Reserves for incurred losses and LAE attributable to claims reported to the Company in prior years have decreased by $3,025,497 and $805,249 during 2012 and 2011, respectively. These changes are generally the result of ongoing analysis of claim files. Original estimates are increased or decreased as additional information becomes known regarding individual claims. In the ordinary course of its insurance operations, the Company is regularly engaged in litigation to determine insurance coverage and other issues related to a claim. Provision for this type of litigation has been recognized by management as part of the reserves disclosed in these statements. In addition, the Company has made reserve provisions for liabilities arising from extra-contractual obligations and excess policy limit obligations in relation to its obligations under its professional liability insurance policy. -23-

28 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 8. LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVES (CONTINUED) As of, the amount of reserve credit recorded for high deductibles on unpaid losses was approximately $3.5 million and $3.7 million, respectively. The amounts billed and recoverable as of were $253,138 and $220,256, of which $57,823 and $49,995 was nonadmitted, respectively. NOTE 9. CONTINGENT LIABILITY The Company is not aware of any pending or threatened litigation or any unasserted claims or assessments that management considers to be probable of assertion, and that, if asserted would have at least a reasonable possibility of an unfavorable outcome, the risk of which has not been adequately insured against or provision for which has not been adequately reserved. NOTE 10. OUTSTANDING SHARES The Company had 5,000,000 shares of $1 par value common stock authorized, issued and outstanding at. NOTE 11. DIVIDEND RESTRICTIONS Dividends on common stock are declared by the Company s Board of Directors. Under the insurance regulations of the state of Montana, dividends are classified into two types: ordinary and extraordinary. Ordinary dividends require 15-day advance notice to the Commissioner of Insurance prior to payment. Extraordinary dividends, those which in total exceed 10% of the current year-end policyholders surplus, require approval from the Commissioner 30 days prior to payment. Following the years ended, dividends in excess of $3,364,581 and $3,072,413, respectively, would be considered extraordinary. An ordinary dividend in the amount of $625,000 was declared and paid by the Company on December 28,

29 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 12. EMPLOYEE BENEFIT PLANS The Company is a participating employer in a qualified, defined contribution plan known as the ALPS Corporation 401(k) Profit Sharing Plan (the Plan ). The Plan is designed as a type of qualified retirement plan commonly referred to as a 401(k) Safe Harbor Plan. The Plan allows participants to make salary deferral contributions to the Plan on a pre-tax basis. In addition, the Company contributes a fixed safe harbor non-elective contribution to the Plan on behalf of each eligible participant. The amount of the Company s safe harbor contribution is equal to 3% of each eligible participant s compensation. Further, the Company may, at its discretion, make additional matching contributions and/or profit sharing contributions to the Plan. During Plan years 2012 and 2011, the Company made total contributions of $76,056 and $154,691, respectively. Effective January 1, 2013, the Plan was amended and restated to eliminate the fixed safe harbor non-elective contribution and to provide for a safe harbor matching contribution. Under the safeharbor matching contribution formula, the Company will now make a matching contribution to each eligible participate in an amount equal to 100% of a participant s salary reduction contribution up to 6% of a participant s eligible compensation. NOTE 13. BONDS HELD IN TRUST The Company has placed in trust with the Montana Commissioner of Securities and Insurance investments valued at $2,791,753 and $2,688,868 at, respectively, as required by state law. NOTE 14. AFFILIATED COMPANIES AND RELATED PARTY TRANSACTIONS ALPS Corporation is the parent company and 100% shareholder of the Company. ALPS Corporation provides administrative services, marketing services, office space, and office equipment to the Company for a fee. An affiliate of the Company provides investment administrative services. The amounts paid by the Company for these services were as follows: Administrative services $ 4,890,578 $ 3,700,000 Investment management services 406, ,088 Rent 172, ,358 Commissions 2,662,185 2,192,284 $ 8,130,894 $ 6,451,

