O N A N U P WA R D J O U R N E Y. ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORT 1 3 7 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 2016 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 devastated 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. Purchased Beacon Bank in Shorewood, Excelsior, Eden Prairie, and Duluth, Minnesota; purchased Alliance Benefit Group North Central States, Inc., in Albert Lea and Eden Prairie, Minnesota. 800.279.3200 :: ALERUS.COM :: MEMBER FDIC © 2016 Alerus Financial Corporation 2418_2015_AnnualReport_Cover.indd 1 3/9/16 4:15 PM 2 0 1 5 I N R E V I E W At Alerus, we stand at the intersection of achievement and potential, of things accomplished and things yet to come. Our customers stand beside us, traveling the same path and seeking a partner’s guidance. We are privileged to be that partner, a companion offering support and direction as together we move across the landscape of their financial lives. We succeed when our customers do, and our greatest accomplishment is helping them reach their destination. DIVERSIFIED REVENUE STREAM TOTAL REVENUE: $146.1 MILLION 36.2% NET INTEREST INCOME 1.1% DEPOSIT FEES 3.1% OTHER 7.8% WEALTH MANAGEMENT INCOME 16.8% MORTGAGE FEES 35.0% RETIREMENT SERVICES FEES COMPANY PORTFOLIO YEAR-END 2015 Diversified financial services company $1.7 billion banking assets $2.7 billion assets under management $17.5 billion assets under administration $625 million brokerage assets $987 million mortgage loans originated STOCKHOLDERS’ EQUITY YEAR-END 2015 Earnings per common share: $1.17 Dividends per share: $0.42 Stock Price Range 2015: $18.50–$21.95 Last Trade 2015: $18.90 Total stockholder return: -2.2%* *Calculated as Last Trade 2015 minus Last Trade 2014 plus 2015 dividends per share divided by Last Trade 2014. N AT I O N A L LY R E CO G N I Z E D F O R O U R P E R F O R M A N C E Ranked 5th on the 2015 Bank Performance Scorecard within the $1-5 billion category by Bank Director Magazine, a rating recognizing performance based on profitability, capitalization and asset quality. (Aug. 2015) Received a financial strength rating of “A-” from Weiss Ratings, an independent provider of ratings and analyses of financial services companies whose standards emphasize a company’s future financial solvency and its ability to withstand severe economic adversity. (Sep. 2015) Ranked 21st for number of sponsors, 35th for number of participants, and 32nd for size of plan assets under management by Pensions & Investments, who ranks the top recordkeepers nationally by size. (Sep. 2014) Earned BauerFinancial’s highest 5-star rating, a distinction for banks excelling in areas of capital adequacy, profitability, and asset quality. (Jun. 2015) Ranked in the top 15th percentile of community banks by Seifried & Brew, a community bank risk management firm. (Apr. 2015) Ranked 31st in the Top 200 Publicly Traded Community Banks listing by American Banker. (Apr. 2015) SENIOR MANAGEMENT TEAM BOARD OF DIRECTORS 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 Daniel E. Coughlin, Former Managing Director and Co-Head of Financial Services, Raymond James & Associates :: Former Chairman and CEO, Howe Barnes Hoefer & Arnett, Chicago, IL 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 BUSINESS LEADERS MARKET PRESIDENTS Chris Wolf, CPA Grand Forks :: Dan Doeden Fargo :: David “Chip” Norris Twin Cities :: Deb Otto Duluth :: Rob Schwister Phoenix CUSTOM ER SEG M ENT MANAG EM ENT Jon Handy Consumer, Business, Small Business :: Sara Ausman Professional Services and Private Banking :: Brad Costello Agriculture BAN KING Karna Loyland Chief Deposit Officer :: Dan Jacobson Chief Lending Officer MORTGAG E Jan Fitzer President :: Kim Onen Vice President, Operations RETIREM ENT AN D B EN EFITS Brian Overby, CEBS President :: Laura Tiemann, CEBS Retirement Plan Services :: Steve Pulley, CPC, QPA, QKA, APA Benefit Services Lee Kliebert, JD, AIF® Retirement Plan Advisory Services Nels Carlson ESOP Fiduciary Services WEALTH MANAG EM ENT Ann McConn, JD, CFA, CFP® Executive Director :: Sunil Swami Chief Investment Officer :: Doug Carpenter, CPA, CFP® Alerus Investment and Fiduciary Services :: Brian Kraft Alerus Securities CORPOR ATE STAFF Chad Johnson, CPA Audit Management :: Bonnie Upham Compliance Mark Nelson Enterprise Risk Management :: Kyle Hendrickson Information Security :: Jerrod Hanson, CPA Accounting :: Travis Ingebrigtson Finance :: A.J. Zielike Branch Operations :: Teresa Wasvick, SPHR Human Resources :: Kara Fosse, CFMP Marketing Missy Keney, CFMP Corporate Communications :: Chris Dunnigan Information Technology :: Tammy Schmitz Project Management TWIN CITIES ADVISORY BOARD Dick Enrico 2nd Wind Exercise :: Larry Gamst DS+B CPAs and Business Advisors :: Lisa Meyer Marketing and Management Executive Dennis Monroe Monroe Moxness Berg PA :: Julie Gilbert Newrai PreciouStatus :: James Nichols James L. Nichols CPA, LLC Michael Opat Hennepin County Commissioner :: David Waldo Banking Executive :: Bob Weiss Banking Executive Randy L. Newman Chairman, President & Chief Executive Officer 35 YEARS WITH ALERUS Kris Compton Chief Operating Officer 41 YEARS WITH ALERUS Dan J. Cheever Executive Vice President and Chief Financial Officer 1 YEAR WITH ALERUS Jay Kim Executive Vice President, General Counsel & Director of Corporate Development 4 YEARS WITH ALERUS Karl Bollingberg, CFP® Executive Vice President & Director of Banking Services 29 YEARS WITH ALERUS John Flesch Executive Vice President, Wealth Management & Retirement Services 14 YEARS WITH ALERUS Jon Hendry Executive Vice President, Chief Information Officer 32 YEARS WITH ALERUS David Latta Executive Vice President, Market Management 10 YEARS WITH ALERUS 2418_2015_AnnualReport_Cover.indd 2 3/9/16 4:15 PM 2 0 1 6 C O M P O S I T I O N As the seasons were changing from summer to fall, Alerus was changing as well. We announced the acquisitions of Beacon Bank and Alliance Benefit Group North Central States, Inc., the two largest transactions in company history, and closed them in January 2016. Those closings meant significant company growth, and as we share our 2015 story in this report, we also feel it prudent to share our composition as of Jan. 15, 2016, when the acquisitions were completed. COMPANY PORTFOLIO CORE BUSINESS LINES ALERUS TEAM Diversified financial services company $2.0 billion banking assets $2.7 billion assets under management $23 billion assets under administration $625 million brokerage assets CORE STRENGTHS Strong balance sheet Diversified earnings Relationship-oriented business model Highly skilled professional service employee base Commitment to business expansion opportunities CUSTOMER BASE 43,545 consumers 9,735 businesses 6,000 employer-sponsored retirement plans 350,000 employer-sponsored retirement plan participants Business Banking 837 employees • Commercial and commercial real estate lending • Agriculture lending • Treasury management • Deposit services Consumer Banking • Deposit products and services • Consumer lending • 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 Retirement and Benefits • Retirement plan administration • Retirement plan investment advisory • ESOP fiduciary services • Payroll administration services • Health and welfare administration • COBRA MARKET PRESENCE Grand Forks, ND 5 full-service banking and wealth management offices Fargo, ND 5 full-service banking and wealth management offices Twin Cities, MN 7 full-service banking and wealth management offices 3 residential mortgage offices Duluth, MN 2 full-service banking and wealth management offices Scottsdale, AZ 1 full-service banking and wealth management office NATIONAL PRESENCE 4 retirement and benefits offices in Minnesota 2 retirement and benefits offices in Michigan 1 retirement and benefits office in New Hampshire Serve customers in 50 states through retirement plan services A L E R U S F I N A N C I A L C O R P O R AT I O N 2 0 1 5 A N N UA L R E P O R T 1 2418_2015_AnnualReport_TextPages.indd 1 3/9/16 4:06 PM Alerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: DEAR STOCKHOLDERS, CUSTOMERS, AND FRIENDS It is my privilege to share with you the story of Alerus Financial Corporation in 2015, a story filled in equal measure with outstanding accomplishments, compelling potential, and inspiring demonstrations of our philosophies in action. OUR PERFORMANCE STORY A company’s financial performance is deeply intertwined with its competitive strategy and long-term objectives. For us, that means prioritizing customer relationships, diversifying our revenue stream, and identifying growth markets into which we can reasonably enter. It further means balancing opportunities against risks, favoring steadiness over impulse, and emphasizing planning over reaction. That time-tested approach produced unprecedented franchise growth in 2015 as we announced the two largest acquisitions in company history, closing each of them in January 2016. Through those acquisitions we entered a new market — Duluth, Minnesota — increased our Twin Cities presence, and expanded our product set. We returned to stockholders a cash dividend of $0.42 per share in 2015, an increase of 10.53% from 2014’s $0.38 per share. We are proud to say our cash dividends have increased roughly 9% per year for 35 years. However, we must acknowledge that while 2015 was a year of exceptional franchise growth, our financial performance fell short of our expectations. We earned net income of $16.5 million in 2015, a decrease of 18.4% from 2014 when we earned $20.2 million. 2015 earnings per common share were $1.17 compared to $1.44 in 2014, a decrease of 18.8%. So, while we grow and evolve as a company, we must explain and address the challenges we faced in 2015, two of which I will touch upon in this letter. I encourage you to read the accompanying Management’s Discussion and Analysis for an in-depth discussion of the factors underlying our performance. After an unprecedented three consecutive years of net loan recoveries, the company returned to net charge-offs during the last half of 2015. This resulted in the utilization of the bank’s excess reserves and contributed to the decline in earnings. Despite this, our ratio of net charge-offs to assets remained below historical averages. In addition, a review of the two most significant credits involved did not reveal any similar weaknesses across the remainder of the bank’s loan portfolio. Our operating expenses increased as we continued to invest in the infrastructure necessary to support future organic and acquisition growth. These investments included personnel additions, technology enhancements, and information security enhancements. These types of investments are necessary for growth and future success, but they did impact our earnings in 2015. THE INSEPARABILITY OF GROWTH AND CHANGE Although this year’s performance did not live up to our expectations, the strategic growth measures we achieved during the year have us well positioned to further build franchise value and, in turn, stockholder value going forward. It also reinforced a powerful truth about our company: We are not as we were; we are changing, and for the better. Since 2003, we have expanded into multiple new markets, reached thousands of new customers, remade our brand, and added hundreds of richly talented employees. And yet we have achieved this franchise growth without sacrificing our business model. In fact, rather than splintering into multiple forms, our business model has proven its durability; it has brought us this far and will continue to carry us forward. 2 2418_2015_AnnualReport_TextPages.indd 2 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: like hesitancy or fear, every indication is that ours will use words like partnership and opportunity. There is a groundswell of energy and enthusiasm building at Alerus, and it is inspiring to see our teams find ways to unlock that potential. FOUR PILLARS OF SUCCESS We have defined four key components of our business that demand ongoing attention if we are to maintain a steady course. We must focus on serving customers, supporting our employees, achieving operational excellence, and optimizing our financial performance. We refer to these components as our Pillars of Success, and we have built strategic plans around each of them. This year’s Annual Report highlights our accomplishments from 2015 and offers a glimpse into our direction for the future with respect to each Pillar. 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 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 stockholders, I continue to be humbled by the trust you place in our company and I remain 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 BALANCING PERFORMANCE , GROWTH, AND RISK The banking industry has been consolidating for decades. 