S OA R I N G TO N E W H E I G H T S . ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT 1 T H E Y E A R I N R E V I E W Our roots are in North Dakota, where honesty and trust are abundant. Our customers are neighbors, friends, and family, and if they’re not, we still consider them as such. In recent years, we’ve grown our company, but haven’t outgrown our relationships. Our customers all have hopes and dreams, and they all deserve a financial partner that’s invested in them. Our pledge to be that partner keeps us grounded, even as we soar to new heights. DIVERSIFIED REVENUE STREAM 39.4% ($51,078,000) 60.6% ($78,406,000) NET INTEREST INCOME NON-INTEREST INCOME 1.3% DEPOSIT FEES 4.7% OTHER 8.7% WEALTH MANAGEMENT INCOME 14.2% MORTGAGE FEES 31.7% RETIREMENT SERVICES FEES N AT I O N A L LY R E CO G N I Z E D FO R O U R P E R FO R M A N C E Ranked 10th as a Top Performing Mid-Size Bank for public banks and thrifts with total assets of $1-10 billion by the American Bankers Association, up from 23rd last year. Earned BauerFinancial’s highest 5-star rating, a distinction for banks excelling in areas of capital adequacy, profitability, and asset quality. Ranked 62nd of top performing banks with trust departments based on annual revenue by Trust Performance Report, the fiduciary industry’s only comprehensive source of gross revenue, net income, and expenses, up from 64th last year. 2 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT COMPANY PORTFOLIO CORE BUSINESS LINES ALERUS TEAM Diversified Financial Services Company $1.5 billion banking assets $2.9 billion wealth management assets $15.5 billion retirement services assets Business Banking • Commercial and commercial real estate lending 660 employees Grand Forks, ND • Agriculture lending • Treasury management • Deposit services $600 million brokerage assets Consumer Banking SHAREHOLDER VALUE • Deposit services • Consumer lending Earnings per common share: $1.44 • Private banking Mortgage • Residential mortgage lending • Purchase or refinance • Residential construction lending • Home equity/second mortgages Wealth Management • Trust and fiduciary services • Investment management • Financial planning • Philanthropic giving Dividends per share: $0.38 Year-end stock price: $19.75 Total shareholder return: 18.57% CORE STRENGTHS Strong balance sheet Diversified earnings Relationship-oriented business model Commitment to business expansion opportunities CUSTOMER BASE 39,896 consumers 7,612 businesses 4,998 employer-sponsored retirement plans 273,963 employer-sponsored retirement plan participants Retirement Services • Retirement plan administration Serve customers in 49 states through retirement plan services • Retirement plan investment advisory • ESOP fiduciary services 5 full-service banking and wealth management offices Fargo, ND 5 full-service banking and wealth management offices Twin Cities, MN 4 full-service banking offices 3 residential mortgage offices 1 wealth management office Scottsdale, AZ 1 full-service banking and wealth management office NATIONAL PRESENCE 2 retirement services offices in Minnesota 2 retirement services offices in Michigan 1 retirement services office in New Hampshire Ranked 57th in the Top 200 Community Banks listing by American Banker. Ranked in the top 15th percentile of community banks by Seifried & Brew, a community bank risk management firm. Ranked 70th of best performing community banks with assets between $500 million and $5 billion by SNL Financial, a leading provider of financial information. Ranked 26th for number of sponsors, 35th for number of participants, and 34th for size of plan assets under management by Pension & Investments, who ranks the top recordkeepers nationally by size; up from 30th, 42nd, and 38th respectively. Received a financial strength rating of “A” or “Excellent” from Weiss Ratings, an independent provider of ratings and analyses of financial service companies whose rigorous standards place greater emphasis on a company’s future financial solvency and its ability to withstand severe economic adversity. Named one of the Best Banks to Work For by American Banker and Best Companies. 3 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT DEAR SHAREHOLDERS, CUSTOMERS, AND FRIENDS It is my distinct pleasure to report to you another strong year for Alerus Financial. I continue to be inspired by the people of Alerus, whose passion allows us to sustain and grow the company. OUR PERFORMANCE STORY As Alerus grows and becomes more complex, it is critical that we communicate not only our results, but also the story behind those results. We earned net income of $20.2 million in 2014, a slight decrease of 0.2% from 2013 when we earned $20.3 million. Earnings were $1.44 per common share in 2014, compared to $1.46 per common share in 2013. Cash Dividends were $0.38 per share in 2014, compared to $0.34 per share in 2013, an increase of 12.7% or $0.04 per share. The story behind the numbers is always interesting, but particularly so in 2014. First, we completed a 3-for-1 stock split in the third quarter, which the earnings per share numbers above have been adjusted to reflect. Second, we completed two acquisitions during the year and began a third that was completed in early 2015 — significant steps forward for our company. Acquisitions do, however, entail certain one-time costs or adjustments affecting our financial statements and reported performance. An in-depth discussion of these impacts and our overall financial performance is included in our 2014 Financial Report. Third and finally, a significant factor in our earnings for the past three years has been the performance of our mortgage division. In 2012 and 2013, when many homeowners took the opportunity to refinance their homes, we originated $1.2 billion and $1 billion in mortgages, respectively. This brought us revenue of $31.1 million in 2012 and $27.2 million in 2013. As expected, mortgage and refinancing activity was curtailed in 2014, and our originations decreased to $750 million with revenues of $18.4 million. Owing to the diverse nature of our company, we were able to make up this lost revenue with double-digit increases in our banking, retirement, and wealth management businesses to close the year with earnings equal or similar to 2013. Our unique structure continues to afford us the ability to increase cash dividends, support organic and acquisition growth, and invest in the infrastructure we need as we move forward. While I’m very proud of our financial performance and what we have accomplished, I am even more proud of who we are and how we operate as a company. 3 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT OUR BRAND EVOLVES Over the course of the year, we spent a great deal of time discussing our aspirations for growth. As those discussions unfolded, it became clear that expanding into new markets and growing our reach in existing ones would require a tremendously strong brand. Our credibility to new audiences is affected greatly by the impressions we give simply by virtue of our presence. As a result, we changed our marketing identity from Alerus Financial to Alerus, modernized our logo, and developed plans to introduce our new brand mark to our customers and markets in 2015. While our previous logo served us well since 2000, our new brand elements are designed to carry us forward into an exciting future. INVESTING IN INFRASTRUCTURE New products, new technologies, new customer demands — our industry is seeing rapid and constant change on all fronts. Thanks to our strong core operating earnings and the quality of our balance sheet, we are able to make needed capital investments to enhance our infrastructure to meet future challenges. We continue to make investments in information security and privacy protection, hire talented professionals in all departments, and keep abreast of cutting-edge developments in the financial services industry. We have cultivated relationships with professional advisors who provide assistance in infrastructure development and leadership development. We do all this as part of an effort to build and support a company two or three times our current size. SENSIBLE AND STRATEGIC GROWTH Our focus remains on organic growth. The true power of our company lies in our diversified business model, our increasing brand awareness, and in the referrals generated by our satisfied customers and employees. From our outstanding product suite to our considerable talent pool, our internal resources are what allow us to continue to grow in all of our markets and all of our divisions. As I discuss often, our industry has been consolidating since 1980. This trend has led to increased costs requiring institutions to prioritize size and scale if they hope to survive, let alone prosper. Alerus has responded to consolidation by making a number of strategic acquisitions — 16 since 2002. If the right opportunities present themselves, we will look to continue to acquire. To be right for us, the opportunity must be consistent with and supportive of our strategic objectives, and must ultimately help build the Alerus franchise and increase shareholder value. FOUR PILLARS OF SUCCESS In 2014, we identified four key components of our business that demand ongoing attention if we are to achieve immediate and future success. We must focus on our financial performance, meeting ever-increasing customer expectations, supporting our employees, and achieving operational excellence. We refer to these components as our Pillars of Success, and we have built strategic plans around each of them. We devote a great deal of this Annual Report to a discussion of our Pillars. THANK YOU In closing, I would like to express my gratitude to all of you who so loyally support Alerus and have confidence in our company. A special thank you is extended to our senior management team, whose clarity of vision safeguards us as we move forward. Similarly, thank you to our board of directors for your support of the initiatives we present in our efforts to achieve competitive greatness. To shareholders, I continue to be humbled by the trust you place in our company and I am as committed as ever to seeing that you achieve strong returns on your investments. Most importantly, to every employee, know that without you nothing I’ve just discussed is possible. You are the primary reason Alerus is able to continually excel. RANDY L. NEWMAN CHAIRMAN, PRESIDENT & CEO 4 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT S H A R E H O L D E R VA LU E Alerus remains true to its core strengths — serving customers, engaging employees, and supporting communities. These strengths, along with prudent management, have allowed us to reward shareholders with 45* straight years of dividends. In 2014, we made a number of strategic decisions to allow us to continue delivering that value amid significant company growth and industry change. One decision took the form of a 3-for-1 stock split in September. As Alerus stock approached $60 per share, the split adjusted the per-share price to a more affordable level. It also made more shares available in the market, which increased our trading volume. We made this decision after careful consideration and analysis of the historical stock prices of Alerus and other financial institutions. It was a sound decision for the company and for shareholders, and set the stage for additional positive developments. Progress can also be seen in our successful efforts to increase the number of broker-dealers who make a market in our stock. Having these “market makers” interested in the company is important because their presence helps create a more liquid environment where sellers and buyers are able to consummate more trades at fair prices. Broker-dealer interest is a sign that the long-standing value of our company is gaining broader recognition in the market. As our profile increases and as we contemplate future growth, we continue to evaluate ways to allow shareholders to realize the full value of their investment in us. To further increase our visibility with current and future investors, trading of our shares moved to the OTCQX marketplace effective February 2015. Alerus was the 50th bank — and one of the largest — to join this marketplace. *Data only available since 1969. FINANCIAL HIGHLIGHTS FINANCIAL PERFORMANCE (per share calculations adjusted to reflect 3-for-1 stock split in 2014) Reported net income of $20.2 million, down 0.2% from 2013. Cash dividends per share increased 12.74% from $0.34 per share to $0.38 per share. Diluted earnings per share of $1.44, down 1.4% from 2013. Return on average assets (ROA) of 1.42%, down 13 basis points from 2013. Return on equity (ROE) of 13.89%, down 151 basis points from 2013. Company revenue of $129.5 million, up 2.4% from 2013. Banking division revenue of $58.8 million, up 11.6% from 2013. Wealth management division revenue of $11.3 million, up 6.2% from 2013. Retirement division revenue was $41 million, up 14% from 2013. Mortgage division revenue of $18.4 million, down 32.4% from 2013. MAINTAINED STRONG CAPITAL RATIOS Tier 1 capital ratio of 11.8% at year-end 2014. Total risk-based capital ratio of 13.1% at year-end 2014. Tangible common equity to tangible asset ratio of 8.8% at year-end 2014. STRONG CUSTOMER GROWTH Total loans grew $186.3 million to $1.1 billion from 2013. Total deposits grew $79.5 million to $1.26 billion from 2013. Total assets under administration grew $2.6 billion to $15.5 billion from 2013. Total assets under management grew $175 million to $2.9 billion from 2013. CONTINUED STRONG CREDIT QUALITY Total nonperforming assets (including covered assets) decreased $4.2 million or 40.6% from the fourth quarter of 2013; nonperforming assets (including covered assets) to total loans plus other nonperforming assets equaled 0.41% at year-end 2014 compared to 0.74% at year-end 2013. Allowance for loan losses to nonperforming loans (including covered loans) was 426.9% at year-end 2014, compared to 313.1% at year-end 2013. 5 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT SHAREHOLDER RETURNS SHAREHOLDER VALUE Dividends per share (DPS) Earnings per common share (EPS) $0.45 $0.40 $0.35 $0.30 $0.25 (DPS) 2010 2011 2012 2013 2014 $1.50 $1.25 $1.00 $0.75 $0.50 $0.25 (EPS) $25.00 $20.00 $15.00 Year-end stock price Book value per share $10.00 $8.13 $5.00 $7.34 $19.75 $10.85 2010 2011 2012 2013 2014 Finally, 2014 saw Alerus enhance its shareholder-relations capabili- ties by appointing American Stock Transfer & Trust Company, LLC (AST) as our new transfer agent. The move was made prior to our stock split in anticipation of the increased trading activity we hoped it would bring. AST’s involvement makes transferring stock owner- ship easier and lets shareholders hold their shares in book entry form as an alternative to traditional stock certificates. Shareholders can now register to view Alerus stock holdings online at amstock.com. In sum, 2014 was a year of real and exciting progress for Alerus and our shareholders. As a company, we make calculated choices about how best to conduct business. Shareholder value will always be a key factor in those calculations. STRATEGIC HIGHLIGHTS ACQUISITIONS/EXPANSIONS Purchased Private Bank Minnesota in Minneapolis, adding $130 million in banking assets, a customer base made up of executives, professionals, and business owners, and one downtown location. Purchased Retirement Alliance, Inc., in Manchester, New Hampshire, adding 700 plans, 42,000 plan participants, and $2.1 billion assets. COMPANY DEVELOPMENTS Announced a 3-for-1 stock split to broaden our investor base and enhance the trading liquidity of our stock. Announced the strategic decision to change our logo mark and design from “Alerus Financial” to simply “Alerus” to serve as a universal, modern logo. Laid the groundwork to become the 50th bank — and one of the largest — to join the OTCQX Marketplace in early 2015 (effective February 13, 2015) to increase our visibility with current and future investors. CUSTOMER TECHNOLOGY INVESTMENTS Initiated project work to consolidate and redesign Alerus web properties to better represent who we are and to enhance our online presence. Launched a new online banking system for business customers, providing them with enhanced reporting, increased security features, and a user-friendly dashboard containing all account information and tools. Initiated enhancements in fraud monitoring technology, workstation protection, and mobile banking to better serve business customers in 2015. Added a significant new feature, mobile deposit, to our Alerus Mobile Banking app allowing consumers to deposit checks by taking a picture with a smartphone. Partnered with Envestnet Retirement Solutions to provide our retirement plan advisors and sponsors with comprehensive fiduciary services to support their evolving regulatory requirements. 