30 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 14. AFFILIATED COMPANIES AND RELATED PARTY TRANSACTIONS (CONTINUED) At, the Company reported amounts due to affiliates of $306,115 and $42,269, respectively. At December 31, 2011, the Company reported amounts due from affiliates of $1,364,774. At December 31, 2012, the Company did not report any amounts due from affiliates. In accordance with the ALPS Corporation Long-term Incentive Plan, the Company has accrued $242,000 due to employees. At December 31, 2011, the Company held two promissory notes issued by ALPS Corporation in the principal sums of $2,250,000 dated August 28, 2009, and $2,400,000 dated December 31, ALPS Corporation granted the Company a security interest in certain collateral to secure its payment obligations under each promissory note. The Company, with the explicit permission of the Commissioner of Securities and Insurance of the State of Montana, and in accordance with SSAP 25 and 64, classified the balances as a collateral loan under other invested assets. At December 31, 2011, the two promissory notes had an outstanding balance of $1,854,298 and $2,400,000, respectively. Both of the foregoing promissory notes were restructured into a single promissory note, dated June 30, 2012, in the original principal sum of $3,309,377. The debt restructuring transaction was approved by the Montana Commissioner of Securities and Insurance. Terms of the June 30, 2012 note called for ALPS Corporation to pay 24 quarterly installment payments in the amount of $158,115, including interest at 4.5% per year, commencing on June 30, ALPS Corporation has timely paid the installment payments due under the June 30, 2012 note. To collateralize and secure all payment obligations under the June 30, 2012 note, the Company obtained a security interest in future payments that ALPS Corporation will receive under the terms of an Asset Sale and Purchase Agreement, and obtained a pledge and security interest in a highly liquid investment account owned by a member of management. As of December 31, 2012, the fair market value of all collateral exceeded the outstanding balance of the June 30, 2012 note. At December 31, 2012, the June 30, 2012 note had an outstanding balance of $3,066,254. The Company, with the explicit permission of the Montana Commissioner of Securities and Insurance, and in accordance with the Statement of Statutory Accounting Principles 25 and 64, has classified the collateral loans under other invested assets as of. -26-

31 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 14. AFFILIATED COMPANIES AND RELATED PARTY TRANSACTIONS (CONTINUED) Subsequent to December 31, 2012, and with the permission of the Montana Commissioner of Securities and Insurance, the Company allowed ALPS Corporation to restructure the June 30, 2012 promissory note in consideration of ALPS Corporation making additional payments to reduce the outstanding balance of the promissory note by approximately fifty percent (50%). Accordingly, ALPS Corporation issued a newly restructured note, dated March 7, 2013, in the principal sum of $1,530,000. Terms of the March 7, 2013 note call for ALPS Corporation to pay 21 quarterly installment payments of $90,000, including interest at 2.51% per year, commencing on June 30, The restructured note allows for the pledge and security interest in a highly liquid investment account owned by a member of management to be released. NOTE 15. NONADMITTED ASSETS A summary of assets nonadmitted under the state of Montana statutes is as follows: Balance of nonadmitted assets - beginning of the year $ 3,610,433 $ 3,119,206 Change in accounting principle (508,003) - Increase (decrease) in nonadmitted assets: Reinsurance recoverable 178,598 12,072 Deductible receivables 7,828 (15,230) Prepaid expenses (5,049) 11,749 Deferred tax assets (634,849) 482,636 Net increase (decrease) (961,475) 491,227 Balance of nonadmitted assets - end of year $ 2,648,958 $ 3,610,

32 NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 16. SURPLUS NOTES The Company has issued the following surplus debentures or similar obligations: Principal 2012: and/or Principal Unapproved Total Interest and/or Principal Interest Carrying Paid Interest and/or Date of Date Issued Rate Par Value Value Current Year Paid Interest Maturity 1) 10/14/2005 LIBOR % $ 10,000,000 $ 10,000,000 $ 412,344 $ 4,285,170 $ 19,290 12/15/2035 2) 12/23/2005 None 1,414,258 1,414, ,819 6,221, ,583 None Principal 2011: and/or Principal Unapproved Total Interest and/or Principal Interest Carrying Paid Interest and/or Date of Date Issued Rate Par Value Value Current Year Paid Interest Maturity 1) 10/14/2005 LIBOR % $ 10,000,000 $ 10,000,000 $ 391,965 $ 3,872,836 $ 17,068 12/15/2035 2) 12/23/2005 None 1,543,921 1,543, ,480 5,364, ,794 None 1) The Company received cash in exchange for a surplus note in the amount of $10,000,000 issued to Merrill Lynch International on October 14, This note is administered by US Bank, National Association, as trustee and has the following repayment conditions and restrictions: (1) payment of interest and principal to be made quarterly in arrears on the 15th of March, June, September, and December and only with the prior approval of the Montana Commissioner of Securities and Insurance; (2) payment of principal prior to December 15, 2010, results in a penalty on principal balance, which is 1% in These notes are junior in right of payment to the prior payment in full of all senior indebtedness and senior claims of the Company. As of December 31, 2012, there have been no principal repayments on this note. 2) The Company s parent, ALPS Corporation, transferred a liability on its books resulting from the redemption of common stock to the Company in the amount of $1,940,892 on December 23, This liability was then simultaneously converted to a surplus note under the approval of the Montana Commissioner of Securities and Insurance. Payment to shareholders of redeemed shares of ALPS Corporation common stock (transferred liability) is based upon the amount of the total value of the shares on the redemption date and is subject to a repayment schedule between one and seven years. Payments to shareholders are issued on a quarterly basis in the months January, April, July, and October and are issued only upon prior approval of the Montana Commissioner of Securities and Insurance. Obligation under this note is subordinated in payment to other indebtedness due to creditors and policyholders of the Company. During 2012 and 2011, new redemptions of stock were $726,250 and $1,277,218, respectively. -28-