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 — 18 since 2002. The acquisitions of Beacon Bank and Alliance Benefit Group North Central States, Inc., are the strongest indicators yet that our strategic framework is indeed sturdy. We were positioned to execute these transactions thanks to our consistent performance — a history of strong core operating earnings and a high-quality balance sheet — which allows us to make the investments needed to deliver value to stockholders over the long term. In coming years, we will continue to evaluate opportunities for growth and assess the risk that comes with it. In the immediate future, however, our focus is executing every facet of these two acquisitions and introducing the power of our business model to the customers and employees who are now part of the Alerus family. In balancing growth and risk in recent years, we chose to focus on our Eastern North Dakota markets and expanding into new markets outside the state. We felt this strategy would benefit our company and stockholders for years to come. As oil drilling in Western North Dakota increased, we adhered to our strategy, which meant applying our energy and resources in other markets. The result was that we did not take on a great deal of exposure to risks in the western part of the state. Today, though oil production has slowed greatly and many companies involved are facing challenges, our steady and strategic approach has us well positioned to move forward. UNLOCKING OUR POTENTIAL Perhaps the most exciting part of the Alerus story is the part that is still being written. It is the part where our new customers reap the benefits of access to financial offerings they didn’t have before, the part where the employees who joined us bring their expertise to bear and make us better than we were before. Where so many stories of corporate combinations contain words 2418_2015_AnnualReport_TextPages.indd 3 3 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: STOCKHOLDER VA LUE We believe that a fundamental measure of our success is the value we generate for stockholders over the long term. We generate that value by remaining true to our core strengths — serving our customers, engaging our employees, and executing our strategies. These strengths, in combination with prudent management, have allowed us to reward stockholders with 46* straight years of dividends. In 2015, we continued to take steps designed to help us deliver the value our stockholders deserve. We are engaged in an ongoing effort to increase our company’s profile and thereby foster interest in our stock. As part of that effort, trading of our shares moved to the OTCQX marketplace in February 2015. Alerus was the 50th bank — and one of the largest — to join this marketplace. This move, along with the activities of two market makers in our stock, has resulted in some improvement in the liquidity of the stock. Additionally, Alerus completed an issuance of $50 million of subordinated debentures to fund a portion of our two acquisitions and to redeem $20 million of Small Business Lending Fund (SBLF) preferred stock. The decision to issue debt rather than stock puts us in position to achieve two goals: grow the company through the aforementioned acquisitions, and leverage the earnings power of our current stockholders’ investments. 2015 was a year of real progress for Alerus and for our stockholders. As a company we make calculated choices about how best to conduct business, and stockholder value will always be a pivotal factor in those calculations. DIVIDENDS AND EARNINGS PER SHARE $0.45 Dividends per share (DPS) $0.40 Earnings per common share (EPS) $0.35 $0.30 $0.25 (DPS) 2011 2012 2013 2014 2015 $1.50 $1.25 $1.00 $0.75 $0.50 (EPS) STOCKHOLDER VALUE Year-end stock price Book value per share $25.00 $20.00 $15.00 $10.00 $5.00 $8.50 $7.97 $18.90 $11.67 2011 2012 2013 2014 2015 STOCKHOLDER TOTAL RETURN (%) (CUMULATIVE) 200 150 100 50 0 (50) A LRS +165.5 6% S&P 500 + 80.75% SNL U.S. Financial Services +52.53% 2011 2012 2013 2014 2015 *Data only available since 1969. 2418_2015_AnnualReport_TextPages.indd 4 3/9/16 4:06 PM Alerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: HIGHLIGHTS FINANCIAL STRATEGIC FINANCIAL PERFORMANCE ACQUISITIONS/EXPANSIONS Reported net income of $16.5 million, down 18.4% from 2014. Cash dividends per share increased 10.53% from $0.38 per share to $0.42 per share. Diluted earnings per share of $1.17, down 18.8% from 2014. Return on average assets (ROA) of 1.08%, down 34 basis points from 2014. Return on equity (ROE) of 10.13%, down 376 basis points from 2014. Company revenue of $146.1 million, up 12.85% from 2014. Banking division revenue of $59 million, up 0.2% from 2014. Mortgage division revenue of $24.6 million, up 33.6% from 2014. Retirement services revenue of $51.1 million, up 24.4% from 2014. Wealth management division revenue of $11.4 million, up 2.7% from 2014. MAINTAINED STRONG CAPITAL RATIOS, YEAR-END 2015 Announced the acquisition of Beacon Bank, adding $350 million in banking assets and five new Minnesota locations, three in the Twin Cities and two in Duluth. This is the largest bank transaction in company history. Announced the acquisition of Alliance Benefit Group North Central States, Inc., in Eden Prairie and Albert Lea, Minnesota, adding: 900 retirement plans, 75,000 participants, and $6 billion assets; and new services including payroll, health and welfare, and COBRA. This is the largest retirement transaction in company history. CUSTOMER ENHANCEMENTS Launched business mobile banking including a mobile app, text banking, and mobile browser to improve account interactivity for business customers. Relocated downtown Minneapolis branch to our first fully Alerus-branded space; remodeled Hugo’s branch in Grand Forks to align with our brand and increase customer convenience. Initiated project work for a February 2016 replacement of all debit cards with chip-protected (EMV) cards to better protect customers against fraud. Common equity tier 1 ratio of 10.9%. COMPANY DEVELOPMENTS Became the 50th bank — and one of the largest — to join the OTCQX Marketplace, increasing our visibility with current and future investors. Received ratings of BBB+ for senior unsecured debt and BBB for subordinated debt from Kroll Bond Rating Agency, with ratings supported by our well-diversified revenue resources, strong credit culture, and strong core earnings metrics. Issued $50 million of subordinated debentures to fund a portion of our two acquisitions and to redeem $20 million of Small Business Lending Fund (SBLF) preferred stock. Remade our brand to present a unified picture of Alerus and better illustrate the depth and breadth of the company and launched a new website. Tier 1 capital ratio of 12.3%. Total risk-based capital ratio of 17.0%. Tier 1 leverage ratio of 10.9%. STRONG CUSTOMER GROWTH Total loans grew $35.1 million to $1.1 billion from 2014. Total deposits grew $195.9 million to $1.46 billion from 2014. Total assets under administration grew $2.0 billion to $17.5 billion from 2014. Total assets under management grew $151 million to $2.7 billion from 2014. CREDIT QUALITY Total non-performing assets increased $5.5 million or 85.5% from 2014 to 2015; non-performing assets to total loans plus other non-performing assets equaled 1.0% at year-end 2015 compared to 0.6% at year-end 2014. Allowance for loan losses to non-performing loans was 132% at year-end 2015, compared to 427% at year-end 2014. 2418_2015_AnnualReport_TextPages.indd 5 5 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: PUT TING CUSTOM ERS FIRST PUTS US A HEA D. Through our unwavering professional service philosophy, we will continue to impress all customers, both old and new. CUSTOM ER PILL A R The defining aspect of the Alerus culture is the customer-focused approach we take to all aspects of our business. The desire to impress customers can be felt in every corner of our company and motivates us to enrich their lives. 6 2418_2015_AnnualReport_TextPages.indd 6 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: CUSTOMER-CENTRICITY FUELS ADVANCEMENT One important offshoot — perhaps a subtle one — of a customer-driven approach is that it demands a certain amount of proactivity. It spurs an internal desire to improve the products and services we deliver. We strive to enhance the customer experience before we have to. We augment our technological capabilities before we have to, and we do so while working to mitigate risks to security and customer information. 2015 saw us unveil a revamped online banking system for consumer customers, with added features and flexibility to better meet today’s demands. We enhanced our fraud monitoring tools to better identify suspect debit and credit card transactions. Our wealth management division prepared to implement eMoney Advisor, a true next generation tool that aggregates a customer’s data from multiple accounts and provides a clear picture of the customer’s overall financial health. Our retirement division worked hand-in-hand with a customer to build a retirement participant portal uniquely tailored to that company’s needs. These investments and others like them are motivated by our customer focus. We think this approach earns the trust of customers and engenders in them a feeling of goodwill. It also reinforces for us the importance of each and every customer interaction, whether it’s a few minutes at the teller line, a few seconds online, or a few weeks of meetings and discussion. LEVERAGING OUR MODEL 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 it 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 ourselves as a financial services company that plays an active role in our customers’ success at all stages of their lives, providing a roadmap for their financial success. This model forms the core of our professional service philosophy, and it is one of the reasons we have been able to grow our franchise organically and through acquisition. Our two most recent acquisitions present the greatest opportunity we have ever had to showcase the strength of our delivery model. We intend not only to make our new customers aware of the breadth and depth of the financial services we offer, but to impress them with the way they are delivered. The degree of success we achieve in these efforts will be the same degree to which we can say the acquisitions were successful. All the evidence gathered thus far indicates that our customer-focused approach will acquit itself well, as it has before. TWIN CITIES ADVISORY BOARD We continue making strides in building brand awareness and credibility in our largest market, the Twin Cities. We took a major step forward in that regard with the formation of our nine-member Twin Cities Advisory Board, comprising highly experienced executives from companies throughout the metro. They bring to Alerus a deep knowledge of the metro area and its business and consumer communities, having successfully served area customers for decades. As a comparatively newer entrant into the market, Alerus stands to benefit greatly from the insights our advisory board members can provide about how best to meet the needs of customers in Twin Cities communities. We look forward to hearing the advisory board’s input and having such strong customer advocates on our side. CHARITABLE GIVING For us, good corporate citizenship is about making a real social impact and expressing solidarity with the communities in which we operate. As a company, we donated $1.75 million to a host of charitable organizations in our communities. Two of those donations, totaling $1 million, went to the North Dakota Housing Incentive Fund, which works to improve affordable housing access in the state. Three-fourths of that amount went to support the Jeremiah Program’s Fargo campus, which offers affordable housing, on-site early childhood education, and support for single mothers to attend college. Alerus will receive dollar-for-dollar tax credits for those donations over the next two years. Through our mortgage division’s giving program, we donated nearly $350,000 to organizations throughout the Twin Cities, including the Salvation Army, Simon Says Give, Second Harvest Heartland, and others too numerous to list here. These contributions help fight against the scourges of hunger, homelessness, and lack of education that plague too many of our communities. Our commitment to communities is more than financial; Alerus employees collectively donated 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. We are humbled that we as a company are able to extend our hands and open our hearts to those who are compelled by circumstance to reach out for help. THE INTERESTS OF CUSTOMERS AND STOCKHOLDERS ALIGN To deliver stockholder value over the long run, we must be fully committed to meeting customers where they are and proactively taking steps to delight them, earn their trust, and earn their business. We will continue taking the steps and making the investments needed to provide the kinds of outstanding customer experiences that translate to added stockholder value. Likewise, we will continue searching for opportunities to reach more new customers and for the chance to demonstrate to them the distinctive qualities that make Alerus special. 