6 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT CUSTOMER PILLAR The need to constantly adapt our business practices to meet customer expectations is one of the most challenging — and most rewarding — aspects of what we do at Alerus. Customers have high expectations, perhaps higher than ever, when it comes to the level of service they receive from their chosen financial institution and how that service is delivered. We continue taking the steps and making the investments needed to provide an outstanding customer experience to all, whether they visit a branch, call us, or engage with us digitally. BALANCING CONVENIENCE, PRIVACY, AND CHANGE There is no question that the financial industry is moving more and more toward online and mobile technologies. Alerus was an early adopter of mobile banking technology in 2008, and we launched our mobile app in 2013 for consumers, with a business mobile app launch planned for 2015. We significantly upgraded our online banking system for business customers in 2014, and will unveil a new consumer online banking system in April 2015. Our wealth management division implemented eMoney Advisor software this year to enhance its ability to serve customers, while our retirement division rolled out a notification system that sends confirmation emails to plan participants who make a Web-based transaction. Conveniences such as these help us provide an exceptional customer experience. They also require us to be even more vigilant in protecting our customer data and private information. To that end, we continue to invest in the technology and staff that are so critical to this effort. We continually create and update policies and procedures for safeguarding data and shielding the company from the potential legal and reputational damage that comes with security breaches. 7 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT ADAPTING TO ONE-OF-A-KIND CHALLENGES We’ve been hard at work developing specialized services that offer customers personalized solutions. ONE ALERUS REACHING MORE CUSTOMERS The customers we best align with are those who seek long-term partnerships with a financial institution, customers seeking ongoing assistance in developing their personal and professional finances. We gain those customers through organic means and also through carefully considered acquisitions. A good example of the latter was our June 2014 acquisition of Private Bank Minnesota, which expanded our Twin Cities private banking and professional services customer segment. The fact that we retained the overwhelming majority of Private Bank Minnesota customers is a testament to the way we approach acquisitions and the energy we expend proving our worth to new customers. We will continue searching for opportunities to reach more new customers and for the chance to impress upon them the distinctive qualities that make Alerus special. Technology alone cannot deliver a stellar customer experience; it is what we do and how we do it that helps us stand out from the crowd. What we do best is customer advocacy — a specialized form of sales and service that focuses on finding personalized ways to help customers achieve their goals. The way we do this is by providing customers with a primary point of contact, a trusted advisor, who takes the time to develop a real knowledge and understanding of each customer he or she serves. One of the overarching goals of this method is to position us as a financial services company that plays an active role in our customers’ success at all stages of their lives, providing a road map for their financial success. The advisor is the personification of a movement we call “One Alerus.” It means that a given advisor is empowered to reach across the organization to bring a customer in contact with a specialist in mortgage, wealth management, banking, or retirement. One Alerus thus represents a bridging of the gaps between our business units in the name of customer advocacy — customers can easily access the professional service they deserve through their advisor, without the need to search for help on their own. 8 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT EMPLOYEE PILLAR OUR FUNDAMENTAL BELIEFS What makes Alerus a place where people can place their trust? We like to think it’s our employees’ commitment to our core principles. DO THE RIGHT THING People do business with people they trust. CHERISH PEOPLE Take care of your co-workers so everyone can take care of customers. EMPOWER WITH KNOWLEDGE Knowledge drives confidence and positive action. RESPECT EVERYONE Mutual respect is an important building block of good teamwork. SERVE WITH PASSION Foster a culture of service. EMBRACE CHANGE Success is never final. SUSTAINED EXCELLENCE WILL BE REWARDED Conversations about the health of a company, particularly in our industry, tend to focus largely on numbers — capital ratios, loans and deposits, mortgage originations, assets under management, and so forth. At Alerus, however, we are ever mindful of the fact it is our employees and their commitment to excellence that makes the numbers conversation a pleasant one. Therefore, we support our employees in every way that we can, knowing that our growth and success is not possible without an engaged and motivated employee base. Our efforts in this vein are being recognized, as we were named one of the Best Banks to Work for in 2014 by American Banker, based on a combination of employee surveys and an evaluation of workplace policies, practices, and demographics. 9 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT SUPPORTING OUR COMMUNITY ANY WAY WE CAN We remained steadfast in our commitment to the employees and neighbors that have helped us grow and prosper. DEVELOPING LEADERS CHARITABLE GIVING Recognizing that our current and future prosperity hinges in large part on the strength and vision of leaders, we created a formalized leadership development program in 2014. The program addresses employees at all levels of the company, defining what it takes to be an outstanding leader at Alerus no matter what position an individual occupies. We are proud to support our communities and a variety of charitable organizations that do so much good for so many people. In 2014, we continued our longstanding commitment to charitable giving through our Connect with the Community program. Our commitment includes corporate giving, scholarships, and employee volunteerism. We contributed nearly $500,000 in 2014 to organizations including United Way, the Salvation Army, local food shelves, and a host of other worthy charities too numerous to mention in the limited space of this Annual Report. We also donated to various park districts, schools, and public programs across our markets. Our mortgage division was especially active in its charitable giving in the Twin Cities market, contributing $100 per closing to Second Harvest Heartland and other entities, with total donations of just over $250,000 for the year. The mortgage team has donated more than $2,000,000 over the life of this program. Our commitment to communities is more than financial; our employees collectively donate hundreds of hours of their time to the causes they cherish. We encourage this charitable spirit by providing every employee with paid time off each year to volunteer at non-profits of their choosing. The program takes a would-be leader on a journey from self-leadership to executive leadership, with a series of intermediate steps along the way. Each phase of the process pushes the employee to cultivate new skills and adopt new behaviors befitting leaders in positions of increasing responsibility. In this fashion, we hope to build a pipeline of future leaders capable of maintaining and improving upon the success Alerus has worked so diligently to achieve. We feel that our leadership development program will play a pivotal role in our company’s sustainable growth in an industry where such growth is a necessity and not a luxury. BUILDING FROM WITHIN Even as we were formalizing the new leadership development process, we remained cognizant of the fact that our company is already home to many employees of substantial ability and demonstrable leadership skill. Recognizing these individuals and promoting from within helps us build a culture of continuity and brings with it a certain clarity of focus. With that in mind, we promoted key leaders to positions such as executive director of wealth management, market president, and chief risk officer, among others. The stability afforded us by internal promotions such as these adds value to our entire company and sends a strong message to employees that sustained excellence will be rewarded. 10 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT OPERATIONAL EXCELLENCE A company’s best-laid plans never come to fruition in the absence of a strong operations team. Assembling and mobilizing resources appropriately is the key to unlocking the potential contained within Alerus. We must, of course, conduct our business within the boundaries drawn up for us by various forces, a small handful of which we discuss here: government, security threats, and infrastructure capability. IN FOCUS: REGULATION AND COMPLIANCE 2014 was another year of increased federal banking regulation. Institutions of our size are seeing a trickle- down effect — the restrictions imposed on larger institutions in the recent past are now becoming restrictions on us. Our response to this heightened scrutiny is focused on regulatory strategy. A well-developed regulatory strategy allows us to define key issues and challenges and proactively discuss these with regulators in an effort to stay ahead of the curve. For example, Alerus developed a capital plan that anticipated the adoption of new capital rules nearly three years in advance of their implementation. This sort of proactive planning helps cultivate strong regulatory relationships and anticipate the competitive impact of regulatory changes. As a general matter, regulators are focusing more on risk management — their objective is to ensure that the banks they regulate are making financially sound decisions and avoiding undue risk. The regulatory regime is designed to ingrain in bank leadership the need to understand risks and plan accordingly in order to garner appropriate risk-adjusted returns. Alerus continues to enhance its capacity to manage its businesses effectively within the current regulatory environment and the regulatory environment of the future. Because we are well positioned financially, we are able to make the investments necessary to remain compliant and prepared for continued regulation. These investments include, among others, improved information technology infrastructure and the hiring of talented people in areas such as audit and compliance. 11 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT STAYING AHEAD OF THE CURVE By proactively defining and meeting operational challenges, we’ve helped ensure our future stays bright. STAYING VIGILANT Outside threats to electronic financial data are more numerous and harbor more damaging potential than ever before. Financial service companies must have agility built into their operations so that they can respond to these threats and prepare for possible future cyber-attacks. Alerus is continually making improvements in the ways we protect customer information from cyber- attacks and cyber fraud. We continue to marshal and deploy people, policies, and systems necessary to protect customers, the company, and ultimately, our shareholders. Our employee training methods have evolved and we emphasize to them the importance of recognizing subtle and nuanced attempts by would- be cyber-criminals to make their way into our systems through various channels. The risk to sensitive information posed by hacking and malware is real, but it is not the only risk. Social engineering — attempts to obtain confidential information through the manipulation of employees — is an issue as well. Social engineers use a variety of tactics designed to take advantage of the very foundation of customer service — friendly and helpful employees. Securing our customers and our company against social engineering efforts and cyber-crime will be one of the most critical and taxing aspects of financial services for many years to come. Alerus is confronting these issues head-on and working diligently to protect customer data, our most important asset. BOLSTERING OUR INFRASTRUCTURE Our ability to integrate acquired companies as well as grow from within throughout 2014 was due, in large part, to the investments we made in infrastructure in preceding years. We will need to lay even more groundwork to replicate that success going forward. Our focus is on developing scalable systems and processes that are capable of growing with us. We envision optimizing everything from hardware and servers to project management systems to teams of employees. This is an open-ended process that demands continued attention and revision in response to competitive pressures, rising customer expectations, and rapid industry change. This is an exciting time for all of us at Alerus. We look forward to making infrastructure improvements that bring added value to our company and pave the way for sustainable growth. 12 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT THE FUTURE OF THE INDUSTRY The industry faces challenges on a number of fronts: technology, privacy, cybersecurity, increased regulatory costs, and low interest rates. Consolidation will continue to be driven by the expenses associated with these and other factors. Roughly 5,000 banks are expected to exist in the United States by 2020, a reduction of about two-thirds from the 15,000 that existed in 1990. As Web-based and mobile functionality proliferates, financial institutions and customers will continue to be threatened by risks to data. Significant investments in technology and personnel must be made to protect customer information and institutional data against cyber-attacks. Community banks will face increased regulatory scrutiny and expensive compliance measures. In fact, the Federal Reserve Bank in Minneapolis quantified the costs stemming from Dodd-Frank’s consumer protection rules, which apply to all banks, and found that the smaller the bank, the greater the effect these rules had. Such outcomes are likely to mean higher expenses and, potentially, lower earnings for community banks across the country. The low interest rate environment is expected to persist, which will impact banks whose business models are traditional — dependent largely upon interest income. Alerus is in an enviable position in this regard because 60% of our revenue is fee- generated and not dependent on interest rates. Our structure as a highly diversified professional service firm — not simply a bank — has us well positioned to thrive in a rate environment where other institutions might struggle. IN CLOSING We will look back at 2014 as a crucial moment in the history of Alerus. Our strong performance and thoughtful planning will serve us well as we move into the future. Thanks to the support of our Board, the dedication of our employees, and the commitment of our shareholders, we are fully prepared to benefit from our unique position in the market, to confront challenges as they arise, and to take advantage of the opportunities that are presented. THRIVING WHERE OTHER INSTITUTIONS MIGHT STRUGGLE Ultimately, our unique, highly diversified financial positioning sets us up for even more success. 13 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT SENIOR MANAGEMENT TEAM Randy L. Newman Chairman, President & Chief Executive Officer 34 YEARS WITH ALERUS Kris Compton Chief Operating Officer 40 YEARS WITH ALERUS Eric Carlson, CFA Chief Financial Officer 21 YEARS WITH ALERUS Jay Kim Executive Vice President, General Counsel & Director of Corporate Development 3 YEARS WITH ALERUS John Flesch Executive Vice President, Wealth Management & Retirement Services 13 YEARS WITH ALERUS David Latta Executive Vice President, Market Management 9 YEARS WITH ALERUS Jon Hendry Executive Vice President, Chief Information Officer 31 YEARS WITH ALERUS Karl Bollingberg, CFP® Executive Vice President & Director of Banking Services 28 YEARS WITH ALERUS BOARD OF DIRECTORS LEADERSHIP TEAM Randy L. Newman, Chairman, President, and Chief Executive Officer, Alerus Financial, N.A., Alerus Financial Corporation, Grand Forks, ND Karen M. Bohn, President, Galeo Group, LLC, Edina, MN; Former Chief Administrative Officer, Piper Jaffray Companies; Former Chief Executive Officer, Piper Trust Company Lloyd G. Case, Past President and CEO of Forum Communications Company, Fargo, ND; Board of Directors, Forum Communications Harold A. Gershman, President, Gershman Enterprises, LLC, Grand Forks, ND; President, Happy Harry’s Bottle Shops A. Bart Holaday, Retired Managing Director, Brinson Partners and UBS, Asset Management, Colorado Springs, CO; Grand Forks, ND James J. Karley, President, Johnstown Bean, Cavalier Bean Companies, and North Central Commodities, Gilby, ND Kevin D. Lemke, President, Virtual Systems, Inc., Grand Forks, ND Sally Smith, President and Chief Executive Officer, Buffalo Wild Wings, Inc., Minneapolis, MN Galen G. Vetter, Retired Global Chief Financial Officer, Franklin Templeton Investments; Former Partner-In-Charge, Upper Midwest Region, McGladrey, Minneapolis, MN Market President, Grand Forks | Chris Wolf, CPA Market President, Fargo | Dan Doeden Market President, Twin Cities | David “Chip” Norris Market President, Phoenix Metro | Rob Schwister Customer Segment Management | Jon Handy Professional Services and Private Banking | Sara Ausman Deposits | Karna Loyland Loans | Dan Jacobson Mortgage Loans | Steve Sherwood and Jan Fitzer Retirement Services | Brian Overby, CEBS Retirement Plan Advisory Services | Lee Kliebert, JD, AIF® ESOP Fiduciary Services | Nels Carlson Wealth Management | Ann McConn, JD, CFA, CFP® Trust and Investments | Doug Carpenter, CPA, CFP® Alerus Investment Advisors | Sunil Swami Brokerage Services | Brian Kraft Audit Management | Chad Johnson, CPA Human Resources | Teresa Wasvick, SPHR Marketing | Kara Fosse, CFMP Corporate Communications | Missy Keney Technology | Chris Dunnigan Project Management | Tammy Adam Information Security | Kyle Hendrickson Branch Operations | A.J. Zielike Compliance | Bonnie Upham Enterprise Risk Management | Mark Nelson Finance and Accounting | Jerrod Hanson, CPA 14 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT 1 3 6 Y E A R S O F G R O W T H 1879 1933 1985 1986 1987 1989 1991 1997 2000 2002 2003 2006 2007 2009 2011 2012 2013 2014 2015 Founded as the Bank of Grand Forks, one of the first chartered in Dakota Territory. First National Bank in Grand Forks opened its doors in Grand Forks, North Dakota. Acquired Northwood State Bank in Northwood, North Dakota. Created Employee Stock Ownership Plan for our employees. Acquired West Fargo State Bank in West Fargo, North Dakota. Purchased Dakota Bank in Grand Forks, North Dakota. First National Bank in Grand Forks entered the Fargo market by purchasing a savings and loan, consolidated its banks, and changed its name to First National Bank North Dakota. Historic flood and fire devestated Grand Forks and First National Bank buildings. First National Bank North Dakota changed its name to Alerus Financial to reflect the evolution from a traditional bank to a total financial services company. Acquired a branch of BNC National Bank in Fargo, North Dakota. Purchased Pension Solutions, Inc., a retirement plan services company located in St. Paul, Minnesota, and serving customers across the country. Opened a trust and investment office in the Twin Cities; opened two new branches in Fargo, North Dakota; purchased Stanton Trust Company in Minneapolis, Minnesota. Opened a business banking office in Minnetonka, Minnesota; purchased the retirement recordkeeping services unit of Acclaim Benefits, Inc. in Minneapolis, Minnesota; acquired Stanton Investment Advisors, Inc., a Minneapolis-based investment advisory firm. Expanded into Phoenix, Arizona, through the purchase of a bank branch from Meridian Bank Arizona; purchased the retirement plan practice of Eide Bailly, LLP in Minneapolis, Minnesota; acquired deposits from BankFirst in Minneapolis, Minnesota; acquired Prosperan Bank in Oakdale, Maplewood, and Minnetonka, Minnesota; acquired Residential Mortgage Group in Minnetonka and Arden Hills, Minnesota. Acquired select loans and deposits from BNC National Bank in Minnesota and Arizona, and a branch of BNC in Scottsdale, Arizona. Purchased PensionTrend Inc., and PensionTrend Investment Advisers, LLC, in Okemos, Michigan. Purchased Tegrit Administrators, LLC. Purchased Private Bank Minnesota in Minneapolis, Minnesota; purchased Retirement Alliance, Inc., in Manchester, New Hampshire. Purchased Interactive Retirement Systems, LTD, in Bloomington, Minnesota. 800.279.3200 :: ALERUS.COM :: MEMBER FDIC © 2015 Alerus Financial Corporation 15 ALERUS FINANCIAL CORPORATION 2014 ANNUAL REPORT FINANCIAL REPORT ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT ABOUT ALERUS FINANCIAL CORPORATION Alerus Financial Corporation (the “Company”) through its subsidiaries Alerus Financial, N.A., Alerus Securities Corporation, Alerus Investment Advisors, Inc., and Alerus Financial Insurance Services Corporation, offers business and consumer banking products and services, residential mortgage financing, employer-sponsored retirement plan administration, and wealth management services including trust, brokerage, insurance, and asset management. The Company’s banking and wealth management offices are located in Grand Forks and Fargo, North Dakota, the Minneapolis-St. Paul, Minnesota metropolitan area, and Scottsdale, Arizona. Alerus Retirement Solutions plan administration offices are located in St. Paul, Minnesota, East Lansing and Troy, Michigan, and Manchester, New Hampshire. The common stock of the Company trades on the OTCQX market under the symbol ALRS. ACQUISITIONS During the two years ended December 31, 2014, the Company completed the following acquisitions: Retirement Alliance, Inc. On October 1, 2014, the Company acquired Retirement Alliance, Inc., and its affiliate Fiduciary Consulting Group, LLC, located in Manchester, New Hampshire. The purchase, consisting of approximately 700 retirement plan clients with more than 42,000 retirement plan participants, grew the Company’s retirement services division by $2.1 billion in retirement and individual asset managed accounts. As part of the transaction, $12.7 million was allocated to an identified customer intangible, based on the estimated value as of the acquisition date, which the Company immediately began amortizing over a five-year period, resulting in an annualized intangible amortization expense of $2.5 million. This resulted in earnings dilution of $390,000 in the fourth quarter of 2014, after giving effect to $600,000 of intangible amortization expense. Private Bank Minnesota On June 25, 2014, the Company acquired Private Bancorporation, Inc., with one branch located in downtown Minneapolis. The Company assumed approximately $116.3 million of deposits and other liabilities, and purchased approximately $130.1 million in cash, securities, loans, and other assets. As part of the transaction, the Company allocated $1.2 million to a core deposit intangible and $852,000 to goodwill. The core deposit intangible is being amortized over five years, generating an amortization expense of $240,000 per year, while the goodwill is not subject to amortization. Neither the core deposit intangible nor the goodwill is deductible for tax purposes. The transaction also included a net operating loss deferred tax asset valued at $943,000 that will be utilized to offset taxable income as permitted by applicable tax laws. The transaction generated $2.0 million of one-time restructuring charges, all of which were incurred in 2014 Tegrit Administrators, LLC On September 30, 2013, the acquisition of Tegrit Administrators, LLC, was completed. The acquisition initially increased the Company’s retirement services division assets under administration by $1.3 billion and expanded the Company’s presence in Michigan. Since December 31, 2014, the Company completed the following acquisition: Interactive Retirement Solutions, LTD On January 2, 2015, the Company acquired Interactive Retirement Solutions, LTD, located in Bloomington, Minnesota. The purchase, consisting of approximately 160 retirement plans with more than 16,200 retirement participants, grew the Company’s retirement division by $1.25 billion in retirement and individual asset managed accounts. As part of the transaction, $4.5 million was allocated to an identified customer intangible, based on the estimated value as of the acquisition date, which the Company immediately began amortizing over a five-year period, resulting in an annualized intangible amortization expense of $899,000. Stock Split and Per Share Data The Company completed a 3-for-1 stock split of shares of its common stock effective September 12, 2014, payable in the form of a stock dividend to shareholders of record as of September 8, 2014. All current and historical share information and per share data has been adjusted to reflect the stock split. COVERED ASSET AND RELATED FDIC LOSS - SHARE INDEMNIFICATION ASSET Effective January 1, 2015, the losses on commercial- related loans (commercial, commercial real estate, and construction real estate) acquired in the FDIC-assisted acquisition of Prosperan Bank ceased being covered under the loss-share agreement. The carrying amount of those loans was $10.7 million as of December 31, 2014. Any recoveries, net of expenses, received on commercial-related loans on which losses were incurred prior to January 1, 2015, will continue to be covered by the loss-share agreement (and any such net recoveries must be shared with the FDIC) through December 31, 2017. Losses and recoveries on single family related loans acquired in connection with the Prosperan Bank transaction will continue to be covered under the loss-share agreement through December 31, 2019. FDIC Loss-Share True-Up Liability During the 1st quarter of 2015, the Company determined that under the terms of the FDIC loss share agreement entered into as part of the Prosperan Bank acquisition, a true-up liability should have been recorded in the year ended December 31, 2012. As a result, the financial statements as of and for the years ended December 31, 2012 and 2013 have been restated to reflect this liability. The Company determined an FDIC true-up liability of $2.6 million should have been recorded as of December 31, 2012. The net effect of this error on the Company’s financial statements for the year ended December 31, 2012 was that Other Liabilities were understated by $2.6 million, Deferred Taxes were understated by $0.99 million, and as a result, net income and retained earnings were overstated by $1.6 million. The net effect of the error on the 2013 financial statements was that Other Liabilities were understated by $2.6 million, Deferred Taxes were understated by $0.99 million and retained earnings was overstated by $1.6 million. There was no impact to net income in 2013 or 2014. All adjustments have been made and are reflected in the financial statements for the years ending 2014, 2013, and 2012. 2 TAX During the fourth quarter of 2014, the Company completed an analysis of revenue apportionment across all filed states applying an alternative method of allocation utilized by other financial institutions. As a result of that analysis, the Company determined that use of an alternative method of allocating revenue is permitted. The principal effect of this change is to reduce the revenues allocated to North Dakota and Minnesota in a manner that, in turn, reduces aggregate state income tax expense based on currently applicable rates. In addition, the Company filed amended tax returns for the 2011 through 2013 tax years seeking refunds based on this alternative method of allocating revenue. As a result, the Company increased its current income taxes receivable by $1.2 million and recognized a current tax benefit of approximately $1.2 million to reflect expected cash flow from anticipated refunds. Of this amount, refunds have already been received in the aggregate amount of $287,000 from the State of North Dakota; however, the State of North Dakota retains the ability to review these refunds since all relevant tax years remain open. CHANGE IN EXTERNAL AUDIT FIRM As a result of a request for proposals and review process, the Company engaged CliftonLarsonAllen LLP as its external audit firm, beginning with the audit of the 2014 annual financial statements. TA BL E 1 – SEL EC T ED F I NA NCI A L DATA For years ended December 31 (dollars in thousands except per-share data) RESULTS OF OPERATIONS Interest income Interest expense Net interest income Taxable equivalent adjustment Taxable equivalent net interest income Non-interest income Net revenue Non-interest expense Provision for loan losses Net Income Net Income Applicable to Shareholders PER SHARE Earnings per common share Common dividends declared Book value per common share Weighted average common shares AVERAGE BALANCES Interest-bearing deposits with banks Federal funds sold Investment securities Loans held for sale Loans – excluding covered assets Covered assets Total interest-bearing assets Total assets Non-interest-bearing deposits Interest-bearing deposits Total deposits Short-term borrowings Other borrowed funds Shareholders’ equity RATIOS Return on average assets Return on average common equity Return on average tangible common equity Net interest margin Efficiency ratio Dividend payout ratio Average shareholders’ equity to average total assets 2014 $ 54,394 3,316 51,078 483 51,561 78,406 129,967 100,115 (400) 20,231 $ 2013 $ 50,510 3,712 46,798 426 47,224 79,269 126,493 92,913 1,200 20,270 $ 2012 $ 52,852 4,586 48,266 461 48,727 79,115 127,842 100,834 833 16,256 $ 2011 47,381 6,821 40,560 539 41,099 56,784 97,883 76,740 4,418 10,709 $ $ 2010 $ 45,983 10,785 35,198 525 35,723 53,101 88,824 72,649 6,820 5,873 $ 5-Year Compound Growth Rate 6.94% -21.60% 13.02% 1.79% 12.88% 13.10% 13.01% 14.11% -156.12% 22.38% $ 20,031 $ 20,070 $ 15,917 $ 10,636 $ 5,873 22.14% 1.44 $ 0.38 $ $ 10.85 13,887,344 1.46 $ 0.34 $ $ 9.65 13,762,044 1.17 $ 0.31 $ $ 8.90 13,591,335 0.80 $ 0.30 $ $ 7.97 13,319,550 0.44 $ 0.29 $ $ 7.34 13,217,592 $ 19,787 17 258,705 27,090 976,257 17,790 1,299,646 1,424,331 278,005 913,841 1,191,846 29,007 21,562 $ 164,203 1.42% 13.89% 16.70% 3.97% 77.32% 26.39% 11.53% $ 56,339 8 264,978 43,361 807,278 25,167 1,197,131 1,308,159 221,199 879,974 1,101,173 13,964 22,650 $ 150,300 1.55% 15.40% 17.99% 3.94% 73.70% 23.29% 11.49% $ 42,121 2,675 262,030 51,548 680,749 37,901 1,077,024 1,197,807 195,939 807,910 1,003,849 19,203 21,817 $ 136,624 1.36% 13.65% 16.78% 4.52% 79.16% 26.78% 11.41% $ 59,423 553 272,431 26,447 606,259 52,685 1,017,798 1,128,835 162,106 820,434 982,540 9,406 22,449 $ 105,930 0.95% 10.80% 12.96% 4.04% 78.83% 37.08% 9.38% $ 38,561 1,238 261,415 35,106 547,599 68,995 952,914 1,079,425 126,513 803,779 930,292 1,679 41,249 $ 93,947 0.54% 6.25% 8.02% 3.75% 82.28% 66.17% 8.70% 20.79% 6.30% 10.23% 1.12% 137.66% -75.41% 11.23% 40.89% 12.67% 5.9% 12.74% 10.92% 18.89% 8.56% 10.51% 191.85% -8.77% 15.11% 1.19% 12.15% 3 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT RESULTS OF OPERATIONS The following is Management’s discussion and analysis of the significant changes in the results of operations, capital resources, and liquidity presented in the accompanying consolidated financial statements. The Company’s consolidated financial condition and results of operations are comprised primarily of the financial condition and results of operations of its subsidiary bank, Alerus Financial, N.A. Current performance does not guarantee, and may not be indicative of, similar performance in the future. For more information on the factors that could affect performance, see “Forward Looking Statements.” EARNINGS SUMMARY The Company’s diversified revenue model continued to generate strong core earnings in 2014, reflecting record revenue from the banking, retirement services, and wealth management divisions, offset in part by a decline in mortgage division revenue consistent with the overall decrease in residential mortgage volumes across the industry. For the year ended December 31, 2014, the Company reported net income of $20.2 million, a decrease of $0.1 million, or 0.2%, from the $20.3 million earned during 2013. Earnings per common share were $1.44 in 2014, a decrease of $0.02, or 1.4%, from the $1.46 earned during 2013. The Company’s 2014 earnings reflect the effect of $4.2 million of amortization of identified intangibles from acquisitions or $0.18 per share net of taxes, compared to $3.3 million or $0.14 per share in 2013. The year to year change in net income over the last five years is illustrated in Chart A, and the year to year change in earnings per share is illustrated in Chart B. Cash dividends per share were $0.38 in 2014, compared to $0.34 in 2013. The year to year change in cash dividends over the last five years is illustrated in Chart C. Return on Average Common Equity (ROE) is net income stated as a percentage of common shareholders’ equity. ROE was 13.89% in 2014, compared to 15.40% in 2013, and 13.65% in 2012, as further illustrated in Chart D. The average ROE over the past five years is 12.00%. Return on Average Assets (ROA) is net income stated as a percentage of average total assets. As Chart E illustrates, ROA was 1.42% in 2014, compared to 1.55% in 2013, and 1.36% in 2012. The average ROA over the past five years is 1.16%. NET INTEREST INCOME Net interest income is a major source of earnings for the Company. Net interest income is calculated as the difference between interest income (which includes yield-related loan fees) and interest expense. Net interest income, on a taxable- equivalent basis, expressed as a percentage of average total earning assets, is referred to as the net interest margin, which represents the average net effective yield on earning assets. While the Company believes that it has the ability to increase net interest income over time, net interest income and the net interest margin in any one period can be significantly affected by a variety of factors including the mix and overall size of our earning asset portfolio and the cost of funding those assets. In addition, some variable sources of interest income such as loan prepayment fees and the collection of interest on nonaccrual loans can vary from period to period. Net interest income on a taxable-equivalent basis was $51.6 million in 2014, an increase of $4.4 million, or 9.2%, from the $47.2 million reported in 2013. Net interest margin was 3.97% in 2014, up three basis points from 3.95% in 2013. The primary reason for the increase in net interest income from the year ended December 31, 2013, was organic loan growth of $96.3 million and acquired loans of $90.1 million associated with the acquisition of Private Bank Minnesota, offset in part by a $61.0 million restructuring of the investment portfolio to reduce price and credit exposure. The Company has elected to account for purchased credit impaired loans under the cost recovery method. Under the cost recovery method, no yield is accreted into income until the Company’s cost is recovered, thus no accretable yield is reported for the years ending December 31, 2014 and 2013. 