2418_2015_AnnualReport_TextPages.indd 7 7 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: T H E P E OP L E OF A L E RUS A R E T H E F U T U R E OF A L E RUS. Our prosperity is fueled by our employees, so attracting and maintaining the best talent will always be a top priority. EM PLOY EE PILL A R All of the big ideas that boards and management teams spend their time formulating will remain nothing more than that — plans and ideas — without the commitment and dedication of the company’s employees. Employees are the lifeblood of Alerus, and their pursuit of personal and team excellence sustains us. 8 A L E R U S F I N A N C I A L C O R P O R AT I O N 2 0 1 5 A N N UA L R E P O R T 2418_2015_AnnualReport_TextPages.indd 8 3/9/16 4:06 PM Alerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: ACQUIRE, RETAIN, PROSPER Building our talent base is crucial to the continued success of our company. With the acquisitions of Beacon Bank and Alliance Benefit Group North Central States, our talent pool grows deeper and we have the opportunity to show our value to these new employees and their customers. The experience gained during previous acquisitions is invaluable now, as we turn our attention to the largest-scale acquisition conversion effort we have undertaken to date. Much of that effort is the retention of employees, something we have emphasized since the day of the announcements, when we had Alerus staff on hand at each location to share the Alerus story. It continues with employee training and the provision of a support system that fosters in our new employees a sense of belonging and provides them the resources they need as they acclimate to our culture. As that acclimation occurs, the benefits to Alerus become clear. We welcome to our team a host of experienced people with established skill sets. That is particularly helpful as we work to incorporate a set of products and services that is entirely new to our company — payroll administration, health savings accounts, flexible spending accounts, COBRA, and more. These business lines open up new revenue streams, as they can be bundled and marketed to existing customers and new ones alike. That, in turn, provides the fuel for continued success. PREPARING FUTURE LEADERS Recognizing that our current and future prosperity hinges in large part on the strength and vision of leaders, we continue to build on our internal leadership programs. Our programs take would-be leaders 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 are building a pipeline of future leaders capable of maintaining and improving upon the success we have enjoyed so far. We are cognizant of the need to fill that pipeline, as leadership changes are inevitable in any company, a rule from which we are not exempt. Our leadership development programs will play a pivotal role, along with thoughtful planning and advice from top-level consulting partners, in our ability to carry forward the legacy our current leaders have built. SUPPORTING OUR EMPLOYEES Attracting and retaining top talent, in other words, being an employer of choice, means making sure we offer employees the support they need at critical times in their lives. That support may come in the form of paid parental leave, attractively designed health care plan options, or the freedom to learn new skills through on-the-job programs. With that in mind, we instituted several employee benefit enhancements, including paid bereavement and parental leave. Employees can also donate unused paid time off to co-workers who might need it, or contribute to the Small Miracles Reached Together Fund, which provides monetary support for co-workers coping with unexpected medical bills or other costs. Supporting our employees in these ways, along with our welcoming company culture and increasing brand visibility, will help us compete for talent in all of our markets and retain the employees who are with us today. OUR FUNDA M ENTA L 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 EMPOWER WITH KNOWLEDGE SERVE WITH PASSION People do business with people they trust. Knowledge drives confidence and positive action. Foster a culture of service. CHERISH PEOPLE RESPECT EVERYONE Take care of your co-workers so everyone can take care of customers. Mutual respect is an important building block of good teamwork. EMBRACE CHANGE Success is never final. 2418_2015_AnnualReport_TextPages.indd 9 9 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: PROGRESS MAKES PERFECT. We stay ahead in the areas of regulation, risk management, and security by investing in the right people and the most relevant technologies. OPER ATIONA L PILL A R Growing companies must prepare themselves to both clear hurdles and take advantage of opportunities. Operations teams are the engines of those preparations. And for a diverse financial services company like Alerus, whose businesses are touched by many outside forces, those teams must be resolute, strong, and forward-thinking in order to succeed within the boundaries that are drawn up for us. Here we discuss a small handful of operational items that are never far from our minds: regulation, risk management, and information security. 10 2418_2015_AnnualReport_TextPages.indd 10 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: REGULATED ENVIRONMENT With our company’s growth comes heightened scrutiny, a trend we expect to continue. One example of significant regulatory change that we worked through this year was the Consumer Financial Protection Bureau’s overhaul of the mortgage industry disclosure rules. The CFPB initiative, commonly called “Know Before You Owe,” is designed to help consumers better understand their loan options and eliminate surprises at the closing table. The new rules were implemented in October, but we had been working to prepare for the change since it was first announced in 2013. We made key additions to our staff in order to meet the rule’s demands for quicker processing and underwriting. We trained our people on the new requirements and how best to meet them. And we reemphasized the importance of doing what we’ve always done — providing customers timely, accurate information in understandable language so they can make informed decisions. Our strong balance sheet allows us 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 risk management and information security. MANAGING RISK The job of managing risk is never finished, and indeed, grows more demanding with time. 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 leadership the need to understand risks and plan accordingly in order to garner appropriate risk-adjusted returns. The risk factors affecting Alerus today are much different than they were a mere 10 years ago. Then, we were a $650 million bank. Today, we are a nearly $2 billion bank with $2.7 billion under management and $23 billion assets under administration. As such, our size now requires us to live at the confluence of risk management and technology. We implement proven software programs that help companies like ours get the most out of our risk management efforts. Further, we continue to invest in the programs and people necessary to bolster our governance, risk, and compliance systems. All of this is done to ensure we understand our environment, make decisions based on the evidence we gather, and remain proactive as we move across an ever-changing business landscape. KEEPING DATA SECURE Outside threats to electronic financial data are more numerous and harbor more damaging potential than ever before. Financial services companies must have agility built into their operations so that they can respond to these threats and prepare for potential cyberattacks. In 2015, we added skilled security professionals to our staff, including a new director of information security. We went away from traditional antivirus software and instead implemented real time malware protection software on all employee computers, a step that puts us on firmer information security footing. We retired aging operating systems and replaced them with new and improved systems. We engaged in comprehensive business continuity planning and strengthened our already robust disaster recovery program. Finally, we continued to build our information security awareness and vulnerability management training, engaging an industry-leading partner to assist in taking our employee training to the next level. Alerus is committed to protecting customer information from cyberattacks and cyber fraud. We continue to marshal and deploy people, policies, and systems necessary to protect customers, the company, and ultimately, our stockholders. Securing our customers and our company against cyber risks will be one of the most critical and taxing aspects of financial services for many years to come. We are confronting these issues head-on and working diligently to protect customer data, our most important asset. ACHIEV ING GROW TH STA RTS BY EM BR ACING CH A NGE. To stay on a steady course toward growing our company and expanding our services, we will always view the industry’s changing landscape as an opportunity, not an obstacle. 2418_2015_AnnualReport_TextPages.indd 11 11 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: THE FUTURE OF THE INDUSTRY Technology is the irresistible force that will define the contours of the financial industry in coming years. While virtually every industry is experiencing disruptive challenges posed by the digital revolution, financial services companies are experiencing perhaps the most sweeping changes of all. Digital distribution of financial services and products is fast becoming the new normal, and those banks that value their relevancy must embrace the shift. Financial technology upstarts — “fintech” firms — are now the country’s leading recipients of venture capital, and these new market entrants present real challenges to established banks. Their slimmed-down structures and ability to quickly assimilate Internet- based and mobile technologies means they can deliver the cutting-edge customer experiences that traditional banks are struggling to provide. A reexamination of legacy systems, a concerted effort to attract innovative tech talent, and a redoubled commitment to customer relationships are just a few of the myriad steps banks will need to take to sustain and grow their operations. The industry will continue to be tested on a number of other fronts including data privacy, cybersecurity, and increasing regulatory costs. Consolidation will continue to be driven by the expenses associated with these and other factors. Some of the largest financial institutions, those deemed systemically important, will evaluate their participation in certain businesses amid increasing regulatory and capital requirements. Roughly 5,000 banks are expected to exist in the United States by 2020, a reduction of about 25% from the 6,800 that exist today. Interest rates are expected to rise gradually but remain lower than normal for some time. Alerus is in an enviable position in this regard because the bulk of our revenue is fee-generated and not dependent on interest income. Our structure as a highly diversified financial services firm — not simply a bank — has us well positioned to succeed even in low interest rate environments. IN CLOSING We will look back on 2015 as a defining moment in the history of Alerus. Years of thoughtful planning and careful execution culminated in unprecedented franchise growth and the introduction of our company to new markets and new businesses. Thanks to the commitment of our stockholders, the support of our Board, and the dedication of our employees, we stand poised to build upon the successes realized this year and forge ahead into an even brighter future. There is cause for great excitement — though our company’s heritage reaches back more than a century, our story in many ways has only just begun. W ELCOM ING OUR NEW EST DIRECTOR We are pleased to welcome Daniel E. Coughlin to the Alerus Board of Directors. Mr. Coughlin is the former Managing Director and Co-Head of the Financial Services practice at Raymond James & Associates. He also served as Chairman and CEO of Howe Barnes Hoefer & Arnett prior to its 2011 merger with Raymond James, and spent seven years with the Federal Reserve Bank of Chicago where he assessed the competitive implications of bank mergers and acquisitions. A 30-year industry veteran, Mr. Coughlin’s vast knowledge and experience in areas such as strategic planning, risk management, and mergers and acquisitions make his a voice we look forward to hearing in our board room. 12 2418_2015_AnnualReport_TextPages.indd 12 3/9/16 4:06 PM ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORTAlerus Financial Corp.Flat Size: 16.5"w x 11.25"hCD: Approvals2015 Annual ReportFolded Size: 8.25"w x 11.25"hAD: Client: CD: 15ALE_2418Bleed: 1/8" (OFC)CW: AE:AD:Annual ReportInks: 4cp throughoutAE: AE:CW:PM: PM:PA: March 2016KeylinePA: 2 0 1 5 I N R E V I E W At Alerus, we stand at the intersection of achievement and potential, of things accomplished and things yet to come. Our customers stand beside us, traveling the same path and seeking a partner’s guidance. We are privileged to be that partner, a companion offering support and direction as together we move across the landscape of their financial lives. We succeed when our customers do, and our greatest accomplishment is helping them reach their destination. DIVERSIFIED REVENUE STREAM TOTAL REVENUE: $146.1 MILLION 36.2% NET INTEREST INCOME 1.1% DEPOSIT FEES 3.1% OTHER 7.8% WEALTH MANAGEMENT INCOME 16.8% MORTGAGE FEES 35.0% RETIREMENT SERVICES FEES COMPANY PORTFOLIO YEAR-END 2015 Diversified financial services company $1.7 billion banking assets $2.7 billion assets under management $17.5 billion assets under administration $625 million brokerage assets $987 million mortgage loans originated STOCKHOLDERS’ EQUITY YEAR-END 2015 Earnings per common share: $1.17 Dividends per share: $0.42 Stock Price Range 2015: $18.50–$21.95 Last Trade 2015: $18.90 Total stockholder return: -2.2%* *Calculated as Last Trade 2015 minus Last Trade 2014 plus 2015 dividends per share divided by Last Trade 2014. N AT I O N A L LY R E CO G N I Z E D F O R O U R P E R F O R M A N C E Ranked 5th on the 2015 Bank Performance Scorecard within