4 Chart A Net Income $16,256 $20,270 $20,231 $20,000 ) s d n a s u o h t n i s r a l l o d ( $17,500 $15,000 $12,500 $10,000 $7,500 $5,000 $10,709 $5,873 2010 2011 2012 2013 2014 Chart B Earnings Per Share $1.46 $1.44 $1.17 $0.80 $1.50 $1.25 $1.00 $0.75 $0.50 $0.44 2010 2011 2012 2013 2014 Chart C Dividends Per Share $0.38 $0.34 $0.29 $0.30 $0.31 2010 2011 2012 2013 2014 Chart D Return on Equity 15.40% 13.65% 13.89% 10.80% $0.25 $0.50 $0.45 $0.40 $0.35 $0.30 $0.25 $0.20 17.00% 15.00% 13.00% 11.00% 9.00% 7.00% 6.25% 5.00% 2010 2011 2012 2013 2014 Chart E Return on Assets 1.55% 1.36% 1.42% 0.95% 0.54% 2010 2011 2012 2013 2014 Chart F Net Interest Income $51,561 $48,727 $47,224 $41,099 $35,723 2010 2011 2012 2013 2014 Chart G Net Interest Margin 4.52% 4.04% 3.94% 3.97% 1.70% 1.50% 1.30% 1.10% 0.90% 0.70% 0.50% ) s d n a s u o h t n i s r a l l o d ( $53,000 $48,000 $43,000 $38,000 $33,000 $28,000 $23,000 4.75% 4.50% 4.25% 4.00% 3.75% 3.75% 3.50% 2010 2011 2012 2013 2014 Average interest-bearing assets were $1.3 billion in 2014, an increase of $0.1 billion, or 8.6%, from the $1.2 billion reported in 2013. The increases were driven by demand for loans and lines by new and existing credit-worthy borrowers, the acquisition of Private Bank Minnesota, and partially offset by a cyclical decrease in the real estate warehouse line utilized to fund residential mortgages awaiting sale. Core deposits are an important low-cost source of funding and affect both net interest income and the net interest margin. Core deposits include non-interest-bearing deposits, interest-bearing checking, savings certificates, and money market savings deposits. Average core deposits were $969 million in 2014, an increase of $105 million from the $864 million in 2013, and funded 74.6% and 72.2% of the Company’s average interest-bearing assets in 2014 and 2013, respectively. Chart F illustrates net interest income on a tax equivalent basis for the past five years. The Company positions the balance sheet to be interest rate neutral to slightly asset sensitive, defined as allowing assets on the balance sheet to reprice faster than the liabilities that fund them. Financial institutions will feel additional pressure on net interest margin the longer short- term rates remain at lower levels since there is limited opportunity to reprice deposits and fixed-rate loans mature or renew at lower rates. The Company actively implements risk management strategies as detailed in the “Interest Rate Risk” discussion to minimize the effects of interest rate volatility. Chart G illustrates net interest margin for the past five years. Table 2 provides detailed information as to average balances, interest income and expense, and rates earned and paid by major balance sheet categories for the years 2012 through 2014. Table 3 provides an analysis of the change in net interest income that is attributable to changes in volume of interest-earning assets or interest- bearing liabilities, and to changes in rates earned and paid. PROVISION FOR LOAN LOSSES The allowance for loan losses (allowance) is an estimate of loan losses inherent in the Company’s loan portfolio. The allowance is established through a provision for loan losses. Additions to the allowance are expected to maintain the adequacy of the total allowance after loan losses and recoveries, loan growth, and changes in management’s assessment of credit quality and estimates of probable loan losses. Loan losses are charged off against the allowance when the Company determines the loan balance to be uncollectible. Cash received on previously charged off amounts is recorded as a recovery to the allowance. Annual fluctuations in the provision for loan losses result from management’s regular assessment of the adequacy of the allowance for loan losses based on the foregoing factors. The provision for loan losses for 2014 was negative $0.4 million compared to $1.2 million during 2013. This was the result of a suspension of the provision for loan losses at the Company’s subsidiary bank to allow the bank’s allowance for loan losses to realign with regular quarterly assessments of the reduced risk in the bank’s loan portfolio due to improved credit quality and recoveries. While there was no negative provision taken at the bank level, the Company itself recorded a negative provision for loan losses of $0.4 million in response to repayment of a loan held at the Company as opposed to its subsidiary bank. The ratio of allowance for loan losses to end-of-year non-covered loans was 1.56% for 2014, compared to 1.88% for 2013. This reflects continued strength in the Company’s overall loan portfolio, fair value adjustments of $2.5 million to loans acquired in the Private Bank transaction based in part on the allowance for loan losses that would otherwise have been attributed to those acquired loans as of the closing of that transaction, and the termination of FDIC loss-share coverage on non-residential real estate loans acquired in the Prosperan Bank transaction effective December 31, 2014. Average loans excluding covered assets were $976.3 million in 2014, an increase of $169 million, or 20.9%, from the $807.3 million reported in 2013. The amount of provision to be taken in future periods will depend on management’s assessment of the adequacy of the allowance for loan losses in relation to the loss experience of the entire loan portfolio. NON -INTEREST INCOME The Company continues to expand non-interest income associated with the Company’s banking, retirement services, and wealth management divisions. The Company’s primary sources of non-interest income consist of trust services, retirement plan and recordkeeping services, service charges on deposit accounts, loan fees, and mortgage originations. Non-interest income is a significant source of revenue for the Company, representing 60.3% of taxable equivalent net revenue in 2014, compared with 62.7% in 2013. Non-interest income was $78.4 million in 2014, a $0.9 million, or 1.1%, decrease from the $79.3 million reported in 2013. Growth in retirement services income helped to offset the decline in mortgage origination income, which declined as a result of a reduction in mortgage refinancing activity across the industry. Table 4 provides a summary of changes in non-interest income the past three years. Retirement services, which includes retirement plan administration and retirement plan investment advisory, is the Company’s largest source of non-interest income. Retirement services income was $41.1 million in 2014, a $5.1 million, or 14.0%, increase from the $36.0 million reported in 2013. At December 31, 2014, assets under administration totaled $15.5 billion, up $2.6 billion, or 20.2%, from $12.9 billion at December 31, 2013. The acquisition of Retirement Alliance, Inc., which closed on October 1, 2014, included 700 retirement plans, with more than 42,000 participants, and added $2.1 billion in assets under administration. 5 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT TA BL E 2 – AV ER AGE BA L A NCE SH EET S A N D AV ER AGE R AT ES For years ended December 31 (dollars in thousands) Average Balance 2014 Average Rate Average Balance 2013 Average Rate Interest Interest Average Balance 2012 Average Rate Interest $ 19,787 0.26% $ 52 $ 56,339 0.26% $ 148 $ 42,121 0.24% $ 100 17 258,705 27,090 0.00% 2.67% 3.46% - 6,915 936 8 264,978 43,361 0.00% 2.64% 2.78% - 7,001 1,206 2,675 262,030 51,548 0.11% 3.03% 3.07% 3 7,937 1,581 341,516 4.44% 15,173 292,449 4.85% 14,194 234,126 5.18% 12,121 40,731 525,873 68,137 4.16% 4.89% 4.57% 1,693 25,729 3,117 43,741 418,397 52,691 4.40% 4.78% 4.74% 1,924 19,999 2,495 42,078 364,411 40,134 5.00% 5.45% 5.19% 2,105 19,866 2,083 976,257 4.68% 45,712 807,278 4.78% 38,612 680,749 5.31% 36,175 25,167 15.77% 7.09% 1,262 4.22% $ 54,877 $ 1,197,131 21,098 (15,673) 37,901 3,969 4.25% $ 50,936 $ 1,077,024 32,429 (14,611) 19.83% 7,517 4.95% $ 53,313 ASSETS Interest-bearing deposits with banks Federal funds sold Investment securities (a) Loans held for sale Loans – excluding covered assets Commercial and financial (a) Agricultural Real estate Consumer loans Total loans – excluding covered assets Covered assets Total Earning Assets Cash and due from banks Loan loss reserve Goodwill and other intangibles Bank premises and equipment Other Total Assets 17,790 $ 1,299,646 23,408 (16,792) 18,271 22,174 77,624 $ 1,424,331 LIABILITIES AND SHAREHOLDERS EQUIT Y Savings, NOW, and money market deposits Time deposits Short-term borrowings Other borrowed funds 222,943 29,007 21,562 0.74% 0.08% 2.88% $ 690,898 0.15% $ 15,251 22,440 67,912 $ 1,308,159 16,795 21,908 64,262 $ 1,197,807 1,023 $ 642,934 0.18% $ 1,174 $ 556,282 0.24% $ 1,344 1,650 22 621 237,040 13,964 22,650 0.81% 0.21% 2.57% 1,927 30 581 251,628 19,203 21,817 1.01% 0.34% 2.97% 2,530 65 647 Total Interest-Bearing Liabilities Non-interest-bearing deposits Other liabilities Shareholders’ equity Total Liabilities and Shareholders’ Equity Net Interest Margin/ Income Interest Rate Spread $ 964,410 0.34% $ 3,316 $ 916,588 0.40% $ 3,712 $ 848,930 0.54% $ 4,586 278,005 17,713 164,203 221,199 20,072 150,300 195,939 16,314 136,624 $ 1,424,331 $ 1,308,159 $ 1,197,807 3.97% $ 51,561 3.95% $ 47,224 4.52% $ 48,727 3.88% 3.85% 4.41% (a) Taxable equivalent adjustment was calculated utilizing a marginal federal income tax rate of 35.5 percent. Wealth management income, which includes personal trust services and investment services offered by Alerus Investment Advisors and Alerus Securities, was $11.3 million, a $0.7 million, or 6.2%, increase from the $10.6 million reported in 2013. The Company earns trust, investment, and individual retirement account fees from managing and administering assets, including mutual funds, corporate trusts, personal trusts, and separately managed accounts. Trust and investment fees are primarily based on a tiered scale relative to the market value of the assets under management. At December 31, 2014, assets under management totaled $2.9 billion, up $0.2 billion, or 8.2%, from the $2.7 billion reported in 2013, and includes some assets also reported under assets under administration that also generate investment management fees. Mortgage origination and loan servicing fees were $18.4 million in 2014, an $8.8 million, or 32.2%, decrease from the $27.2 million reported in 2013. The Company’s mortgage division originated $749.2 million in loans 2014, a $250.8 million, or 25.0% decrease from the $1.0 billion originated in 2013. Other non-interest income was $6.0 million in 2014, a $2.3 million, or 56.9%, increase from the $3.7 million reported in 2013. Overall, mortgage originations experienced an industry-wide decline of roughly 39% in 2014, reflecting further declines from the record levels of mortgage refinance activity seen over the previous four years. The Company’s mix of refinance and home purchase mortgage originations shifted from 45% refinance and 55% purchase in 2013 to 15% and 85%, respectively, in 2014. 6 Increase (decrease) in: Interest income Interest bearing deposits with banks Federal funds sold Investment securities Loans Held for Sale Loans - excluding covered assets Commercial and financial Agricultural Real estate Consumer loans Total loans excluding covered assets Covered assets Total Interest Income Interest expense Savings, NOW, and money market deposits Time deposits Short term borrowings Other borrowed funds Total Interest Expense TA BL E 3 – VOLUM E/R AT E VA R I A NCE A NA LYSIS (dollars in thousands) Change from 2013 to 2014 Change from 2012 to 2013 Volume Rate Total Volume Rate Total $ (96) $ - (166) (453) - 2,381 (132) 5,137 731 8,118 (1,163) 6,240 88 (115) 32 (28) (23) $ $ $ $ - - (80) 183 - (1,402) (99) 593 (109) (1,018) (1,544) (2,299) (239) (162) (40) 68 (373) $ (96) - (86) (270) $ 979 (231) 5,730 622 7,100 (2,707) 3,941 (151) (277) (8) 40 (396) 34 (3) 89 (251) - 3,019 83 2,943 652 6,697 (2,526) 4,041 209 (147) (18) 25 70 $ $ 14 (0) (1,025) (124) - (946) (264) (2,810) (240) (4,260) (1,022) (6,418) $ $ (379) (456) (17) (91) (944) 48 (3) (936) (375) 2,073 (181) 133 412 2,437 (3,548) (2,377) (170) (603) (35) (66) (874) Net Variance $ 6,263 $ (1,926) $ 4,337 $ 3,971 $ (5,474) $ (1,503) TA BL E 4 – NON-I N T ER EST I NCOM E For years ended December 31 (dollars in thousands) 2014 41,058 8,249 2,041 995 11,285 1,626 18,435 2,179 3,823 78,406 $ $ $ 2013 36,003 7,352 1,951 1,321 10,624 1,639 27,177 (70) 3,896 79,269 $ $ $ 2012 32,484 6,908 1,978 1,251 10,137 1,626 31,061 217 3,590 79,115 $ $ $ % Increase/ Decrease 2014/2013 14.04% % Increase/ Decrease 2013/2012 10.83% 12.20% 4.61% -24.68% 6.22% -0.79% -32.17% 3212.86% -1.87% -1.09% 6.43% -1.37% 5.60% 4.80% 0.80% -12.50% -132.26% 8.52% 0.19% Retirement services income Wealth management income Trusts, agencies, wills, estates and other Brokerage commissions Investment advisory fees Total Wealth Management Income Service charges on deposit accounts Mortgage origination and loan servicing fees Investment security gains (losses) Other non-interest income Total Non-Interest Income NON -INTEREST EXPENSE Total non-interest expense was $100.1 million in 2014, a $7.2 million, or 7.8% increase from the $92.9 million reported in 2013. In 2012, non-interest expense was impacted by a non-recurring impairment of the FDIC indemnification asset and the recording of an FDIC True-Up Liability, both as a result of the Prosperan Bank acquisition in 2009. In 2014, non-interest expense was impacted by $2.0 million in one-time restructuring charges associated with the Private Bank acquisition and amortization of identified intangibles resulting from the Retirement Alliance, Inc. transaction that began amortizing in the fourth quarter. While control of non-interest expense is a top priority of management, the higher-than-average efficiency ratio is partially due to the Company’s goal of generating 50% of total revenue from non-interest income sources. The efficiency ratio for a business comprised solely of net interest margin income is generally lower than a business comprised solely of asset management income and mortgage origination income; however, the income generated from asset management has higher risk-adjusted returns since the Company allocates significant amounts of capital and reserves to the balance sheet risks generated by more traditional banking activities. The Company’s efficiency ratio, defined as the percent of expense to total income, increased to 77.3% in 2014, compared to 73.7% in 2013. Chart H (page 9) illustrates the trend in the efficiency ratio over the last five years. Salary and employee benefit costs are the largest expense component for the Company. Salary and employee benefit costs represented 60.4% of total expenses in 2014, compared to 64.4% in 2013. Salary and employee benefit costs were $60.4 million in 2014, a $0.6 million, or 0.1%, increase from the $59.8 million reported in 2013. This marginal increase 7 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT in salary and employee benefit costs was influenced by increased staffing associated with acquisitions completed in 2014, offset by declines in variable commissions associated with declines in mortgage origination activity. Occupancy expense was $4.4 million in 2014, a $0.6 million, or 16.7%, increase from the $3.8 million reported in 2013. This increase in occupancy expense is primarily the result of costs associated with acquisitions completed in 2014. Furniture and equipment expense was $4.7 million in 2014, reflecting no material change from 2013. Other non-interest expense was $13.3 million in 2014, a $2.9 million, or 28.1%, increase from the $10.4 million reported in 2013. The increase in other non-interest expense is the result of expenses associated with acquisitions completed in 2014, including $2 million of one-time restructuring charges relating to the Private Bank Minnesota transaction and the amortization of identified intangibles associated with the Retirement Alliance transaction. The Company has acquired 16 companies since 2002 for an aggregate premium of $41.1 million in excess of book value creating identified intangible assets of $39.6 million and $1.5 million in goodwill on the balance sheet. The identified intangible assets amortize for book purposes and are reported in other non-interest expense. For most transactions, goodwill does not amortize for book purposes and is not deductible for tax purposes. The amortization schedules vary based on the type and quality of the acquisition. The aggregate unamortized intangible balance as of December 31, 2014, is $20.8 million and will fully amortize by December 31, 2019. The intangible amortization expense for 2014 was $4.1 million. Table 5 provides a summary of changes in non-interest expenses for the past three years. TA BL E 5 – NON-I N T ER EST EX PENSE For years ended December 31 (dollars in thousands) Salaries Employee benefits Occupancy expense Furniture and equipment expense Marketing, business development and public relations Supplies, telephone and postage FDIC insurance Professional fees (legal, audit and consulting) Correspondent and other service fees Other non-interest expenses Total Non-Interest Expenses 2013 2014 2012 $ 48,839 $ 49,203 $ 49,072 10,302 4,189 4,147 3,052 3,148 893 1,894 5,668 18,649 $ 100,834 10,621 3,791 4,687 2,613 3,033 960 2,042 5,547 10,416 $ 100,115 $ 92,913 11,580 4,424 4,659 2,745 3,838 1,040 2,667 6,982 13,341 % Increase/ Decrease 2014/2013 -0.74% 9.03% 16.70% -0.60% 5.05% 26.54% 8.33% 30.61% 25.87% 28.08% 7.75% % Increase/ Decrease 2013/2012 0.27% 3.10% -9.50% 13.02% -14.38% -3.65% 7.50% 7.81% -2.13% -43.60% -7.86% STATEMENT OF FINANCIAL CONDITION OVERVIEW SECURITIES Total assets of the Company were $1.5 billion at December 31, 2014, a $0.1 billion, or 7.7% increase from the $1.4 billion reported at December 31, 2013. Total average assets of the Company were $1.4 billion in 2014, a $0.1 billion, or 9.1%, increase from the $1.3 billion reported in 2013. Chart I illustrates average total assets for the past five years. Average earning assets were $1.3 billion in 2014, an increase of $0.1 billion, or 8.6%, from the $1.2 billion reported in 2013. Average earning assets represent 91.2% of average total assets in 2014, compared to 91.5% in 2013. The change in average earning assets was primarily driven by an increase in non-covered loans, which was offset by a decrease in covered loans and loans to be sold. Average interest-bearing liabilities represented 74.2% of average earning assets in 2014, compared to 76.6% in 2013. The Company uses its investment securities portfolio to manage enterprise interest rate risk, provide liquidity (including the ability to meet proposed regulatory requirements), generate interest and dividend income, and as collateral for public funds. While it is the Company’s intent to hold its investment securities to maturity, the Company may take actions to sell before maturity in response to structural changes in interest rate risks and to meet liquidity requirements, among other factors. At December 31, 2014, investment securities totaled $206.1 million, compared with $279.7 million at December 31, 2013. The $73.6 million year-over-year decrease was associated with $18.4 million in purchases, $85.5 million in sales, and the continued monthly amortization of our agency-backed mortgage portfolio. The weighted average yield of the investment portfolio was 2.61% at December 31, 2014, compared with 2.64% at December 31, 2013. The decrease in weighted average yield was associated with unscheduled prepayments on the agency-backed mortgage portfolio and reinvestments made under a lower interest rate environment. 8 Chart H Efficiency Ratio 78.83% 79.16% 77.32% 73.70% 85.00% 82.50% 82.28% 80.00% 77.50% 75.00% 72.50% 70.00% Chart I Average Total Assets $1,424,331 $1,308,159 $1,197,807 $1,128,835 $1,079,425 ) s d n a s u o h t n i s r a l l o d ( $1,450,000 $1,400,000 $1,350,000 $1,300,000 $1,250,000 $1,200,000 $1,100,000 $1,050,000 $1,000,000 2010 2011 2012 2013 2014 2010 2011 2012 2013 2014 The investment portfolio was rebalanced during the third quarter of 2014 to reduce risk and duration. Corporate securities with a face amount of $61 million were liquidated for a pre-tax gain of $1.8 million. Additional portfolio restructuring resulted in a gain of $0.4 million during the reporting period. The investment securities portfolio contains amortizing securities resulting in monthly cash flow of approximately $2.5 million. During 2014, the Company transferred all held-to-maturity securities to available-for-sale. At the time of transfer the book value of the securities was $53.8 million. The unrealized gain of $1.9 million was recorded immediately in other comprehensive income. The transaction was the result of a strategic decision by the Company to liquidate its corporate bond portfolio which comprised 51.4% of the held- to-maturity portfolio. The Company’s available-for-sale securities are carried at fair value with changes in fair value reflected in other comprehensive income (loss) unless a security is deemed to be other-than-temporarily impaired. At December 31, 2014, the Company’s gross unrealized gains on the available- for-sale securities were $3.8 million, compared with $5.3 million at December 31, 2013. Gross unrealizable losses on available-for-sale securities totaled $1.7 million, compared with $4.9 million at December 31, 2013. The Company conducts a regular assessment of its investment portfolio to determine whether any securities are other-than-temporarily impaired. When assessing unrealized losses for other-than-temporary impairment, the Company considers the nature of the investment, the financial condition of the issuer, the extent and duration of the unrealized loss, and expected cash flows of the underlying assets and market conditions. On December 31, 2014, the Company held certain investments having continuous unrealized loss positions for more than 12 months. As of December 31, 2014, the unrealized losses on these securities totaled $1.6 million. Substantially all of these losses were in the government agency debt securities. During the year ended December 31, 2014, the Company evaluated all of its debt securities for credit impairment and determined there were no credit losses evident and did not record any other-than-temporary impairment. At December 31, 2014, the Company had no plans to sell securities with unrealized losses and believes it is likely that it would not be required to sell such securities before a recovery of their amortized cost. LOANS Total loans were $1.1 billion at December 31, 2014, a $181 million, or 19.8%, increase from the $914 million reported at December 31, 2013. The increase was driven by the acquisition of Private Bank as well as organic growth in commercial loans of $7.4 million (2.2%), real estate mortgages of $81.2 million (15.0%), and consumer loans of $12.8 million (19.0%). Table 6A provides a summary of changes in loans, excluding covered loans, for the past five years. Table 6B provides a summary of the loan mix on covered loans. Average loans were $994 million in 2014, a $162 million, or 19.4%, increase from the $832 million reported in 2013. The increase in average loans was driven by strong organic growth across all geographic locations and loans acquired in the Private Bank Minnesota transaction. The loan/deposit ratio increased to 87.2% at December 31, 2014, compared to 77.33% at December 31, 2013, as the Company utilized excess liquidity to fund loan growth. The Company periodically sells loans to a participation network to manage concentration risk and reduce credit exposure. The sold loan portfolio was $518.8 million on December 31, 2014, a $54.9 million, or 11.8%, increase from the $464.1 million reported at December 31, 2013. The Company originated and sold $87.1 million of real estate mortgages to Fannie Mae and FHLB during 2014 and retained the servicing asset. The Company also held $35.0 million of loans for sale at December 31, 2014, a $4.8 million, or 15.8%, increase from the $30.3 million reported at December 31, 2013. Loans held for sale are all single family residential mortgage loans that will be sold to the secondary market. DEPOSITS Core deposits provide the Company’s major source of funds from individuals, businesses, and local government units. Core deposits include non-interest-bearing deposits, interest-bearing checking, savings certificates, and money market saving deposits. Core deposits funded 70.7% and 69.3% of total assets at December 31, 2014 and 2013, respectively. Total deposits were $1.3 billion at December 31, 2014, an $80 million, or 6.7%, increase from the $1.2 billion reported at December 31, 2013. The increase was the result of the Private Bank Minnesota acquisition which added $116 million in deposits. Average deposits were $1.2 billion in 2014, a $90.7 million, or 8.2%, increase compared with the $1.1 billion reported in 2013. Non-interest-bearing deposits were $330.2 million at December 31, 2014, a $25.2 million, or 8.3%, increase from the $305.0 million reported at December 31, 2013. Average non- interest-bearing deposits were $278.0 million in 2014, a $56.8 million, or 25.7 %, increase compared with $221.2 million in 2013. The increase in non-interest-bearing deposits was primarily attributable to the Private Bank Minnesota transaction. 9 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT TA BL E 6A – LOA NS EXCLU DI NG COV ER ED A SSET S BY T Y PE As of December 31 (dollars in thousands) 2014 345,249 49,081 615,956 79,741 1,090,027 2013 $ 327,388 54,214 452,874 60,067 $ 894,543 2012 $ 260,518 46,607 381,672 49,289 $ 738,086 2011 $ 209,406 44,328 336,874 34,773 $ 625,381 2010 $ 185,645 48,073 278,542 23,420 $ 535,681 $ $ $ $ 31.67% 4.50% 56.51% 7.32% 100.00% 72,107 2,000 443,898 816 518,821 36.60% 6.06% 50.63% 6.71% 100.00% 35.30% 6.31% 51.71% 6.68% 100.00% 33.48% 7.09% 53.87% 5.56% 100.00% 34.66% 8.97% 52.00% 4.37% 100.00% $ 68,156 10,892 385,060 - $ 464,108 $ 57,146 5,049 332,590 4,600 $ 399,385 $ 57,446 - 285,184 - $ 342,630 $ 54,294 - 267,076 - $ 321,370 TA BL E 6B – COV ER ED LOA NS BY T Y PE As of December 31 (dollars in thousands) 2014 - - 5,432 - 5,432 2013 793 31 19,099 98 20,021 $ $ 2012 1,457 64 30,998 173 32,692 $ $ 2011 3,379 74 44,318 279 48,050 $ $ 2010 5,246 85 56,455 392 62,179 $ $ $ $ 0.00% 0.00% 100.00% 0.00% 100.00% 3.96% 0.15% 95.39% 0.49% 100.00% 4.46% 0.20% 94.82% 0.53% 100.00% 7.03% 0.15% 92.23% 0.58% 100.00% 8.44% 0.14% 90.79% 0.63% 100.00% TA BL E 7 – DEP OSI T S BY T Y PE As of December 31 (dollars in thousands) 2014 $ 330,218 2013 $ 305,042 2012 $ 267,208 2011 $ 188,630 2010 $ 156,844 30,397 243,334 447,346 28,774 182,099 $ 1,262,168 24,750 186,916 439,946 35,182 190,767 $ 1,182,603 20,168 188,995 386,089 40,103 213,187 $ 1,115,750 20,427 138,579 377,003 34,389 226,082 $ 985,110 14,033 136,392 363,169 31,712 248,631 $ 950,780 26.16% 25.79% 23.95% 19.15% 16.50% 2.41% 19.28% 35.44% 2.28% 14.43% 100.00% 2.09% 15.81% 37.20% 2.97% 16.13% 100.00% 1.81% 16.94% 34.60% 3.59% 19.11% 100.00% 2.07% 14.07% 38.27% 3.49% 22.95% 100.00% 1.48% 14.35% 38.20% 3.34% 26.15% 100.00% Commercial and financial Agricultural Real estate Consumer loans Total Loans PERCENT OF LOANS BY T YPE Commercial and financial Agricultural Real estate Consumer loans Total Loans SOLD LOANS Commercial and financial Agricultural Real estate Consumer loans Total Sold Loans Commercial and financial Agricultural Real estate Consumer loans Total Covered Loans PERCENT OF LOANS BY T YPE Commercial and financial Agricultural Real estate Consumer loans Total Loans Non-interest-bearing deposits Interest-bearing deposits Saving accounts NOW accounts Money market deposit accounts Time deposits in excess of $250,000 Time deposits of $250,000 and less Total Deposits PERCENT OF DEPOSITS BY T YPE Non-interest-bearing deposits Interest-bearing deposits Saving accounts NOW accounts Money market deposit accounts Time deposits in excess of $250,000 Time deposits of $250,000 and less Total Deposits 10 Interest-bearing non-maturity deposits totaled $721.1 million at December 31, 2014, a $69.5 million, or 10.7%, increase from the $651.5 million reported at December 31, 2013. Average interest-bearing non-maturity deposits were $690.9 million in 2014, a $48.0 million, or 7.5%, increase compared with $642.9 million in 2013. The increase in these deposits was primarily the result of the Private Bank Minnesota transaction. Interest-bearing time deposits were $210.9 million at December 31, 2014, a $15.1 million, or 6.7%, decrease from the $225.9 million reported at December 31, 2013. Average interest-bearing time deposits were $222.9 million in 2014, a $14.1 million, or 5.9%, decrease compared with $237.0 million reported in 2013. Time certificates of deposit are largely viewed as purchased funds and are managed to levels deemed appropriate given alternative funding sources. Table 7 provides a summary of changes in deposits for the past five years. OTHER BORROWED FUNDS The Company utilizes both short-term and long-term borrowings to fund growth of earning assets in excess of deposit growth. Other borrowed funds, as of December 31, 2014, totaled $21.5 million, a $0.13 million, or 0.63%, decrease from the $21.6 million reported at December 31, 2013. Other borrowed funds consists of one Federal Home Loan Bank advance totaling $20 million, and obligations under a capital lease associated with the lease agreement on the Corporate Center office located in Grand Forks, North Dakota, of $1.5 million. CAPITAL RESOURCES The Company is committed to managing capital for maximum shareholder benefit and maintaining strong protection for depositors and creditors. The Company continually assesses its business risk and capital position. The Company also manages its capital to exceed regulatory capital requirements for well-capitalized bank holding companies. To achieve these capital goals, the Company employs a variety of capital management tools including dividends and common share repurchases. Total common shareholders’ equity was $151.1 million at December 31, 2014, a $17.8 million, or 13.35%, increase from the $133.3 million reported at December 31, 2013. The increase is the result of current year’s earnings less dividend payments to shareholders, common stock repurchases, and the market value change in the investment portfolio. In 2012 the Company applied for and received approval for $20 million in Small Business Lending Funds (SBLF) at an initial interest rate of 1%. The Company is committed to small business lending and is proud to contribute to the nation’s recovery. The Company views the SBLF as an intermediate source of capital and its plans to repay these funds will depend, in part, on other potential uses of excess capital and the cost and quality of other alternative capital sources. The Company paid dividends of $0.38 during 2014, representing a $0.04, or 12.74%, increase over the $0.34 paid during 2013. Dividends per share data was adjusted for a 3-for-1 stock split completed in the third quarter of 2014. The Company’s dividend policy is influenced by the belief that most shareholders are interested in long-term appreciation as well as current yield. The current dividend yield is considered reasonable given the Company’s present cash flow position, level of earnings, and the strength of its capital. Banking industry regulators define minimum capital requirements for banks and holding companies. The Company’s Tier 1 and total risk-based capital ratios as of December 31, 2014, amounted to 11.8% and 13.1%, respectively, well above the requirements to be considered well capitalized of 6.00% for Tier 1 and 10.00% for total risk based capital. This compares to Tier 1 and total risk- based capital ratios of 12.8% and 14.1% at December 31, 2013. Regulatory authorities also have established a minimum leverage ratio of 5.00%, which is defined as Tier 1 capital to average assets. The Company’s leverage ratio was 10.1% in 2014, compared to 10.6% in 2013. RISK ANALYSIS ASSET QUALITY RISK Management believes its ability to identify and assess risk and return characteristics of the Company’s loan portfolio is critical for profitability and growth. It is in the best interest of shareholders, regional communities, customers, and the Company to follow a credit policy that carefully balances risk and return tradeoffs, and ensures that potential credit problems are closely monitored. The Company’s strategy for credit risk management includes well-defined, centralized credit policies; uniform underwriting criteria; and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The strategy also emphasizes diversification on a geographic, industry, and customer level; regular credit examinations; and management reviews of loans experiencing deterioration of credit quality. The Company strives to identify potential problem loans early, take necessary charge-offs promptly, and maintain adequate reserve levels for probable loan losses inherent in the portfolio. Management performs ongoing, internal reviews of any problem credits and continually assesses the adequacy of the allowance for possible loan loss. The Company utilizes an internal lending division, Special Credit Services, to develop and implement strategies for the management of individual non-performing loans. The allowance for credit losses provides coverage for probable and estimable losses inherent in the Company’s loan portfolio. Management evaluates the allowance each quarter to determine if it is adequate to cover inherent losses. The evaluation of each element and the overall allowance is based on a continuing assessment of problem loans and related off-balance sheet items, recent loss experience, and other factors including regulatory guidance and economic conditions. At December 31, 2014, non-performing assets excluding covered assets were $6.1 million, compared to $3.4 million 11 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT TA BL E 8A – NON-PER FOR M I NG A SSET S EXCLU DI NG COV ER ED A SSET S As of December 31 (dollars in thousands) 2014 2013 2012 2011 2010 Non-accrual loans Commercial and financial Agricultural Real estate Consumer loans Total Non-Accrual Loans Foreclosed assets Other real estate owned Total Non-Performing Assets Loans past due 90 days or more Commercial and financial Agricultural Real estate Consumer loans Total Loans Past Due 90 Days or More Percentage of non-performing loans to loans Percentage of non-performing assets to assets Percentage of allowance for loan losses to non-performing loans $ $ $ $ $ 572 - 3,013 20 3,605 11 2,478 6,094 - - 392 - 392 0.33% 0.41% $ 1,209 109 510 9 $ 1,837 11 1,558 3,406 $ - - - - - $ $ $ $ $ 941 - 854 354 2,149 19 2,603 4,771 95 - 1 - 96 0.21% 0.25% 0.29% 0.36% $ 2,620 69 3,395 - $ 6,084 $ $ $ 20 2,866 8,970 332 - 87 - 419 0.97% 0.78% $ 1,738 - 4,956 - $ 6,694 - 4,780 $ 11,474 - - 26 - 26 1.25% 1.02% $ 426.90% 916.60% 672.65% 197.23% 131.56% TA BL E 8B – NON-PER FOR M I NG COV ER ED A SSET S As of December 31 (dollars in thousands) 2013 2014 2012 2011 2010 Non-accrual loans Commercial and financial Agricultural Real estate Consumer loans Total Non-Accrual Loans Foreclosed assets Other real estate owned Total Non-Performing Covered Assets* Loans past due 90 days or more Commercial and financial Agricultural Real estate Consumer loans Total Loans Past Due 90 Days or More - - - - - - - - - - - - - $ 227 - 3,313 - $ 3,540 - 3,319 $ 6,859 - - - - - $ 380 8 3,746 - $ 4,134 - 7,439 $ 11,573 - - 541 - 541 $ $ $ 459 - 6,083 - $ 6,542 - 9,050 $ 15,592 - - - - - $ 271 - 11,021 - $ 11,292 - 7,638 $ 18,930 - - 377 - 377 $ $ *Exposure on covered assets is limited to 20% on the first $66 million and 5% thereafter. in 2013, and $4.8 million in 2012. Non-performing assets excluding covered assets represented 0.41% of total assets and other non-performing assets in 2014, compared to 0.25% in 2013, and 0.36% in 2012. Table 8A provides a summary of the non-performing history for the past five years. At December 31, 2014, there were no non-performing covered assets. Table 8B provides a summary of the non- performing covered assets. At December 31, 2014, the allowance for loan losses was $17.1 million, or 1.56% of total loans excluding covered assets, compared with $16.8 million, or 1.88%, at December 31, 2013, and $15.1 million, or 2.05%, at December 31, 2012. The provision for loan losses was $(400,000) in 2014, $1.2 million in 2013, and $0.8 million in 2012. Net recoveries in 2014 were $625,000, or 0.06% of average total loans excluding cover assets, compared with net recoveries of $537,000, or 0.07%, in 2013, and net recoveries of $1.4 million, or 0.21%, in 2012. The Company considers the allowance for loan losses of $17.1 million adequate to cover losses inherent in loans, commitments to extend credit, and standby letters of credit at December 31, 2014. Table 9 provides a summary of the loan loss experience for the past five years. LIQUIDITY RISK The Company’s liquidity risk management process is designed to identify, measure, and manage the Company’s funding and liquidity risk to meet its daily funding needs and to address expected and unexpected changes in its funding requirements. The Asset/Liability Committee (“ALCO”) establishes policies, as well as analyzes and manages the Company’s liquidity to ensure adequate funds are always available at reasonable rates to meet normal operating requirements in addition to unexpected 12 Average loans excluding covered assets 2014 $ 976,257 2013 $ 807,278 2012 $ 680,749 2011 $ 606,259 2010 $ 547,599 TA BL E 9 – SUM M A RY OF LOA N LOSS EX PER I ENCE As of December 31 (dollars in thousands) Allowance for loan losses Balance at beginning of year Charge-offs Commercial and financial Agricultural Real estate Consumer loans Total Charge-Offs Recoveries Commercial and financial Agricultural Real estate Consumer loans Total Recoveries (Net charge-offs)/Recoveries Provision charged to earnings Balance at end of year Ratio of net charge-offs to average loans Commercial and financial Agricultural Real estate Consumer loans Total loans Ratio of allowance for loan losses to end-of-year non-covered loans $ 16,838 $ 15,101 $ 12,826 $ 8,841 $ 11,053 $ $ $ $ (408) (73) (351) (188) (1,020) 968 20 512 145 1,645 625 (400) 17,063 -0.16% 0.13% -0.03% 0.06% -0.06% $ $ $ $ (538) - (16) (531) (1,085) 1,187 19 275 141 1,622 537 1,200 16,838 -0.22% -0.04% -0.06% 0.74% -0.07% $ $ $ $ (440) (22) (1,191) (409) (2,062) 230 1 3,084 189 3,504 1,442 833 15,101 0.09% 0.05% -0.52% 0.55% -0.21% $ $ $ $ (739) (7) (321) (199) (1,266) 371 13 318 131 833 (433) 4,418 12,826 0.17% -0.01% 0.00% 0.24% 0.07% $ $ $ $ (2,592) (14) (7,256) (82) (9,944) 684 12 163 53 912 (9,032) 6,820 8,841 1.02% 0.01% 2.34% 0.12% 1.65% 1.57% 1.88% 2.05% 2.05% 1.65% customer demands for funds, such as high levels of deposit withdrawals or loan demand, in a timely and cost effective manner. Liquidity needs are provided for on both the asset and liability side of the balance sheet. Asset liquidity is provided by regular maturities of loans and maintaining relatively short-term, marketable investments and federal funds. As of December 31, 2014, the Company had $60.1 million of un-pledged, available-for-sale securities. Liability liquidity is provided through short-term federal fund borrowings and borrowing capacity at the Federal Home Loan Bank. As of December 31, 2014, the Company had $87 million of unsecured lines of credit for federal funds that may be drawn as needed and borrowing capacity at the Federal Home Loan Bank of $120.3 million. INTEREST RATE RISK The Company’s major market risk exposure is changing interest rates. To minimize the volatility of net interest income and exposure to economic loss, the Company manages its exposure to interest rate risk through asset/ liability management activities within the guidelines established by ALCO. Interest rate risk can be broken down into four components which are as follows: 1) repricing risk results from the difference in the timing of rate changes and the timing of cash flows that occur in the pricing and maturity of the bank’s assets and liabilities, 2) basis risk occurs when market rates for different financial instruments, or the indices used to price assets and liabilities change at different times or by different amounts, 3) option risk occurs when customers have the right to alter the level and/or timing of the cash flows of an asset or a liability, and 4) term structure risk occurs from variations in the movement of interest rates across maturity spectrums. Interest rate risk is managed within an overall asset/ liability framework for the Company. The Company positions the balance sheet to be interest rate neutral to slightly asset sensitive, defined as allowing assets on the balance sheet to reprice faster than the liabilities. The Company chooses to manage the balance sheet to be slightly asset sensitive to take advantage of a normally upward sloping yield curve. The Company employs a sensitivity analysis in the form of a net interest income simulation to help quantify the existing interest rate risk embedded in the Company’s balance sheet and to help identify ways to minimize the risk. The monthly analysis incorporates substantially all of the Company’s assets and liabilities and off-balance sheet instruments, together with forecasted changes in the balance sheet and assumptions that reflect the current interest rate environment. The simulation model is used to measure the impact on net interest income, relative to a base case scenario, of interest rates increasing or decreasing 100, 200, and 300 basis points over the next 12 months. The simulation run at December 31, 2014, illustrates a negative 5.55% change in net interest income for a 100 basis point decline in interest rates, and a positive 3.69% change in net interest income for a 100 basis point rise in interest rates. The base case interest rates for the simulation included the prime rate at 3.25% and the federal funds rate at 0.25%. 13 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT TA BL E 10 – CONSOL I DAT ED AV ER AGE BA L A NCE SH EET As of December 31 (dollars in thousands) ASSETS Cash and due from banks Interest bearing deposits with banks Federal funds sold Investment securities: Taxable Exempt from federal tax Total Investment Securities Loans held for sale Loans – excluding covered assets Commercial and financial Agricultural Real estate Consumer loans Total Loans Allowance for loan losses Net Loans – Excluding Covered Assets Covered loans Bank premises and equipment Goodwill and other intangibles FDIC indemnification asset Interest receivable and other assets Total Assets LIABILITIES AND SHAREHOLDERS’ EQUIT Y Deposits Non-interest-bearing deposits Savings, NOW, and money market deposits Time deposits Total Deposits Federal funds purchased and other short-term borrowings Other borrowed funds Other liabilities Total Liabilities $ 2014 23,408 19,787 17 230,998 27,707 258,705 $ 2013 21,098 56,339 8 242,082 22,896 264,978 $ 2012 32,429 42,121 2,675 242,121 19,909 262,030 $ 2011 34,326 59,423 553 254,668 17,763 272,431 $ 2010 53,466 38,561 1,238 241,819 19,596 261,415 27,090 43,361 51,548 26,447 35,106 341,516 40,731 525,873 68,137 976,257 (16,792) 959,465 292,449 43,741 418,397 52,691 807,278 (15,673) 791,605 34,126 42,078 364,411 40,134 680,749 (14,611) 666,138 210,851 41,670 325,633 28,105 606,259 (10,665) 595,594 187,058 33,333 303,293 23,915 547,599 (11,209) 536,390 17,790 22,174 18,271 200 77,424 $ 1,424,331 25,167 22,440 15,251 1,530 66,382 $ 1,308,159 37,901 21,908 16,795 9,295 54,967 $ 1,197,807 52,685 22,763 12,213 12,583 39,817 $ 1,128,835 68,995 19,233 15,025 23,011 26,985 $ 1,079,425 $ 278,005 690,898 222,943 1,191,846 $ 221,199 642,934 237,040 1,101,173 $ 195,939 556,282 251,628 1,003,849 $ 162,106 548,362 272,072 982,540 $ 126,513 503,143 300,636 930,292 29,007 21,562 17,713 $ 1,260,128 13,964 22,650 20,072 $ 1,157,859 19,203 21,817 16,314 $ 1,061,183 9,406 22,449 8,510 $ 1,022,905 Preferred stock and related surplus Common stock and surplus Retained earnings Total Shareholders’ Equity $ $ 20,000 30,990 113,213 164,203 $ $ 20,000 25,733 104,567 150,300 Total Liabilities and Shareholders’ Equity $ 1,424,331 $ 1,308,159 $ $ $ 20,000 23,509 93,115 136,624 $ $ 7,419 20,973 77,538 105,930 1,197,807 $ 1,128,835 $ 1,079,425 1,679 41,249 12,258 985,478 - 19,585 74,362 93,947 $ $ The Company has successfully implemented interest rate floors in a substantial number of underlying loan contracts at rates above market indications. These interest rate floors have preserved net interest rate margin in the current environment but will cause slight interest rate compression when interest rates begin to rise since these loans will not reprice until the floor rate is surpassed. REGULATORY CHANGES Financial institutions, their holding companies and their affiliates, along with securities broker dealers, registered investment advisors, and insurance agencies, are extensively regulated under federal and state law. As a result, the growth and earnings performance of the Company may be affected not only by management decisions and general economic conditions, but also by requirements of federal and state statutes and by the regulations and policies of various bank regulatory agencies, including the Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”), and the recently created Bureau of Consumer Financial Protection (the “CFPB”). Furthermore, taxation laws administered by the Internal Revenue Service and state taxing authorities, accounting rules developed by the Financial Accounting Standards Board (the “FASB”), and securities laws administered by the Securities and Exchange Commission 14 (the “SEC”) and state securities authorities have an impact on the business of the Company. The effect of these statutes, regulations, regulatory policies, and accounting rules are significant to the operations and results of the Company, its subsidiary bank, Alerus Financial, N.A. (the “Bank”), and its indirect subsidiaries, Alerus Securities, Alerus Investment Advisors, and Alerus Insurance Services. Federal and state banking laws impose a comprehensive system of supervision, regulation, and enforcement on the operations of financial institutions, their holding companies, and affiliates that is intended primarily for the protection of the FDIC-insured deposits and depositors of banks, rather than shareholders. These federal and state laws, and the regulations of the bank regulatory agencies issued under them, affect, among other things, the scope of business, the kinds and amounts of investments banks may make, reserve requirements, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, the ability to merge, consolidate and acquire, dealings with insiders and affiliates, and the payment of dividends. Federal and state securities and insurance laws impose a comprehensive system of supervision, regulation, and enforcement on the operations of securities broker dealers, registered investment advisors, and insurance agencies’ financial institutions, that is intended primarily for the protection of customers, rather than shareholders. The following is a summary of the material elements of the supervisory and regulatory framework applicable to the Company and the Bank. It does not describe all of the statutes, regulations, and regulatory policies that apply, nor does it restate all of the requirements of those that are described. The descriptions are qualified in their entirety by reference to the particular statutory and regulatory provision. FINANCIAL REGULATORY REFORM On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. The Dodd-Frank Act represented a sweeping reform of the U.S. supervisory and regulatory framework applicable to financial institutions and capital markets in the wake of the global financial crisis. In particular, and among other things, the Dodd-Frank Act: (i) created a Financial Stability Oversight Council as part of a regulatory structure for identifying emerging systemic risks and improving interagency cooperation; (ii) created the CFPB, which is authorized to regulate providers of consumer credit, savings, payment, and other consumer financial products and services; (iii) narrowed the scope of federal preemption of state consumer laws enjoyed by national banks and federal savings associations and expanded the authority of state attorneys general to bring actions to enforce federal consumer protection legislation; (iv) imposed more stringent capital requirements on bank holding companies and subjected certain activities, including interstate mergers and acquisitions, to heightened capital conditions; (v) with respect to mortgage lending, (a) significantly expanded requirements applicable to loans secured by 1-4 family residential real property, (b) imposed strict rules on mortgage servicing, and (c) required the originator of a securitized loan, or the sponsor of a securitization, to retain at least 5% of the credit risk of securitized exposures unless the underlying exposures are qualified residential mortgages or meet certain underwriting standards; (vi) repealed the prohibition on the payment of interest on business checking accounts; (vii) restricted the interchange fees payable on debit card transactions for issuers with $10 billion in assets or greater; (viii) in the so-called “Volcker Rule,” subject to numerous exceptions, prohibited depository institutions and affiliates from certain investments in, and sponsorship of, hedge funds and private equity funds and from engaging in proprietary trading; (ix) provided for enhanced regulation of advisers to private funds and of the derivatives markets; (x) enhanced oversight of credit rating agencies; and (xi) prohibited banking agency requirements tied to credit ratings. These statutory changes shifted the regulatory framework for financial institutions, impacted the way in which they do business and have the potential to constrain revenues. Numerous provisions of the Dodd-Frank Act are required to be implemented through rulemaking by the appropriate federal regulatory agencies. Furthermore, while the reforms primarily target systemically important financial service providers, their influence is expected to filter down in varying degrees to smaller institutions over time. THE INCREASING REGULATORY EMPHASIS ON CAPITAL Regulatory capital represents the net assets of a financial institution available to absorb losses. Because of the risks attendant to their businesses, depository institutions are generally required to hold more capital than other businesses, which directly affects earnings capabilities. Certain provisions of the Dodd-Frank Act and Basel III establish strengthened capital standards for banks and bank holding companies, require more capital to be held in the form of common stock, and disallow certain funds from being included in capital determinations. Once fully implemented, these standards will represent regulatory capital requirements that are meaningfully more stringent than those in place historically. THE COMPANY AND BANK REQUIRED CAPITAL LEVELS Bank holding companies have historically had to comply with less stringent capital standards than their bank subsidiaries and were able to raise capital with hybrid instruments such as trust preferred securities. The Dodd- Frank Act mandated the Federal Reserve to establish minimum capital levels for bank holding companies on a consolidated basis that are as stringent as those required for insured depository institutions. Under current federal regulations, the Bank is subject to the following minimum capital standards: • A leverage requirement, consisting of a minimum ratio of Tier 1 Capital to total adjusted book assets of 3% for the most highly-rated banks with a minimum requirement of at least 4% for all others; and • A risk-based capital requirement, consisting of a minimum ratio of Total Capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 Capital to total risk-weighted assets of 4%. 