the $1-5 billion category by Bank Director Magazine, a rating recognizing performance based on profitability, capitalization and asset quality. (Aug. 2015) Received a financial strength rating of “A-” from Weiss Ratings, an independent provider of ratings and analyses of financial services companies whose standards emphasize a company’s future financial solvency and its ability to withstand severe economic adversity. (Sep. 2015) Ranked 21st for number of sponsors, 35th for number of participants, and 32nd for size of plan assets under management by Pensions & Investments, who ranks the top recordkeepers nationally by size. (Sep. 2014) Earned BauerFinancial’s highest 5-star rating, a distinction for banks excelling in areas of capital adequacy, profitability, and asset quality. (Jun. 2015) Ranked in the top 15th percentile of community banks by Seifried & Brew, a community bank risk management firm. (Apr. 2015) Ranked 31st in the Top 200 Publicly Traded Community Banks listing by American Banker. (Apr. 2015) SENIOR MANAGEMENT TEAM BOARD OF DIRECTORS 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 Daniel E. Coughlin, Former Managing Director and Co-Head of Financial Services, Raymond James & Associates :: Former Chairman and CEO, Howe Barnes Hoefer & Arnett, Chicago, IL 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 BUSINESS LEADERS MARKET PRESIDENTS Chris Wolf, CPA Grand Forks :: Dan Doeden Fargo :: David “Chip” Norris Twin Cities :: Deb Otto Duluth :: Rob Schwister Phoenix CUSTOM ER SEG M ENT MANAG EM ENT Jon Handy Consumer, Business, Small Business :: Sara Ausman Professional Services and Private Banking :: Brad Costello Agriculture BAN KING Karna Loyland Chief Deposit Officer :: Dan Jacobson Chief Lending Officer MORTGAG E Jan Fitzer President :: Kim Onen Vice President, Operations RETIREM ENT AN D B EN EFITS Brian Overby, CEBS President :: Laura Tiemann, CEBS Retirement Plan Services :: Steve Pulley, CPC, QPA, QKA, APA Benefit Services Lee Kliebert, JD, AIF® Retirement Plan Advisory Services Nels Carlson ESOP Fiduciary Services WEALTH MANAG EM ENT Ann McConn, JD, CFA, CFP® Executive Director :: Sunil Swami Chief Investment Officer :: Doug Carpenter, CPA, CFP® Alerus Investment and Fiduciary Services :: Brian Kraft Alerus Securities CORPOR ATE STAFF Chad Johnson, CPA Audit Management :: Bonnie Upham Compliance Mark Nelson Enterprise Risk Management :: Kyle Hendrickson Information Security :: Jerrod Hanson, CPA Accounting :: Travis Ingebrigtson Finance :: A.J. Zielike Branch Operations :: Teresa Wasvick, SPHR Human Resources :: Kara Fosse, CFMP Marketing Missy Keney, CFMP Corporate Communications :: Chris Dunnigan Information Technology :: Tammy Schmitz Project Management TWIN CITIES ADVISORY BOARD Dick Enrico 2nd Wind Exercise :: Larry Gamst DS+B CPAs and Business Advisors :: Lisa Meyer Marketing and Management Executive Dennis Monroe Monroe Moxness Berg PA :: Julie Gilbert Newrai PreciouStatus :: James Nichols James L. Nichols CPA, LLC Michael Opat Hennepin County Commissioner :: David Waldo Banking Executive :: Bob Weiss Banking Executive Randy L. Newman Chairman, President & Chief Executive Officer 35 YEARS WITH ALERUS Kris Compton Chief Operating Officer 41 YEARS WITH ALERUS Dan J. Cheever Executive Vice President and Chief Financial Officer 1 YEAR WITH ALERUS Jay Kim Executive Vice President, General Counsel & Director of Corporate Development 4 YEARS WITH ALERUS Karl Bollingberg, CFP® Executive Vice President & Director of Banking Services 29 YEARS WITH ALERUS John Flesch Executive Vice President, Wealth Management & Retirement Services 14 YEARS WITH ALERUS Jon Hendry Executive Vice President, Chief Information Officer 32 YEARS WITH ALERUS David Latta Executive Vice President, Market Management 10 YEARS WITH ALERUS 2418_2015_AnnualReport_Cover.indd 2 3/9/16 4:15 PM O N A N U P WA R D J O U R N E Y. ALERUS FINANCIAL CORPORATION 2015 ANNUAL REPORT 1 3 7 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 2016 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 devastated 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. Purchased Beacon Bank in Shorewood, Excelsior, Eden Prairie, and Duluth, Minnesota; purchased Alliance Benefit Group North Central States, Inc., in Albert Lea and Eden Prairie, Minnesota. 800.279.3200 :: ALERUS.COM :: MEMBER FDIC © 2016 Alerus Financial Corporation 2418_2015_AnnualReport_Cover.indd 1 3/9/16 4:15 PM FINANCIAL REPORT ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT TABLE 1 – SELECTED FINANCIAL DATA Year ended December 31, (dollars in thousands, except per share amounts) Income Statement Data Interest income Interest expense Net interest income Provision for credit losses Net interest income, after provision for credit losses Non-interest income Non-interest expense Income before income taxes Income tax expense Net income Diluted earnings per common share Performance Ratios Net interest margin Return on average total assets Return on average common equity Return on average tangible common equity Efficiency ratio Balance Sheet Data Cash and due from banks Investment securities Mortgages held for sale Loans Allowance for loan and lease losses Goodwill Other intangible assets Total assets Deposits Subordinated notes payable Total liabilities Stockholders’ equity Capital Common equity tier 1 ratio Tier 1 capital ratio Total capital ratio Tier 1 leverage ratio Tangible common equity / tangible assets 2015 2014 2013 2012 2011 $ 56,328 3,458 ______________________ 52,870 4,200 ______________________ 48,670 93,255 118,134 ______________________ 23,791 7,289 ______________________ 16,502 $ ______________________ ______________________ 1.17 $ $ 54,394 3,316 ______________________ 51,078 (400) ______________________ 51,478 78,406 100,115 ______________________ 29,769 9,538 ______________________ 20,231 $ ______________________ ______________________ 1.44 $ $ 50,510 3,712 ______________________ 46,798 1,200 ______________________ 45,598 79,269 92,913 ______________________ 31,954 11,684 ______________________ 20,270 $ ______________________ ______________________ 1.46 $ $ 52,852 4,586 _____________________ 48,266 833 _____________________ 47,433 79,115 100,834 _____________________ 25,714 9,458 _____________________ 16,256 $ _____________________ _____________________ 1.17 $ $ 47,381 6,821 ______________________ 40,560 4,418 ______________________ 36,142 56,784 76,740 ______________________ 16,186 5,477 ______________________ 10,709 $ ______________________ ______________________ 0.80 $ 3.81% 1.08 10.13 12.99 80.84 3.97% 1.42 13.89 16.67 77.32 3.94% 1.55 15.40 17.99 73.70 4.52% 1.36 13.65 16.78 79.16 4.04% 0.95 10.80 12.96 78.83 $ 266,159 192,343 48,642 1,126,921 (14,688) 3,683 21,751 1,744,863 1,458,021 49,375 1,562,042 182,821 $ 45,526 206,101 35,042 1,095,458 (17,063) 3,264 22,442 1,487,732 1,262,168 - 1,316,646 171,086 $ 72,544 279,672 30,254 914,564 (16,838) 664 15,014 1,381,727 1,182,603 - 1,228,416 153,311 $ 123,679 263,659 77,432 770,778 (15,101) 664 15,251 1,323,087 1,115,750 - 1,181,806 141,281 $ 58,894 278,112 48,910 673,431 (12,826) 664 11,316 1,156,609 985,110 - 1,029,359 1,322,095 10.9% 12.3 17.0 10.9 8.2 N/A 11.8% 13.0 10.1 8.8 6,484 2,478 0.59% -0.06 1.56 N/A 12.8% 14.1 10.6 8.8 N/A 12.8% 14.1 9.9 9.2 N/A 13.7% 14.9 9.9 8.5 $ 10,265 4,877 $ 16,326 9,386 $ 24,979 11,916 1.12% -0.06 1.84 2.09% -0.20 1.96 3.64% 0.07 1.90 Asset Quality Nonperforming assets OREO Nonperforming assets / loans and other real estate Net charge-offs (recoveries) / average total loans Allowance for loan and lease losses / total loans $ $ 12,028 842 1.07% 0.58 1.30 Other Assets under management Assets under administration Mortgage originations $ 2,734,850 17,459,308 986,979 $ 2,583,808 15,518,303 729,913 $ 2,424,642 12,860,780 1,028,208 $ 1,991,841 9,762,247 1,174,514 $ 1,747,377 7,634,209 584,836 2 ABOUT ALERUS FI NANCIAL CORPORATION Alerus Financial Corporation (the “Company”) through its subsidiaries Alerus Financial, N.A., Alerus Securities Corporation and Alerus Investment Advisors, Inc., 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 is a diversified financial services company with $1.7 billion in banking assets, $2.7 billion of assets under management and $17.5 billion of assets under administration. 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 years ended December 31, 2015 and 2014, the Company completed the following acquisitions: Interactive Retirement Systems, LTD On January 2, 2015, the Company acquired Interactive Retirement Systems, LTD, located in Bloomington, Minnesota, for cash consideration of $4.1 million. The purchase, consisting of approximately 160 retirement plans with more than 16,200 retirement participants, increased the Company’s retirement division by $1.3 billion in retirement assets under administration. As part of the transaction, $3.8 million was allocated to an identified customer intangible and $420 thousand to goodwill, based on the estimated value of the acquired assets and liabilities as of the acquisition date. The identified customer intangible is being amortized over a 10-year period, resulting in an annualized intangible amortization expense of $378 thousand, while the goodwill is not subject to amortization. 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, for cash consideration of $12.0 million. The purchase, consisting of approximately 700 retirement plan clients with more than 42,000 retirement plan participants, increased the Company’s retirement services division by $2.1 billion in retirement assets under administration. As part of the transaction, $10.1 million was allocated to an identified customer intangible and $2.0 million to goodwill, based on the estimated value of the acquired assets and liabilities as of the acquisition date. The identified customer intangible is being amortized over a 10-year period, resulting in an annualized intangible amortization expense of $1.0 million, while the goodwill is not subject to amortization. Private Bank Minnesota On June 25, 2014, the Company acquired Private Bancorporation, Inc., with one branch located in downtown Minneapolis, Minnesota, for cash consideration of $15.9 million. 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 thousand to goodwill. The core deposit intangible is being amortized over five years, generating an amortization expense of $240 thousand per year, while the goodwill is not subject to amortization. Neither the core deposit intangible nor the goodwill is deductible for tax purpose. The transaction also included a net operating loss deferred tax asset valued at $943 thousand 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. Since December 31, 2015, the Company completed the following acquisitions: Alliance Benefit Group North Central States, Inc. (ABGNCS) On January 1, 2016, the Company acquired Alliance Benefit Group North Central States, Inc., with locations in Albert Lea and Eden Prairie, Minnesota, for initial cash consideration of $17.5 million, with the potential for an additional $4.4 million consideration, during an earn-out period. The purchase, consisting of approximately 900 retirement plans with more than 75,000 retirement participants, increasing the Company’s retirement division by $6.0 billion in retirement assets under administration. As part of the transaction, approximately $22 million will be allocated to goodwill and an identified customer intangible, based on the estimated value as of the acquisition date. The actual allocation between goodwill and a customer intangible will be determined through a third-party evaluation. The identified customer intangible will be amortized over the estimated life, resulting in an intangible amortization expense, while the goodwill is not subject to amortization. If these intangibles are valued similar to other recent transactions, approximately 20% may be allocated to goodwill and 80% to a customer intangible. The customer intangible will likely be amortized over a ten-year period, whereas goodwill is not subject to amortization. Beacon Bank On January 15, 2016, the Company acquired Beacon Bank and its five branches, three located in the southwestern suburbs of Minneapolis, Minnesota and two located in Duluth, Minnesota, for cash consideration of $46.0 million. The Company assumed approximately $315.5 million of deposits and other liabilities, including $10.0 million of Trust Preferred Securities and purchased approximately $350.0 million in cash, securities, loans, and other assets. As part of the transaction, the Company will allocate ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 3 approximately $20 million to goodwill and a core deposit intangible, based on a third-party evaluation. The core deposit intangible will be amortized over the estimated life, resulting in an intangible amortization expense, while the goodwill is not subject to amortization. SUBORDINATED NOTES OFFERING On December 17, 2015, Alerus issued $50 million of Subordinated Notes maturing December 30, 2025. The Kroll Bond Rating Agency assigned a rating of BBB+ on the Company’s senior unsecured debt and BBB on its subordinated debt, and a rating of A- on the senior unsecured debt of the Bank. The notes bear a fixed rate of interest at 5.75%, through December 30, 2020, and then convert to floating rate notes that reset quarterly to an interest rate equal to three month LIBOR plus 412 basis points. Through December 30, 2020, interest is payable semi- annually on June 30 and December 30, and thereafter interest is paid quarterly on March 30, June 30, September 30, and December 30. The Subordinated Notes qualify as Tier 2 capital for regulatory purposes. The proceeds were utilized primarily to retire the Small Business Lending Fund (SBLF) preferred stock of $20.0 million and for the acquisitions of ABGNCS and Beacon Bank. 