15 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT TA BL E 11 – CONSOL I DAT ED STAT EM EN T OF I NCOM E For years ended December 31 (dollars in thousands except per-share data) INTEREST INCOME Deposits with banks Investment securities Taxable Exempt from federal income taxes Total Investment Securities Federal funds sold Loans held for sale Loans and leases, including fees Total Interest Income INTEREST EXPENSE Deposits Federal funds purchased and other short-term borrowings Other borrowed funds Total Interest Expense Net interest income Provision for loan losses Net Interest Income After Provision for Loan Losses NON-INTEREST INCOME Retirement services and wealth management income Service charges on deposit accounts Mortgage origination and loan servicing fees Other Investment security gains (losses) Total Non-Interest Income NON-INTEREST EXPENSE Salaries and employee benefits Net occupancy expense Furniture and equipment expense Other Total Non-Interest Expense Income before income taxes and extraordinary items Applicable income taxes Net Income 2014 52 $ 2013 148 $ 2012 100 $ 2011 154 $ 2010 93 $ 5,649 817 6,466 5,905 707 6,612 6,853 699 7,552 7,754 700 8,454 7,155 782 7,937 – 936 46,940 $ 54,394 – 1,206 42,544 $ 50,510 3 1,581 43,616 $ 52,852 1 1,076 37,696 $ 47,381 2 1,553 36,398 $ 45,983 $ $ 2,673 22 621 3,316 51,078 (400) $ 51,478 $ 52,343 1,626 18,435 3,823 2,179 $ 78,406 $ 60,419 4,424 4,658 30,614 $ 100,115 29,769 9,538 $ 20,231 $ $ 3,101 30 581 3,712 46,798 1,200 $ 45,598 $ 46,627 1,639 27,177 3,896 (70) $ 79,269 $ 59,824 3,791 4,687 24,611 $ 92,913 31,954 11,684 $ 20,270 $ $ 3,874 65 647 4,586 48,266 833 $ 47,433 $ 42,621 1,626 31,061 3,590 217 $ 79,115 $ 59,374 4,189 4,147 33,124 $ 100,834 25,714 9,458 $ 16,256 $ $ 6,070 39 712 6,821 40,560 4,418 $ 36,142 $ 34,925 1,655 15,746 4,469 (11) $ 56,784 $ 45,164 4,112 3,698 23,766 $ 76,740 16,186 5,477 $ 10,709 $ 9,464 47 1,274 $ 10,785 35,198 6,820 $ 28,378 $ 32,840 1,940 18,073 3,030 (2,782) $ 53,101 $ 44,161 3,959 3,297 21,231 $ 72,649 8,830 2,958 5,873 5,873 $ $ Net Income Applicable to Common Shareholders $ 20,031 $ 20,070 $ 15,917 $ 10,636 For these purposes, “Tier 1 Capital” consists primarily of common stock, noncumulative perpetual preferred stock, and related surplus less intangible assets (other than certain loan servicing rights and purchased credit card relationships). Total Capital consists primarily of Tier 1 Capital plus “Tier 2 Capital,” which includes other nonpermanent capital items, such as certain other debt and equity instruments that do not qualify as Tier 1 Capital, and a portion of the Bank’s allowance for loan and lease losses. Further, “risk-weighted assets” for the purposes of the risk- weighted ratio calculations are balance sheet assets and off- balance sheet exposures to which required risk-weightings of 0% to 100% are applied. These capital standards are minimum requirements and will be increased under Basel III, as discussed below. Bank regulatory agencies are uniformly encouraging banks and bank holding companies to be “well-capitalized” and, to that end, federal law and regulations provide various incentives for banking organizations to maintain regulatory capital at levels in excess of minimum regulatory requirements. Under the capital regulations of the OCC and Federal Reserve, in order to be “well capitalized,” a banking organization, under current federal regulations, must maintain: • A leverage ratio of Tier 1 Capital to total assets of 5% or greater; • A ratio of Tier 1 Capital to total risk-weighted assets of 6% or greater; and • A ratio of Total Capital to total risk-weighted assets of 10% or greater. The OCC and Federal Reserve guidelines also provide that banks and bank holding companies experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines indicate that the agencies will continue to consider a “tangible Tier 16 1 leverage ratio” (deducting all intangibles) in evaluating proposals for expansion or to engage in new activities. Higher capital levels may also be required if warranted by the particular circumstances or risk profiles of individual banking organizations. PROMPT CORRECTIVE ACTION A banking organization’s capital plays an important role in connection with regulatory enforcement as well. Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. The extent of the regulators’ powers depends on whether the institution in question is “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized,” in each case as defined by regulation. Depending upon the capital category to which an institution is assigned, the regulators’ corrective powers include: (i) requiring the institution to submit a capital restoration plan; (ii) limiting the institution’s asset growth and restricting its activities; (iii) requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; (iv) restricting transactions between the institution and its affiliates; (v) restricting the interest rate that the institution may pay on deposits; (vi) ordering a new election of directors of the institution; (vii) requiring that senior executive officers or directors be dismissed; (viii) prohibiting the institution from accepting deposits from correspondent banks; (ix) requiring the institution to divest certain subsidiaries; (x) prohibiting the payment of principal or interest on subordinated debt; and (xi) ultimately, appointing a receiver for the institution. As of December 31, 2014: (i) the Bank exceeded its minimum regulatory capital requirements under OCC capital adequacy guidelines; and (ii) the Bank was “well- capitalized,” as defined by OCC regulations. As of December 31, 2014, the Company had regulatory capital in excess of the Federal Reserve’s requirements and met the Dodd-Frank Act’s capital requirements. THE BASEL III INTERNATIONAL CAPITAL ACCORD After an extended rulemaking process, the U.S. federal banking agencies approved the implementation of the Basel III regulatory capital reforms in pertinent part, and, at the same time, promulgated rules effecting certain changes required by the Dodd-Frank Act (the “Basel III Rule”). The Basel III Rule not only increases most of the required minimum capital ratios, but it also introduces the concept of Common Equity Tier 1 Capital, which consists primarily of common stock, related surplus (net of treasury stock), retained earnings, and Common Equity Tier 1 minority interests subject to certain regulatory adjustments. The Basel III Rule also expanded the definition of capital as in effect currently by establishing more stringent criteria that instruments must meet to be considered Additional Tier 1 Capital (Tier 1 Capital in addition to Common Equity) and Tier 2 Capital. A number of instruments that now qualify as Tier 1 Capital will not qualify, or their qualifications will change. For example, cumulative preferred stock and certain hybrid capital instruments, including trust preferred securities, will no longer qualify as Tier 1 Capital of any kind, with the exception, subject to certain restrictions, of such instruments issued before May 10, 2010, by bank holding companies with total consolidated assets of less than $15 billion as of December 31, 2009. For those institutions, trust preferred securities and other nonqualifying capital instruments currently included in consolidated Tier 1 Capital are permanently grandfathered under the Basel III Rule, subject to certain restrictions. Noncumulative perpetual preferred stock, which now qualifies as simple Tier 1 Capital, will not qualify as Common Equity Tier 1 Capital, but will qualify as Additional Tier 1 Capital. The Basel III Rule also constrains the inclusion of minority interests, mortgage-servicing assets, and deferred tax assets in capital and requires deductions from Common Equity Tier 1 Capital in the event such assets exceed a certain percentage of a bank’s Common Equity Tier 1 Capital. The Basel III Rule requires: • A new required ratio of minimum Common Equity Tier 1 equal to 4.5% of risk-weighted assets; • An increase in the minimum required amount of Tier 1 Capital from the current level of 4% of total assets to 6% of risk-weighted assets; • A continuation of the current minimum required amount of Total Capital (Tier 1 plus Tier 2) at 8% of risk-weighted assets; and • A minimum leverage ratio of Tier 1 Capital to total assets equal to 4% in all circumstances. In addition, institutions that seek the freedom to make capital distributions (including for dividends and repurchases of stock) and pay discretionary bonuses to executive officers without restriction must also maintain 2.5% of risk-weighted assets in Common Equity Tier 1 attributable to a capital conservation buffer to be phased- in over three years beginning in 2016. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. Factoring in the fully phased-in conservation buffer increases the minimum ratios depicted above to 7% for Common Equity Tier 1, 8.5% for Tier 1 Capital, and 10.5% for Total Capital. The leverage ratio is not impacted by the conservation buffer. The Basel III Rule maintained the general structure of the current prompt corrective action framework, while incorporating the increased requirements. The prompt corrective action guidelines were also revised to add the Common Equity Tier 1 Capital ratio. In order to be a “well- capitalized” depository institution under the new regime, a bank and holding company must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more, a Tier 1 Capital ratio of 8% or more, a Total Capital ratio of 10% or more, and a leverage ratio of 5% or more. It is possible under the Basel III Rule to be well-capitalized while remaining out of compliance with the capital conservation buffer discussed above. The Basel III Rule revises a number of the risk weightings (or their methodologies) for bank assets that are used to determine the capital ratios. For nearly every class of assets, the Basel III Rule requires a more complex, detailed and calibrated assessment of credit risk and calculation of risk weightings. 17 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT Furthermore, there was significant concern noted by the financial industry in connection with the Basel III rulemaking as to the proposed treatment of accumulated other comprehensive income (“AOCI”). Basel III requires unrealized gains and losses on available-for-sale securities to flow through to regulatory capital as opposed to the current treatment, which neutralizes such effects. Recognizing the problem for community banks, the U.S. bank regulatory agencies adopted the Basel III Rule with a one-time election for smaller institutions like the Company and the Bank to opt out of, including most elements of AOCI in regulatory capital. This opt-out, which must be made in the first quarter of 2015, would exclude from regulatory capital both unrealized gains and losses on available-for- sale debt securities and accumulated net gains and losses on cash-flow hedges and amounts attributable to defined benefit post-retirement plans. The Company intends to make the opt-out election. Generally, financial institutions (except for large, internationally active financial institutions) became subject to the new rules on January 1, 2015. However, there will be separate phase-in/phase-out periods for: (i) the capital conservation buffer; (ii) regulatory capital adjustments and deductions; (iii) nonqualifying capital instruments; and (iv) changes to the prompt corrective action rules. The phase-in periods commence on January 1, 2016, and extend until 2019. THE COMPANY GENERAL The Company, as the sole shareholder of the Bank, is a bank holding company. As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the “BHCA”). In accordance with Federal Reserve policy, and as now codified by the Dodd- Frank Act, the Company is legally obligated to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where the Company might not otherwise do so. Under the BHCA, the Company is subject to periodic examination by the Federal Reserve. The Company is required to file with the Federal Reserve periodic reports of the Company’s operations and such additional information regarding the Company and its subsidiaries as the Federal Reserve may require. DIVIDEND PAYMENTS The Company’s ability to pay dividends to its shareholders may be affected by both general corporate law considerations and the policies of the Federal Reserve applicable to bank holding companies. As a Delaware corporation, the Company is subject to the limitations of the Delaware General Corporation Law (the “DGCL”). The DGCL allows the Company to pay dividends only out of its surplus (as defined and computed in accordance with the provisions of the DGCL) or, if the Company has no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should eliminate, defer, or significantly reduce dividends to shareholders if: (i) the company’s net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) the prospective rate of earnings retention is inconsistent with the company’s capital needs and overall current and prospective financial condition; or (iii) the company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. The Federal Reserve also possesses enforcement powers over bank holding companies and their nonbank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. THE BANK GENERAL The Bank is a national bank, chartered by the OCC under the National Bank Act. The deposit accounts of the Bank are insured by the FDIC’s Deposit Insurance Fund (the “DIF”) to the maximum extent provided under federal law and FDIC regulations, and the Bank is a member of the Federal Reserve System. As a national bank, the Bank is subject to the examination, supervision, reporting, and enforcement requirements of the OCC. The FDIC, as administrator of the DIF, also has regulatory authority over the Bank. DEPOSIT INSURANCE As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system whereby FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. The Dodd-Frank Act permanently increases the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per insured depositor, retroactive to January 1, 2009. 18 BANK DIVIDEND PAYMENTS The primary source of funds for the Company is dividends from the Bank. Under the National Bank Act, a national bank may pay dividends out of its undivided profits in such amounts and at such times as the bank’s board of directors deems prudent. Without prior OCC approval, however, a national bank may not pay dividends in any calendar year that, in the aggregate, exceed the bank’s year-to-date net income plus the bank’s retained net income for the two preceding years. The payment of dividends by any financial institution is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2014. Notwithstanding the availability of funds for dividends, however, the OCC may prohibit the payment of dividends by the Bank if it determines such payment would constitute an unsafe or unsound practice. SAFETY AND SOUNDNESS STANDARDS/RISK MANAGEMENT The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings. During the past decade, the bank regulatory agencies have increasingly emphasized the importance of sound risk management processes and strong internal controls when evaluating the activities of the institutions they supervise. Properly managing risks has been identified as critical to the conduct of safe and sound banking activities and has become even more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking markets. The agencies have identified a spectrum of risks facing a banking institution including, but not limited to, credit, market, liquidity, operational, legal, and reputational risk. COMMUNITY REINVESTMENT ACT REQUIREMENTS The Community Reinvestment Act requires the Bank to have a continuing and affirmative obligation in a safe and sound manner to help meet the credit needs of its entire community, including low- and moderate- income neighborhoods. Federal regulators regularly assess the Bank’s record of meeting the credit needs of its communities. Applications for additional acquisitions would be affected by the evaluation of the Bank’s effectiveness in meeting its Community Reinvestment Act requirements. FORWARD-LOOKING STATEMENTS The following information appears in accordance with the Private Securities Litigation Reform Act of 1995: This annual report contains forward-looking statements about Alerus Financial Corporation. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements and are based on the information available to, and assumptions and estimates made by, management as of the date made. These forward-looking statements cover, among other things, anticipated future revenue and expenses and the future plans and prospects of Alerus Financial Corporation. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated. Global and domestic economies could fail to recover from the recent economic downturn or could experience another severe contraction, which could adversely affect Alerus Financial Corporation’s revenues and the values of its assets and liabilities. Global financial markets could experience a recurrence of significant turbulence, which could reduce the availability of funding to certain financial institutions and lead to a tightening of credit, a reduction of business activity, and increased market volatility. Alerus Financial Corporation’s results could also be adversely affected by continued deterioration in general business and economic conditions; changes in interest rates; deterioration in the credit quality of its loan portfolios or in the value of the collateral securing those loans; deterioration in the value of securities held in its investment securities portfolio; legal and regulatory developments; increased competition from both banks and non-banks; cyber-attacks; changes in customer behavior and preferences; effects of mergers and acquisitions and related integration; effects of critical accounting policies and judgments; and management’s ability to effectively manage credit risk, residual value risk, market risk, operational risk, interest rate risk, liquidity risk, and cybersecurity. Forward-looking statements speak only as of the date they are made, and Alerus Financial Corporation undertakes no obligation to update them in light of new information or future events. 19 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT CONSUMER FINANCIAL SERVICES There are numerous developments in federal and state laws regarding consumer financial products and services that impact the Bank’s business. Importantly, the current structure of federal consumer protection regulation applicable to all providers of consumer financial products and services changed significantly on July 21, 2011, when the CFPB commenced operations to supervise and enforce consumer protection laws. The CFPB has broad rulemaking authority for a wide range of consumer protection laws that apply to all providers of consumer products and services, including the Bank, as well as the authority to prohibit “unfair, deceptive, or abusive” acts and practices. The CFPB has examination and enforcement authority over providers with more than $10 billion in assets. Banks and savings institutions with $10 billion or less in assets, like the Bank, will continue to be examined by their applicable bank regulators. Below are additional recent regulatory developments relating to consumer mortgage lending activities. The Company does not currently expect these provisions to have a significant impact on Bank operations; however, additional compliance resources will be needed to monitor changes. ABILITY-TO - REPAY REQUIREMENT AND QUALIFIED MORTGAGE RULE The Dodd-Frank Act contains additional provisions that affect consumer mortgage lending. First, it significantly expands underwriting requirements applicable to loans secured by 1-4 family residential real property and augments federal law combating predatory lending practices. In addition to numerous new disclosure requirements, the Dodd-Frank Act imposes new standards for mortgage loan originations on all lenders, including banks and savings associations, in an effort to strongly encourage lenders to verify a borrower’s ability to repay, while also establishing a presumption of compliance for certain “qualified mortgages.” On January 10, 2013, the CFPB issued a final rule, effective January 10, 2014, that implements the Dodd-Frank Act’s ability- to-repay requirements and clarifies the presumption of compliance for “qualified mortgages.” In assessing a borrower’s ability to repay a mortgage-related obligation, lenders generally must consider eight underwriting factors: (i) current or reasonably expected income or assets; (ii) current employment status; (iii) monthly payment on the subject transaction; (iv) monthly payment on any simultaneous loan; (v) monthly payment for all mortgage-related obligations; (vi) current debt obligations, alimony, and child support; (vii) monthly debt-to-income ratio or residual income; and (viii) credit history. Further, the final rule also clarifies that qualified mortgages do not include “no-doc” loans and loans with negative amortization, interest-only payments, balloon payments, terms in excess of 30 years, or points and fees paid by the borrower that exceed 3% of the loan amount, subject to certain exceptions. In addition, for qualified mortgages, the monthly payment must be calculated on the highest payment that will occur in the first five years of the loan, and the borrower’s total debt-to-income ratio generally may not be more than 43%. Jerrod Hanson, Controller Alerus Financial Corporation February 20, 2015 INDEPENDENT AUDITORS’ REPORT REPORT ON CONSOLIDATED FINANCIAL STATEMENTS We have audited the accompanying consolidated financial statements of Alerus Financial Corporation and Subsidiaries, which comprise the consolidated balance sheet of December 31, 2014, and the related consolidated statement of income, comprehensive income, change in stockholders’ equity, and cash flows for the year then ended, and the related notes to the consolidated financial statements. MANAGEMENT’S RESPONSIBILITY FOR THE CONSOLIDATED FINANCIAL STATEMENTS Management is responsible for the preparation and fair presentation of these consolidated financial 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 consolidated financial statements that are free from material misstatement, whether due to fraud or error. AUDITORS’ RESPONSIBILITY Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. 20 An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the financial 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 financial 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 financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. OPINION In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alerus Financial Corporation and Subsidiaries as of December 31, 2014, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. EMPHASIS OF MATTER Correction of Error As described in Note 19 to the consolidated financial statements, Alerus Financial Corporation and Subsidiaries discovered and corrected an error in the 2012 and 2013 consolidated financial statements related to recognition of the FDIC true-up liability arising from the loss share agreements with the FDIC. Our opinion is not modified with respect to that matter. OTHER MATTERS Report on Internal Control over Financial Reporting We also have audited in accordance with attestation standards established by the American Institute of Certified Public Accountants, Alerus Financial Corporation and Subsidiaries’ internal control over financial reporting as of December 31, 2014, based on criteria established in 2013 Internal Control – Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 20, 2015, except for Notes 13 and 19, as to which the date is March 31, 2015, expressed an adverse opinion on the Company’s internal control over financial reporting because of a material weakness. Prior Period Consolidated Financial Statements The consolidated financial statements of Alerus Financial Corporation and Subsidiaries as of December 31, 2013 and 2012 were audited by other auditors whose report, dated February 18, 2014, expressed an unqualified opinion on those statements, before the restatement described in Note 19 to the consolidated financial statements. As part of our audit of the 2014 consolidated financial statements, we also audited adjustments described in Note 19 that were applied to restate the 2012 and 2013 consolidated financial statements. In our opinion, such adjustments are appropriate and have been properly applied. We were not engaged to audit, review, or apply any procedures to the 2012 and 2013 consolidated financial statements of the Company other than with respect to the adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2012 and 2013 consolidated financial statements as a whole. CliftonLarsonAllen LLP Minneapolis, Minnesota March 31, 2015 Independent Auditors’ REPORT 21 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT FDICIA COMPLIANCE ASSERTIONS 2014 MANAGEMENT ASSERTION FDICIA COMPLIANCE Statement of Management’s Responsibilities Management of Alerus Financial (the “Bank”) is responsible for preparing the Bank’s annual financial statements in accordance with generally accepted accounting principles; for establishing and maintaining an adequate internal control structure and procedures for financial reporting, including controls over the preparation of regulatory financial statements in accordance with Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income (call report instructions); and for complying with the Federal laws and regulations pertaining to insider loans and the Federal laws and regulations pertaining to dividend restrictions. Management’s Assessment of Compliance with Designated Laws and Regulations Management of the Bank has assessed the Bank’s compliance with the Federal laws and regulations pertaining to insider loans and the Federal laws and regulations pertaining to dividend restrictions during the fiscal year that ended December 31, 2014. Based upon its assessment, management has concluded that the Bank complied with the Federal laws and regulations pertaining to insider loans and the Federal laws and regulations pertaining to dividend restrictions during the fiscal year ended on December 31, 2014. Management’s Assessment of Control Over Financial Reporting The Bank’s internal control over financial reporting is a process effected by those charged with governance, management, and other personnel, designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America and financial statements for regulatory reporting purposes, i.e. the Consolidated Reports of Condition and Income. The Bank’s internal control over financial reporting includes those policies and procedures that 1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the Bank; 2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and financial statements for regulatory reporting purposes, and that receipts and expenditures of the Bank are being made only in accordance with authorization of management and directors of the Bank; and 3) provided reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use or disposition of the Bank’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent, or detect and correct misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures deteriorate. Management assessed the effectiveness of the Bank’s internal control over financial reporting, including controls over the preparation of regulatory financial statements in accordance with the instructions for the call report as of December 31, 2014, based on the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in 2013 Internal Control- Integrated Framework. Because of the material weakness noted below, management determined that the institution’s internal control over financial reporting, including controls over the preparation of regulatory financial statements in accordance with the instructions for the Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income, was not effective as of December 31, 2014, based on the criteria established in 2013 Internal Control-Integrated Framework. Management determined controls surrounding business combination accounting over its failed bank acquisition in 2009 were not effective, which resulted in an overstatement of earnings in 2012 of approximately $1.6 million. Management’s assessment of the effectiveness of internal control over financial reporting, including controls over the preparation of regulatory financial statements in accordance with the instructions for the call report, as of December 31, 2014, has been audited by CliftonLarsonAllen LLP, an independent public accounting firm, as stated in their report dated March 31, 2015. Randy Newman, Chief Executive Officer Alerus Financial, N.A. March 31, 2015 Jerrod Hanson, Controller Alerus Financial, N.A. March 31, 2015 22 INDEPENDENT AUDITORS’ REPORT We have audited management’s assertion included in the accompanying 2014 Management Assertion FDICIA Compliance that Alerus Financial maintained effective internal control over financial reporting, including controls over the preparation of regulatory financial statements in accordance with the instructions for the Consolidated Reports of Condition and Income as of December 31, 2014, based on criteria established in 2013 Internal Control – Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Alerus Financial’s management is responsible for maintaining effective internal control over financial reporting, and for its assertion about the effectiveness of internal control over financial reporting, included in the accompanying Management Assertion FDICIA Compliance. Our responsibility is to express an opinion on management’s assertion based on our audit. We conducted our audit in accordance with attestation standards established by the American Institute of Certified Public Accountants. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe our audit provides a reasonable basis for our opinion. An entity’s internal control over financial reporting is a process effected by those charged with governance, management, and other personnel, designed to provide reasonable assurance regarding the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America. Because management’s assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our audit of Alerus Financial’s internal control over financial reporting included controls over the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and with the Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income (call report instructions). An entity’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the entity; (2) provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the entity are being made only in accordance with authorizations of management and those charged with governance; and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use, or disposition of the entity’s assets that could have a material effect on the financial statements. Based on inherent limitations, internal control over financial reporting may not prevent, or detect and correct misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may be come inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis. The following material weakness has been identified and included in the accompanying 2014 Management Assertion FDICIA Compliance: Management determined controls surrounding business combination accounting over its failed bank acquisition in 2009 were not effective, which resulted in an overstatement of earnings in 2012 of approximately $1.6 million. In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Alerus Financial has not maintained effective internal control over financial reporting as of December 31, 2014 based on criteria established in 2013 Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. We also have audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated financial statements of Alerus Financial. We considered the material weakness identified above in determining the nature, timing, and extent of audit tests applied in our audit of the 2014 consolidated financial statements, and this report does not affect our report dated March 31, 2015, which expressed unqualified opinion. This report is intended solely for the information and use of the audit committee and management of Alerus Financial and its regulators and is not intended to be and should not be used by anyone other than these specified parties. CliftonLarsonAllen LLP Minneapolis, Minnesota March 31, 2015 23 ALERUS FINANCIAL CORPORATION 2014 ANNUAL FINANCIAL REPORT SUM M A RY CONSOL I DAT ED BA L A NCE SH EET For years ended December 31 (dollars in thousands) ASSETS Cash and deposits with banks Investments and federal funds sold Loans held for sale Net loans and leases - non-covered Covered loans and leases Covered other assets FDIC indemnification asset Bank premises, equipment and other assets Total Assets $ 2014 45,526 206,101 35,042 1,072,963 5,432 - - 123,243 $ 1,488,307 $ 2013 72,544 279,672 30,254 877,705 20,021 3,319 632 97,580 $ 1,381,727 $ 2012 123,679 263,659 77,432 722,985 32,692 7,439 2,229 92,972 $ 1,323,087 $ 2011 58,894 278,112 48,910 612,554 48,050 9,050 11,255 89,784 $ 1,156,609 $ 2010 141,094 246,004 35,789 526,840 62,179 7,638 14,297 85,899 $ 1,119,739 LIABILITIES AND SHAREHOLDERS’ EQUIT Y Deposits Federal funds/repo agreements Other borrowed funds Interest payable and other liabilities Total Liabilities Preferred stock and surplus Common stock and capital surplus Retained earnings Unearned stock compensation Accumulated other comprehensive income Total Shareholders’ Equity $ 1,262,168 10,532 21,494 23,027 $ 1,317,221 $ 1,182,603 7,875 21,630 16,308 $ 1,228,416 $ 1,115,750 12,603 21,755 31,698 $ 1,181,806 $ 985,110 6,194 21,871 16,184 $ 1,029,359 $ 950,780 358 32,261 39,350 $ 1,022,750 $ $ 20,000 38,265 115,258 (3,807) 1,370 171,086 $ $ 20,000 26,581 109,840 (3,319) 209 153,311 $ $ 20,000 24,167 94,623 (2,362) 4,853 141,281 $ $ 20,000 22,258 82,972 (1,762) 3,782 127,250 $ - 19,750 76,578 (1,715) 2,377 96,989 Total Liabilities and Shareholders’ Equity $ 1,488,307 $ 1,381,727 $ 1,323,087 $ 1,156,609 $ 1,119,739 SUM M A RY CONSOL I DAT ED I NCOM E STAT EM EN T For years ended December 31 (dollars in thousands) Interest income and expenses Interest income Interest expense Provision for loan losses $ Net Interest Income After Provision for Loan Losses $ Other operating income and expense Retirement services and wealth management income Other income Other Non-Interest Income Salaries and employee benefits Occupancy and equipment expense Other expenses Other Operating Expenses Income before taxes and extraordinary items Income taxes Net Income Net Income Applicable to Common Shareholders $ $ $ $ $ $ $ 2014 54,394 3,316 (400) 51,478 52,343 26,063 78,406 60,419 9,083 30,613 100,115 29,769 9,538 20,231 20,031 $ $ $ $ $ $ $ $ $ 2013 50,510 3,712 1,200 45,598 46,627 32,642 79,269 59,824 8,478 24,611 92,913 31,954 11,684 20,270 20,070 $ $ $ $ $ $ $ $ $ 2012 52,852 4,586 833 47,433 42,621 36,494 79,115 59,374 8,336 33,124 100,834 25,714 9,458 16,256 15,917 $ $ $ $ $ $ $ $ $ 2011 47,381 6,821 4,418 36,142 34,925 21,859 56,784 45,164 7,811 23,765 76,740 16,186 5,477 10,709 10,636 SUM M A RY CONSOL I DAT ED STAT EM EN T OF SH A R EHOL DERS’ EQU I T Y For years ended December 31 (dollars in thousands) Balance at January 1 Net income for the year Cash dividend declared preferred Cash dividends declared common Stock-based compensation expense Increase from stock plans and other adjustments Repurchase of stock Comprehensive income Balance at December 31 2014 153,311 20,231 (200) (5,332) 1,061 854 - 1,161 171,086 $ $ 2013 141,281 20,270 (200) (4,689) 943 351 - (4,645) 153,311 $ $ 2012 127,250 16,256 (339) (4,266) 799 509 - 1,072 141,281 $ $ $ $ 2011 96,989 10,709 (74) (3,961) 709 21,823 (350) 1,405 127,250 2010 45,983 10,785 6,820 28,378 32,840 20,261 53,101 44,161 7,256 21,231 72,648 8,831 2,958 5,873 5,873 2010 88,342 5,873 - (3,882) 655 327 (41) 5,714 96,989 $ $ $ $ $ $ $ $ $ $ $ 800.279.3200 | ALERUS.COM ©2015 Alerus Financial Corporation