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 stockholders 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. In connection with the Prosperan Bank acquisition in 2009, the Bank agreed to pay the FDIC, should the estimated losses on the acquired loan portfolios as well as servicing fees earned on the acquired loan portfolios not meet thresholds as stated in the loss sharing agreements (the “true-up liability”). This contingent consideration is classified as a liability within other liabilities on the Consolidated Balance Sheet and is re-measured at fair value each reporting date until the contingency is resolved. The changes in fair value are recognized in non-interest income or expense. The fair value of the true-up liability associated with the Prosperan acquisition was $2.8 million and $2.6 million as of December 31, 2015, and 2014, respectively. TAX In 2015, Alerus made two contributions, totaling $1.0 million, to housing-related projects in North Dakota, sponsored by the North Dakota Housing Incentive Fund, for which the Company received a State of North Dakota income tax credit of $1.0 million. The contributions are tax deductible for Federal Income tax purposes, and increased other operating expenses by $1.0 million, but reduced North Dakota state income tax expense by the same amount. The full tax credit was not utilized in 2015, resulting in a deferred tax asset, which will be utilized in 2016 and future years. 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 current 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. Refunds were received in the aggregate amount of $928 thousand from the State of Minnesota and $287 thousand 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. 4 RESU LTS 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 Net income for 2015 was $16.5 million ($1.17 diluted earnings per common share), compared with $20.2 million ($1.44 diluted per share) for 2014 and $20.3 million ($1.46 diluted per share) for 2013. The Company’s financial performance in 2015 reflects a $4.2 million provision for credit losses, an increase of $4.6 million from 2014, reflecting a return to a more normal credit environment after three years of less than $1.2 million in annual provisions. The 2014 results also included $2.1 million of gains on sales of securities from a restructuring of the investment portfolio. The Company’s 2015 earnings reflect the effect of $4.4 million of amortization of identified intangibles from acquisitions, which lower earnings per share, net of taxes, by $0.19, compared to $4.2 million or $0.18 per share in 2014. 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 diluted share is illustrated in Chart B. Revenue, the sum of net interest income and non-interest income, was $146.1 million in 2015, compared with $129.5 million in 2014 and $126.1 million in 2013. The Company’s diversified revenue model continued to generate strong core earnings in 2015, reflecting revenue growth in all business divisions: banking, mortgage, retirement services, and wealth management. The increase in revenue for 2015 compared to 2014 was predominantly due to an increase in non-interest income in the retirement services and mortgage divisions of the Company. Retirement services revenue increased by 24% as a result of the acquisitions that occurred in late 2014 and early 2015, as well as organic growth in the business. The increased level of mortgage originations during 2015 ($987 million vs. $730 million in 2014) increased mortgage banking revenue by 34%. In 2015, non-interest income of $93.3 million represented 64% of revenue, compared with $78.4 million (61%) in 2014 and $79.3 million (63%) in 2013. Net interest income was $52.9 million in 2015, representing 36% of revenue, compared to $51.1 million, or 39% of revenue, in 2014 and $46.8 million, or 37% of revenue, in 2013. The net interest income increase in 2015 was due to higher average earning asset balances, although at a lower yield. Non-interest expense was $118.1 million in 2015, compared with $100.1 million in 2014 and $92.9 million in 2013. The increase in non-interest expense in 2015, compared to 2014, reflected higher personnel, occupancy, and other operating expenses resulting from higher mortgage origination volumes, acquisitions, and added infrastructure. Cash dividends per common share were $0.42 in 2015, compared to $0.38 in 2014 and $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 stockholders’ equity. ROE was 10.13% in 2015, compared to 13.89% in 2014, and 15.40% in 2013, as further illustrated in Chart D. The average ROE over the past five years is 12.77%. Return on Average Assets (ROA) is net income stated as a percentage of average total assets. As Chart E illustrates, ROA was 1.08% in 2015, compared to 1.42% in 2014, and 1.55% in 2013. The average ROA over the past five years is 1.27%. Chart A Net Income $20,270 $20,231 $16,256 $16,502 $10,709 2011 2012 2013 2014 2015 Chart B Earnings Per Diluted Share $1.46 $1.44 $1.17 $1.17 $0.80 2011 2012 2013 2014 2015 Chart C Dividends Per Share $0.42 $0.38 $0.34 $22,500 $20,000 $17,500 $15,000 $12,500 $10,000 $7,500 $5000 $1.60 $1.40 $1.20 $1.00 $0.80 $0.60 $0.45 $0.40 $0.35 $0.30 $0.30 $0.31 $0.25 2011 2012 2013 2014 2015 16.00% Chart D Return on Equity 15.40% 14.00% 13.65% 13.89% 12.00% 10.00% 8.00% 1.70% 1.55% 1.40% 1.25% 1.10% 0.95% 0.80% 10.80% 10.13% 2011 2012 2013 2014 2015 Chart E Return on Assets 1.55% 1.42% 1.36% 0.95% 1.08% 2011 2012 2013 2014 2015 ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 5 Chart F Net Interest Income $52,870 $51,078 $48,266 $46,798 $40,560 2011 2012 2013 2014 2015 ) s d n a s u o h t n i s r a l l o d ( $55,000 $50,000 $45,000 $40,000 $35,000 Chart G Net Interest Margin 4.52% 4.70% 4.50% 4.30% 4.10% 4.04% 3.90% 3.70% 3.94% 3.97% 3.81% 2011 2012 2013 2014 2015 NET INTEREST INCOME Net interest income is the interest earned on investment securities, loans (including yield-related loan fees) and other interest-earning assets minus the interest paid for deposits, short-term borrowings and long-term debt. Net interest margin is the average yield on earning assets minus the average interest rate paid for deposits and other sources of funding. Net interest income and net interest margin are presented on a taxable-equivalent basis in Table 2 to consistently reflect income from taxable and tax-exempt loans and securities based on a 35.5% federal statutory rate. While the Company believes that it has the ability to increase net interest income over time, net interest income and 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. Interest income was $56.3 million in 2015, an increase of $1.9 million, or 3.6%, from the $54.4 million reported in 2014 and the $50.5 million in 2013. The increase in interest income for 2015, compared with 2014, was largely driven by higher average loans outstanding, $1.1 billion vs. $994 million, although at a lower average rate: 4.48% vs. 4.72%. As loans matured and/or repriced during the year, they were renewed at lower rates which were in effect throughout the year. Average earning assets increased by $100 million to $1.4 billion in 2015; however the average rate decreased to 4.06% from 4.22% in 2014. In 2015 the average interest bearing liabilities increased by $40 million to $1.0 billion, with an average rate of 0.34%, the same as the prior year. Average non-interest bearing deposits increased to $328 million in 2015, from $278 million in 2014. Core deposits are an important low-cost source of funding and affect both net interest income and net interest margin. Core deposits include non-interest- bearing deposits, interest-bearing checking, certificates of deposit less than $250 thousand, and money market savings deposits. Core deposits rose to $1.4 billion at December 31, 2015, an increase of $200 million from the $1.2 billion in 2014. Net interest margin was 3.81% in 2015, down 16 basis points from 3.97% in 2014, and 3.94% in 2013 as a result of lower yields on average earning assets. Chart F illustrates net interest income on a tax equivalent basis for the past five years. Chart G illustrates net interest margin for the past five years. 6 TABLE 2 – AVERAGE BALANCE SHEETS AND AVERAGE RATES Year ended December 31, (dollars in thousands) Assets Interest bearing deposits with banks Federal funds sold Investment securities (a) Mortgages held for sale Loans Commercial: Commercial and industrial (a) Real estate mortgage Construction and land development Farmland and agricultural Total commercial (a) Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total loans (a) Total earning assets (a) Cash and due from banks Loan loss reserve Goodwill & other intangibles Bank premises and equipment Other Total assets Average Balance $ 48,273 95 183,103 43,515 383,098 257,110 34,772 55,067 _____________________ 730,047 155,137 159,772 59,982 19,663 _____________________ 394,554 _____________________ 1,124,601 _____________________ 1,399,587 23,676 (17,218) 28,093 21,375 77,884 _____________________ $1,533,397 _____________________ _____________________ Liabilities and Stockholders’ Equity Savings, Checking, and money market deposits Certificates of deposit Short term borrowings Other borrowed funds Subordinated notes payable $ 743,237 225,096 12,599 21,441 2,039 _____________________ 2015 Average Rate Interest Average Balance 2014 Average Rate Interest Average Balance 2013 Average Rate Interest 0.25% $ 0.00 2.69 3.24 123 - 4,474 1,409 $ 19,787 17 258,705 27,090 0.26% $ 0.00 2.68 3.46 52 $ - 6,496 936 56,339 8 264,978 43,361 0.26% $ 0.00 2.64 2.78 148 - 6,612 1,206 4.58 4.65 4.15 4.18 _________ 4.55 4.42 4.82 2.92 3.95 _________ 4.33 _________ 4.48 _________ 4.06 17,526 11,963 341,516 260,907 1,442 2,300 ________________ 33,231 18,846 51,338 _____________________ 672,607 4.43 5.21 5.41 4.39 _________ 4.76 15,109 13,590 292,449 251,688 1,019 2,252 12,342 43,741 _______________ _____________________ 600,220 31,970 4.85 5.90 5.30 4.40 _________ 5.27 14,157 14,850 654 1,924 _________________ 31,585 6,862 128,123 4.46 5,713 92,664 4.58 4,243 4.88 4.11 5.89 _________ 4.65 _________ 4.72 _________ 4.22 7,700 1,753 125,180 50,340 776 ________________ 17,091 ________________ 50,322 ________________ 56,328 17,797 _____________________ 321,440 _____________________ 994,047 _____________________ 1,299,646 23,408 (16,792) 18,271 22,174 77,624 _____________________ $1,424,331 _____________________ _____________________ 6,110 2,068 86,870 40,286 1,049 14,940 46,910 12,405 _______________ _____________________ 232,225 _______________ _____________________ 832,445 _______________ _____________________ 1,197,131 21,098 (15,673) 54,394 4.85 4.46 5.72 _________ 4.72 _________ 5.12 _________ 4.25 4,210 1,796 710 _________________ 10,959 _________________ 42,544 _________________ 50,510 15,251 22,440 67,912 _____________________ $1,308,159 _____________________ _____________________ 0.15 0.73 0.25 2.56 $ 1,106 1,652 32 548 $ 690,898 222,943 29,007 21,562 0.15 0.74 0.29 2.60 $ 1,023 $ 642,934 237,040 13,964 22,650 1,650 83 560 0.18 0.81 0.21 2.57 $ 1,174 1,927 30 581 5.89 _________ 120 ________________ - _____________________ 0.00 ________ - _______________ _____________________ - 0.00 _________ - _________________ Total interest bearing liabilities Non-interest bearing deposits Other liabilities Stockholders’ equity Total liabilities and stockholders’ equity Net interest margin/income (a) Interest rate spread (a) 1,004,412 _____________________ 0.34 _________ 3,458 ________________ 964,410 _____________________ 0.34 ________ 916,588 _______________ _____________________ 3,316 0.40 _________ 3,712 _________________ 327,654 20,400 180,931 _____________________ $ 1,533,397 _____________________ _____________________ 278,005 17,713 164,203 _____________________ $1,424,331 _____________________ _____________________ 221,199 20,072 150,300 _____________________ $1,308,159 _____________________ _____________________ 3.81% $ 52,870 ________________ _________ _________ ________________ 3.71% 3.97% $ 51,078 _______________ _________ _________ _______________ 3.88% 3.94% $ 46,798 _________________ ________ ________ _________________ 3.85% (a) Taxable equivalent adjustment was calculated utilizing a marginal income tax rate of 35.5 percent. The Company manages 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. 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 2013 through 2015. 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. ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 7 TABLE 3 – VOLUME AND RATE VARIANCE ANALYSIS (dollars in thousands) Increase(decrease) in: Interest income: Interest bearing deposits with banks Federal funds sold Investment securities Mortgages held for sale Loans Commercial: Commercial and industrial Real estate mortgage Construction and land development Farmland and agricultural Total commercial Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total loans Total Interest expense: Savings, checking, and money market deposits Certificates of deposit Short term borrowings Other borrowed funds Subordinated notes payable Total interest expense Increase (decrease) in net interest income Change from 2015 to 2014 Volume Rate Total Change from 2014 to 2013 Rate Volume Total $ 75 - (2,030) 568 1,844 (198) 861 164 _______________ 2,671 1,205 1,688 396 110 _______________ 3,399 _______________ 6,070 _______________ 4,683 _______________ 77 16 (47) (3) - _______________ 43 _______________ $ 4,640 _______________ _______________ $ (4) - 8 (95) 573 (1,429) (438) (116) _______________ (1,410) (56) (98) (711) (383) _______________ (1,248) _______________ (2,658) _______________ (2,749) _______________ 6 (14) (4) (9) 120 _______________ 99 _______________ $ 71 - (2,022) 473 2,417 (1,627) 423 48 _____________ 1,261 1,149 1,590 (315) (273) _____________ 2,151 _____________ 3,412 _____________ 1,934 _____________ 83 2 (51) (12) 120 _____________ 142 _____________ $ (96) - (166) (453) $ - - 50 183 2,381 544 345 334 _____________ 3,604 1,624 1,857 448 309 _____________ 4,238 _____________ 7,842 _____________ 7,127 _____________ 88 (115) 32 (28) - _____________ (23) _____________ (1,429) (1,804) 20 (6) _______________ (3,219) (154) 43 (176) 30 _______________ (257) _______________ (3,476) _______________ (3,243) _______________ (239) (162) 21 7 - _______________ (373) _______________ $(2,848) _______________ _______________ $ 1,792 _____________ _____________ $ 7,150 _____________ _____________ $(2,870) _______________ _______________ $ (96) - (116) (270) 952 (1,260) 365 328 _______________ 385 1,470 1,900 272 339 _______________ 3,981 _______________ 4,366 _______________ 3,884 _______________ (151) (277) 53 (21) - _______________ (396) _______________ $ 4,280 _______________ _______________ PROVISION FOR CREDIT LOSSES The allowance for loan and lease losses (allowance) is an estimate of losses inherent in the Company’s loan and lease portfolios and is established through a regular provision for credit losses (provision) based on historical losses incurred on similar pools of loans and periodic analysis of the portfolios’ credit quality. Provisions are expected in order to maintain the adequacy of the total allowance after loan losses and recoveries, loan growth, 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 result from management’s quarterly assessment of the adequacy of the allowance based on the factors described above. The provision for 2015 was $4.2 million compared to negative $0.4 million during 2014. This was the result of reinstatement of a regular monthly provision, based on growth in the loan portfolio, as well as identified loan losses. No regular provision was recorded in 2014 at the Company’s subsidiary bank. This allowed the bank to realign its allowance based on 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 in 2014, the Company itself recorded a negative provision of $0.4 million in response to repayment of a loan held at the Company as opposed to its subsidiary bank. The ratio of the end-of-year balance of the allowance to end-of- year loans was 1.30% for 2015, compared to 1.56% for 2014. Average loans and leases were $1,124.6 million in 2015, an increase of $130.6 million, or 13.1%, from the $994.0 million reported in 2014. The amount of provision to be taken in future periods will depend on management’s assessment of the adequacy of the allowance in relation to the loss experience of the entire loan portfolio and periodic analysis of the portfolio’s credit quality. The Company’s banking assets are distributed across eastern North Dakota, Minneapolis-St. Paul, Minnesota and the Phoenix, Arizona metropolitan area. The Company has minimal exposure to the western North Dakota oil-related areas. The bank has less than 2.0% of its loan and lease portfolio in oil and gas related credits and less than 4.0% in loans in western North Dakota. The Company believes the allowance is adequate to cover any losses in the portfolio. NON- INTEREST INCOME The Company continues to expand non-interest income associated with the Company’s banking, mortgage, retirement services, and wealth management divisions. The Company’s primary sources of non-interest income consist of retirement plan and recordkeeping services, trust services, service charges on deposit accounts, loan fees, and net gains on mortgage loan origination/sales activities. Non- 8 interest income of $93.3 million represented 64% of revenue for 2015 compared with $78.4 million, or 61% of revenue, for 2014, and $79.3 million, or 63% of revenue, for 2013. The increase in non-interest income in 2015 was primarily due to additional retirement services fee income related to acquisitions and organic growth, as well as increased mortgage banking revenue from higher originations/sales. 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, reporting fees of $51.1 million in 2015, a $10.0 million, or 24% increase, from the $41.1 million reported in 2014. A majority of retirement services fees are transaction or participant based plan fees, with the remainder based on the market value of assets under administration. At December 31, 2015, assets under administration totaled $17.5 billion, up $1.9 billion, or 12.5%, from $15.5 billion at December 31, 2014. The acquisition of Interactive Retirement Systems, LTD, which closed on January 2, 2015, included 160 retirement plans, with more than 16,000 participants, and added $1.2 billion in assets under administration. Wealth management income, which includes personal trust services and investment services offered by Alerus Investment Advisors and Alerus Securities, was $11.4 million, a $0.3 million, or 2.7%, increase from the $11.1 million reported in 2014. 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, 2015, assets under management totaled $2.7 billion, up $0.1 billion, or 5.8%, from the $2.6 billion reported in 2014. Mortgage banking income, consisting of net servicing income and net gains on loan origination/sales activities, totaled $24.6 million in 2015, a $6.2 million, or 33.6%, increase from the $18.4 million reported in 2014. The Company’s mortgage division originated $987 million in loans in 2015, a $257 million, or 35%, increase from the $730 million in loans originated in 2014. The Company’s mix of refinance and home purchase mortgage originations shifted from 20% refinance and 80% purchase in 2014 to 32% and 68%, respectively, in 2015. TABLE 4 – NON-INTEREST INCOME Year ended December 31, (dollars in thousands) Retirement services Wealth management Mortgage banking Service charges on deposit accounts Investment security gains (losses) Other non-interest income Total non-interest income 2015 $51,059 11,418 24,630 1,611 (17) 4,554 ________________ $93,255 ________________ ________________ 2014 $ 41,058 11,119 18,435 1,626 2,179 3,989 _________________ $ 78,406 _________________ _________________ 2013 $36,003 10,313 27,177 1,639 (70) 4,207 _________________ $79,269 _________________ _________________ % Increase/ decrease 2015/2014 % Increase/ decrease 2014/2013 24.36% 2.69 33.60 -0.92 100.78 14.16 _____________ 18.94% _____________ _____________ 14.04% 7.82 -32.17 -0.79 -3,212.86 -5.18 ____________________ -1.09% ____________________ ____________________ NON- INTEREST EXPENSE Total non-interest expense was $118.1 million in 2015, an $18.0 million, or 18.0%, increase from the $100.1 million reported in 2014. Operating expenses increased in 2015 as a result of several factors, including higher mortgage loan originations, acquisition expenses, and investments in the Company’s infrastructure to support growth. The Company’s efficiency ratio, defined as the percent of non-interest expense to total revenue, increased to 80.8% in 2015, compared to 77.3% in 2014. Chart H illustrates the trend in the efficiency ratio over the last five years. Chart H Efficiency Ratio 78.8% 79.2% 80.8% 77.3% 73.7% 2011 2012 2013 2014 2015 82.5% 80.0% 77.5% 75.0% 72.5% 70.0% While control of non-interest expense is a priority for management, the higher-than-average efficiency ratio is partially due to the Company generating 64% of total revenue from non-interest income sources. The efficiency ratio for a business comprised primarily of net interest margin income is generally lower than a business comprised primarily of asset management income and mortgage origination income. Personnel expenses, which include salaries, commissions, incentive compensation, and employee benefits, are the largest expense component for the Company, representing 60% of non-interest expenses in both 2015 and 2014. Salary and employee benefit costs were $71.9 million in 2015, an $11.5 million, or 19.0%, increase from the $60.4 million reported in 2015. The increase in salary and employee benefit costs was influenced by increased staffing associated with acquisitions completed in 2015 and 2014, as well as to support the infrastructure of the Company, and in variable commissions associated with increased mortgage origination activity, which increased 35% in 2015. ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 9 Marketing, business development, and public relations expenses were $3.9 million in 2015, a $1.2 million increase from 2014. The increase resulted from $1.0 million in contributions to projects of the North Dakota Housing Incentive Fund, which provided $1.0 million of North Dakota state income tax credits. The contributions are deductible for federal income tax and provide a dollar-for-dollar tax credit for North Dakota state income taxes. The Company’s income tax expense was reduced for these credits, which will be utilized in 2015 and future years. Correspondent and other service fees increased 34.6% to $9.4 million in 2015, from $7.0 million in 2014, primarily as a result of expenditures for information technology to support the growth of the Company. Table 5 provides a summary of changes in non-interest expenses for the past three years. Occupancy expense was $5.2 million in 2015, a $0.8 million, or 17.6%, increase from the $4.4 million reported in 2014. The increase in occupancy expense is primarily the result of facilities costs associated with acquisitions completed in 2015 and 2014. Furniture and equipment expense was $5.0 million in 2015, reflecting a 7.7% increase from the $4.7 million reported in 2014. The Company has acquired 16 companies since 2002 for an aggregate premium of $42.7 million in excess of book value, creating identified intangible assets of $39.0 million and $3.7 million in goodwill on the balance sheet. The identified intangible assets amortize for book purposes and are reported in other non-interest expense. Goodwill does not amortize for book purposes. The amortization schedules vary based on the type and quality of the acquisition. The aggregate unamortized intangible balance as of December 31, 2015, is $17.6 million, which will fully amortize by December 31, 2024. The intangible amortization expense for 2015 was $4.4 million, up from $4.2 million in 2014. TABLE 5 – NON-INTEREST EXPENSE Year ended December 31, (dollars in thousands) Salaries Employee benefits Occupancy expense Furniture and equipment expense Intangible amortization 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 2015 $ 59,122 12,804 5,203 5,018 4,361 3,907 4,404 1,175 2,512 9,394 10,234 ________________ $118,134 ________________ ________________ 2014 $ 48,839 11,580 4,424 4,658 4,196 2,745 3,838 1,040 2,667 6,982 9,146 _________________ $100,115 _________________ _________________ 2013 $49,203 10,621 3,791 4,687 3,321 2,613 3,033 960 2,042 5,547 7,095 _________________ $92,913 _________________ _________________ STATEM ENT OF FI NANCIAL CON DITION % Increase/ decrease 2015/2014 % Increase/ decrease 2014/2013 21.06% 10.57 17.61 7.73 3.93 42.37 14.75 12.98 -5.81 34.55 11.87 __________ 18.00% __________ __________ -0.74% 9.03 16.70 -0.62 26.35 5.05 26.54 8.33 30.61 25.87 28.91 __________ 7.75% __________ __________ OVERVIEW At December 31, 2015, total assets were $1.7 billion, up $257.1 million from December 31, 2014. Cash and due from banks increased by $220.6 million as the Company increased liquidity and raised funds for the acquisitions of Alliance Benefit Group North Central States, Inc., and Beacon Bank, which were completed in January 2016, and the redemption of the SBLF preferred stock in February 2016. Total average assets of the Company were $1.5 billion in 2015, a $109.1 million, or 7.7%, increase from the $1.4 billion reported in 2014. Chart I illustrates average total assets for the past five years. Average earning assets were $1.4 billion in 2015, an increase of $99.9 million, or 7.7%, from the $1.3 billion reported in 2014. Average earning assets represent 91.3% of average total assets in 2015, compared to 91.2% in 2014. The change in average earning assets was primarily driven by an increase in loans. Average interest-bearing liabilities represented 71.8% of average earning assets in 2015, compared to 74.2% in 2014. Chart I Average Assets $1,533 $1,424 $1,308 $1,198 $1,129 2011 2012 2013 2014 2015 $1,600 $1,500 $1,400 $1,300 $1,200 $1,100 $1,000 INVESTMENT SECURITIES 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. 10 At December 31, 2015, investment securities totaled $192.3 million, with a weighted average tax equivalent yield of 2.69%, compared with $206.1 million, with a weighted average yield of 2.68%, at December 31, 2014. 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, 2015, the Company’s gross unrealized gains on the available-for-sale securities were $2.7 million, compared with $3.9 million at December 31, 2014. Gross unrealizable losses on available-for-sale securities totaled $1.1 million at December 31, 2015, compared with $1.7 million at December 31, 2014. 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, 2015, the Company held certain investments having continuous unrealized loss positions for more than 12 months. As of December 31, 2015, the unrealized losses on these securities totaled $0.6 million. Substantially all of these losses were in government agency debt securities. During the year ended December 31, 2015, the Company evaluated all of its debt securities for credit impairment and determined no credit losses were evident. At December 31, 2015, the Company had no plans to sell securities with unrealized losses and believes it is likely it will not be required to sell such securities before the recovery of their amortized cost. LOANS Total loans were $1.1 billion at December 31, 2015, a $31.5 million increase from December 31, 2014. The increase was driven by organic growth in commercial loans of $20.9 million (3.0%), real estate mortgages of $7.6 million (2.3%), and consumer loans of $3.0 million (3.7%). Table 6 provides a summary of loans for the past five years. Average loans were $1.1 billion in 2015, a $130.5 million, or 13.1%, increase from the $994.0 million reported in 2014. The increase in average loans was driven by strong organic growth across all geographic locations. The average loan/deposit ratio increased to 86.8% for 2015, compared to 83.4% for 2014. The Company periodically sells loans to a participation network to manage concentration risk and reduce credit exposure. The sold loan portfolio was $572.1 million on December 31, 2015, a $53.3 million, or 10.3%, increase from the $518.8 million reported at December 31, 2014. The Company also had $48.6 million of mortgages held for sale at December 31, 2015, a $13.6 million, or 38.8%, increase from the $35.0 million reported at December 31, 2014. Mortgages held for sale are all single-family residential mortgage loans that will be sold to the secondary market, usually within 30 days of origination. TABLE 6 – LOANS AND LEASES As of December 31, (dollars in thousands) Commercial: Commercial and industrial Real estate mortgage Construction and land development Farmland and agricultural Total commercial Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total loans and leases Percent of Loans by Type Commercial: Commercial and industrial Real estate mortgage Construction and land development Farmland and agricultural Total commercial Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total loans and leases 2015 2014 2013 2012 2011 $ 379,914 261,345 16,780 53,514 711,553 170,397 162,295 62,509 20,167 _____________________ 415,368 _____________________ $ 1,126,921 _____________________ _____________________ $ 351,460 256,281 20,544 62,340 690,625 167,177 157,921 57,214 22,521 _______________________ 404,833 _______________________ $ 1,095,458 _______________________ _______________________ $ 328,183 259,681 8,260 54,245 650,369 108,682 95,348 46,150 14,015 __________________ 264,195 __________________ $ 914,564 __________________ __________________ $ 261,974 244,994 15,574 46,670 569,212 75,628 76,476 33,414 16,048 ___________________ 201,566 ___________________ $ 770,778 ___________________ ___________________ $212,786 233,040 14,756 44,402 504,984 71,797 61,598 21,451 13,601 __________________ 168,447 __________________ $ 673,431 __________________ __________________ 33.7% 23.2 1.5 4.7 _____________________ 63.1 32.1% 23.4 1.9 5.7 _______________________ 63.0 35.9% 28.4 0.9 5.9 __________________ 71.1 34.0% 31.8 2.0 6.1 ___________________ 73.8 31.6% 34.6 2.2 6.6 __________________ 75.0 15.1 14.4 5.5 1.8 _____________________ 36.9 _____________________ 15.3 14.4 5.2 2.1 _______________________ 37.0 _______________________ 11.9 10.4 5.0 1.5 __________________ 28.9 __________________ 9.8 9.9 4.3 2.1 ___________________ 26.2 ___________________ 10.7 9.1 3.2 2.0 __________________ 25.0 __________________ _____________________ _____________________ 100.0% _______________________ _______________________ 100.0% 100.0% __________________ __________________ 100.0% ___________________ ___________________ 100.0% __________________ __________________ ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 11 DEPOSITS Deposits totaled $1.5 billion at December 31, 2015, compared with $1.3 billion at December 31, 2014, representing an increase of $195.9 million, or 15.5%. 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, certificates of deposit less than $250 thousand, and money market saving deposits. Core deposits funded 82.1% and 82.9% of total assets at December 31, 2015, and 2014, respectively. At year-end there was a temporary increase in short-term deposits which were withdrawn in January. Average deposits were $1.3 billion in 2015, an $89.7 million, or 7.2%, increase compared with the $1.2 billion reported in 2014. Non-interest-bearing deposits were $425.6 million at December 31, 2015, a $95.4 million, or 28.9%, increase from the $330.2 million reported at December 31, 2014. Average non- interest-bearing deposits were $327.7 million in 2015, a $49.6 million, or 17.9 %, increase compared with $278.0 million in 2014. Interest-bearing non-maturity deposits totaled $816.0 million at December 31, 2015, a $94.9 million, or 13.2%, increase from the $721.1 million reported at December 31, 2014. Average interest-bearing non-maturity deposits were $743.2 million in 2015, a $52.3 million, or 7.6%, increase compared with $690.9 million in 2014. Interest-bearing time deposits were $216.5 million at December 31, 2015, a $5.6 million, or 2.6%, increase from the $210.9 million reported at December 31, 2014. Average interest-bearing time deposits were $225.1 million in 2015, a $2.1 million, or 1.0%, increase compared with $222.9 million reported in 2014. 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. TABLE 7 – DEPOSITS As of December 31, (dollars in thousands) Non-interest-bearing deposits Interest bearing deposits: Savings Checking Money market deposit Certificates of deposits of $250,000 and less Certificates of deposits in excess of $250,000 Total deposits Percent of Deposits by Type Non-interest bearing deposits Interest bearing deposits: Savings Checking Money market deposit Certificates of deposits of $250,000 and less Certificates of deposits in excess of $250,000 Total deposits 2015 2014 2013 2012 2011 $ 425,608 $ 330,218 $ 305,042 $ 267,208 $188,630 37,798 291,979 486,181 191,568 24,887 _____________________ $1,458,021 _____________________ _____________________ 30,397 243,334 447,346 182,099 28,774 _____________________ $1,262,168 _____________________ _____________________ 24,750 186,916 439,946 190,767 35,182 _____________________ $1,182,603 _____________________ _____________________ 20,168 188,995 386,089 213,187 40,103 _____________________ $1,115,750 _____________________ _____________________ 20,427 138,579 377,003 226,082 34,389 ___________________ $985,110 ___________________ ___________________ 29.19% 26.16% 25.79% 23.95% 19.15% 2.59 20.03 33.35 13.14 1.71 _____________________ 2.41 19.28 35.44 14.43 2.28 _____________________ 2.09 15.81 37.20 16.13 2.97 _____________________ 1.81 16.94 34.60 19.11 3.59 _____________________ 2.07 14.07 38.27 22.95 3.49 ___________________ 100.00% _____________________ _____________________ 100.00% _____________________ _____________________ 100.00% _____________________ _____________________ 100.00% _____________________ _____________________ 100.00% ___________________ ___________________ 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, 2015, totaled $21.4 million, a $0.1 million, or 0.6%, decrease from the $21.5 million reported at December 31, 2014. Other borrowed funds consists of Federal Home Loan Bank advances 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 $1.4 million. SUBORDINATED NOTES PAYABLE On December 17, 2015 the Company issued $50 million of Subordinated Notes with a maturity date of December 30, 2025. The notes bear a fixed rate of interest at 5.75%, through December 30, 2020 and then convert to floating-rate notes that reset quarterly to an interest rate equal to three month LIBOR plus 412 basis points. Through December 30, 2020, interest is payable semi-annually on June 30 and December 30 and thereafter interest is paid quarterly on March 30, June 30, September 30 and December 30. The Subordinated Notes qualify as Tier 2 capital for regulatory purposes. The proceeds were utilized for the acquisitions of Alliance Benefit Group North Central States, Inc., (ABGNCS) and Beacon Bank in January 2016 and to retire the $20.0 million of SBLF preferred stock in February 2016. CAPITAL RESOURCES The Company is committed to managing capital for maximum stockholder 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. Total common stockholders’ equity was $162.8 million at December 31, 2015, an $11.7 million, or 7.8%, increase from the $151.1 million reported at December 31, 2014. The increase is the result of current year’s earnings less dividend payments to preferred and common stockholders, and the market value change in the investment portfolio. 12 In 2012 the Company applied for and received approval for $20 million in SBLF at an initial interest rate of 1%. The Company viewed the SBLF as an intermediate source of capital and redeemed the preferred stock in February 2016 utilizing a portion of the proceeds from the subordinated note issuance. The SBLF preferred stock interest rate was scheduled to increase to 9% in February 2016. The Company’s regulatory capital ratios, as of December 31, for the past five years are set forth in Table 8 and exceeded all minimum capital and well capitalized standards. While the acquisitions that closed in January 2016 utilized a substantial amount of the Company’s excess capital, the Company continues to maintain capital above the levels required for well capitalized banks. The Company paid dividends of $0.42 during 2015, representing a $0.04, or 10.53%, increase over the $0.38 paid during 2014. 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 stockholders 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 and well capitalized standards for banks and holding companies (see The Company and Bank Required Capital Levels below). The Basel III Capital Rules contain provisions which require certain adjustments and deductions from common equity Tier 1 capital, including goodwill and other intangible assets (excluding mortgage servicing rights). Basel III provided for a phase-in period for certain deductions from capital that requires deductions of 40% in 2015, 60% in 2016, 80% in 2017, and 100% thereafter of the deduction. The Company’s deduction for goodwill and identifiable intangible assets, net of deferred tax liabilities, represents goodwill of $3.5 million and identifiable intangible assets of $7.0 million (40% of $17.5 million). As a result of the acquisitions of ABGNCS and Beacon Bank and the phase-in rules, these amounts will increase in 2016, net of intangible amortization. TABLE 8 – REGULATORY CAPITAL As of December 31, Common equity tier 1 ratio Tier 1 capital ratio Total capital ratio Tier 1 leverage ratio Well Capitalized (a) 6.5% 8.0 10.0 5.0 2015 10.9% 12.3 17.0 10.9 2014 N/A 11.8% 13.0 10.1 2013 N/A 12.8% 14.1 10.6 2012 N/A 12.8% 14.1 9.9 2011 N/A 13.7% 14.9 9.9 (a) Well capitalized ratios as of December 31, 2015. RISK ANALYSIS ASSET QUALITY RISK Management believes its ability to identify and assess the risk and return characteristics of the Company’s loan portfolio is critical for profitability and growth. It is in the best interest of stockholders, regional communities, customers, and the Company to follow a credit policy that carefully balances risk and return, 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. 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 provides coverage for probable and estimable losses inherent in the Company’s loan and lease portfolios. 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, historic loss experience, and other factors including regulatory guidance and economic conditions. At December 31, 2015, non-performing assets were $12.0 million, compared to $6.5 million in 2014, and $10.3 million in 2013. Non-performing assets represented 1.07% of total loans and other real estate in 2015, compared to 0.59% in 2014, and 1.12% in 2013. Table 9 provides a summary of non-performing assets for the past five years. At December 31, 2015, the allowance for loan and leases losses was $14.7 million, or 1.30%, of total loans compared with $17.1 million, or 1.56%, at December 31, 2014, and $16.8 million, or 1.88%, at December 31, 2013. The provision for credit losses was $4.2 million in 2015, as compared to a net recovery of $0.4 million in 2014, and provisions of $1.2 million in 2013. Net charge-offs in 2015 were $6.6 million, or 0.58%, of average total loans, compared with net recoveries of ($0.6) million, or (0.06%), in 2014, and net recoveries of ($0.5) million, or (0.07%), in 2013. ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 13 TABLE 9 – NONPERFORMING ASSETS As of December 31, (dollars in thousands) Nonperforming loans Commercial: Commercial and industrial Real estate mortgage Construction and land development Farmland and agricultural Total commercial Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total nonperforming loans Foreclosed assets Other real estate owned Total nonperforming assets 2015 2014 2013 2012 2011 $ 6,011 2,634 - 158 ___________________ 8,803 1,501 825 - 22 ___________________ 2,348 ___________________ 11,151 35 842 ___________________ $ 12,028 ___________________ ___________________ $ 572 1,844 - - ___________________ 2,416 144 1,400 35 - ___________________ 1,579 ___________________ 3,995 11 2,478 ___________________ $ 6,484 ___________________ ___________________ $ 1,437 3,091 - 108 ___________________ 4,636 277 455 9 - ___________________ 741 ___________________ 5,377 11 4,877 ___________________ $ 10,265 ___________________ ___________________ $ 1,769 3,468 1,152 8 ___________________ 6,397 96 427 - - ___________________ 523 ___________________ 6,920 19 9,387 ___________________ $ 16,326 ___________________ ___________________ $ 3,479 4,433 3,353 - ___________________ 11,265 927 852 - - ___________________ 1,779 ___________________ 13,044 20 11,915 ___________________ $ 24,979 ___________________ ___________________ Nonperforming assets / loans and other real estate Allowance for loan and lease losses / nonperforming loans 1.07% 131.72% 0.59% 427.11% 1.12% 313.15% 2.09% 218.22% 3.64% 98.33% TABLE 10 – SUMMARY OF CREDIT LOSS EXPERIENCE As of December 31, (dollars in thousands) Average loans and leases Allowance for loan and lease losses: Balance at beginning of year Charge-offs: Commercial: Commercial and industrial Real estate mortgage Construction and land development Farmland and agricultural Total commercial Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total charge-offs Recoveries: Commercial: Commercial and industrial Real estate mortgage Construction and land development Farmland and agricultural Total commercial Consumer: Real estate 1-4 family first mortgage Real estate 1-4 family junior lien mortgage Automobile Other revolving and installment Total consumer Total recoveries Net (charge-offs)/recoveries Provision for credit losses Balance at end of year 14 2015 $ 1,124,601 ___________________ 2014 $ 994,047 ___________________ 2013 $ 832,445 ___________________ 2012 $ 718,650 ___________________ 2011 $658,944 ___________________ $ 17,063 $ 16,838 $ 15,101 $ 12,826 $ 8,841 6,797 400 - 109 ___________________ 7,306 5 596 155 115 ___________________ 871 ___________________ 8,177 ___________________ 230 166 697 3 ___________________ 1,096 10 287 93 116 ___________________ 506 ___________________ 1,602 ___________________ (6,575) 4,200 ___________________ $ 14,688 ___________________ ___________________ 408 79 4 73 ___________________ 564 1 267 128 60 ___________________ 456 ___________________ 1,020 ___________________ 968 201 128 20 ___________________ 1,317 70 113 55 90 ___________________ 328 ___________________ 1,645 ___________________ 625 (400) ___________________ $ 17,063 ___________________ ___________________ 538 16 2 - ___________________ 556 10 146 148 225 ___________________ 529 ___________________ 1,085 ___________________ 1,187 75 200 19 ___________________ 1,481 6 36 15 84 ___________________ 141 ___________________ 1,622 ___________________ 537 1,200 ___________________ $ 16,838 ___________________ ___________________ 593 924 41 22 ___________________ 1,580 80 146 41 215 ___________________ 482 ___________________ 2,062 ___________________ 325 1,552 1,515 2 ___________________ 3,394 17 - 23 70 ___________________ 110 ___________________ 3,504 ___________________ 1,442 833 ___________________ $ 15,101 ___________________ ___________________ 739 41 106 7 ___________________ 893 9 165 16 183 ___________________ 373 ___________________ 1,266 ___________________ 371 72 162 13 ___________________ 618 3 81 2 129 ___________________ 215 ___________________ 833 ___________________ (433) 4,418 ___________________ $ 12,826 ___________________ ___________________ After three consecutive years of net recoveries, 2012 through 2014, the Company returned to a more normal credit risk environment. During 2015, the Company recorded total charge-offs of $8.2 million, of which $7.3 million was in the commercial loan portfolio, primarily with two credit relationships. The Company considers its allowance of $14.7 million adequate to cover losses inherent in loans, commitments to extend credit, and standby letters of credit at December 31, 2015. Table 10 provides a summary of the credit loss experience for the past five years. 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 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, 2015, the Company had $80.8 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, 2015, the Company had $87.0 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 $186.4 million. INTEREST RATE RISK The Company’s major market risk exposure is to changes in 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, 2015, illustrates a negative 2.10% change in net interest income for a 100 basis point decline in interest rates, and a positive 5.03% 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 3.50% and the federal funds rate at 0.50%. 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. REGU LATORY CHANG ES 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 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 (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 and Alerus Investment Advisors. ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 15 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 stockholders. 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 stockholders. 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, and impacted the way in which they do business. 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 returns on equity. 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 The Company and the Bank are subject to various regulatory capital adequacy requirements administered by the Federal Reserve and the Office of the Comptroller of Currency (OCC). 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 and subordinated debentures. 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. Additionally, 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”), effective beginning January 1, 2015. The Basel III Rule not only increased most of the required minimum capital ratios, but it also introduced the concept of Common Equity Tier 1 Capital (CET1), which consists primarily of common stock, related surplus (net of treasury stock), retained earnings, and CET1 minority interests subject to certain regulatory adjustments. The Basel III Rule also expanded the definition of capital 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 previously qualified as Tier 1 Capital do not qualify, or their qualifications changed. For example, cumulative preferred stock and certain hybrid capital instruments, including trust preferred securities, 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 non-qualifying capital instruments previously included in consolidated Tier 1 Capital are permanently 16 grandfathered under the Basel III Rule, subject to certain restrictions. Qualifying trust preferred securities may also be assumed in conjunction with a bank acquisition without impairing their grandfathered Tier 1 capital status. Noncumulative perpetual preferred stock, which qualified as simple Tier 1 Capital, does not qualify as CET1, but does 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 CET1 in the event such assets exceed a certain percentage of a bank’s CET1. The Basel III Capital Rules contain provisions which require certain adjustments and deductions from common equity Tier 1 capital, including goodwill and other intangible assets (excluding mortgage servicing rights). Basel III provided for a phase-in period for certain deductions from capital that requires deductions of 40% in 2015, 60% in 2016, 80% in 2017, and 100% thereafter of the deduction. Identifiable intangible assets that are not deducted during the transitional period are risk weighted. Under current federal regulations, incorporating the Basel III Capital Rules, the Bank is subject to the following minimum capital standards: • 4.5% CET1 to risk-weighted assets; • 6.0% Tier 1 capital (i.e., CET1 plus Additional Tier 1) to risk-weighted assets; • 8.0% Total capital (i.e., Tier 1 plus Tier 2) to risk-weighted assets; and • 4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (leverage ratio). 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 7.0% for CET1, 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 CET1 Capital ratio. In order to be a “well-capitalized” depository institution under the new regime, a bank and holding company must maintain a CET1 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 revised 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 required a more complex, detailed, and calibrated assessment of credit risk and calculation of risk weightings. 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 previous 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 was required to be made in the first quarter of 2015, excluded 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 elected to opt-out. Generally, financial institutions (except for large, internationally active financial institutions) became subject to the new rules on January 1, 2015. However, there are separate phase-in/phase-out periods for: (i) the capital conservation buffer; (ii) regulatory capital adjustments and deductions; (iii) non-qualifying capital instruments; and (iv) changes to the prompt corrective action rules. The phase-in periods commenced on January 1, 2016, and extend until 2019. 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 of an institution that is not adequately capitalized, 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, 2015: (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, 2015, the Company had regulatory capital in excess of the Federal Reserve’s requirements and met the Dodd-Frank Act’s capital requirements. ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 17 TH E COM PANY GENERAL The Company, as the sole stockholder of the Bank, is a financial holding company. As a financial 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 stockholders 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 TH E BAN K 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. 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 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 financial holding company should eliminate, defer, or significantly reduce dividends to stockholders if: (i) the company’s net income available to stockholders 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. 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, 2015. 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. 18 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. Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. The Company relies on the secure processing, transmission, and storage of confidential information in our computer systems and networks. Cybersecurity and the continued development and enhancement of the controls, processes, and systems designed to protect our networks, computers, software, and data is a priority for the Company. 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. CONSUM ER FI NANCIAL 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%. ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 19 FORWARD-LOOKI NG STATEM ENTS 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. Dan J. Cheever Executive Vice President and Chief Financial Officer Alerus Financial Corporation March 4, 2016 20 ALERUS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2015 AND 2014 (dollars in thousands, except share and per share amounts) Assets Cash and cash equivalents Interest-bearing deposits Cash and due from banks Investment securities Securities held for trading Securities available for sale at fair value (Amortized cost $188,743 and $201,984) Mortgages held for sale Loans and leases Loans and leases Less: Allowance for loan and lease losses Net loans and leases Premises and equipment, net Accrued interest receivable Bank-owned life insurance Goodwill Other intangible assets, net Deferred tax assets, net Other assets Total assets Liabilities and Stockholders’ Equity Liabilities Deposits: Noninterest-bearing Interest-bearing Total deposits Federal funds purchased and repurchase agreements Other borrowed funds Subordinated notes payable Accrued interest payable Accrued expenses Other liabilities Total liabilities Stockholders’ Equity Preferred stock, $1 par value, 2,000,000 shares authorized 20,000 shares issued and outstanding Common stock, $1 par value, 30,000,000 shares authorized; 13,433,801 and 13,346,346 issued and outstanding Additional paid-in capital Retained earnings Accumulated other comprehensive income Total stockholders’ equity Total liabilities and stockholders’ equity 2015 $ 28,482 237,677 266,159 1,947 190,396 48,642 1,126,921 (14,688) ___________ 1,112,233 22,419 4,830 28,308 3,683 21,751 13,780 30,715 ___________ $ 1,744,863 ___________ ___________ $ 425,608 1,032,413 ___________ 1,458,021 - 21,369 49,375 711 8,509 24,057 ___________ 1,562,042 20 13,434 42,617 125,701 1,049 ___________ 182,821 ___________ $ 1,744,863 ___________ ___________ $ 2014 28,861 16,665 45,526 1,960 204,141 35,042 1,095,458 (17,063) ____________ 1,078,395 21,456 4,774 27,484 3,264 22,442 14,177 29,071 ____________ $ 1,487,732 ____________ ____________ $ 330,218 931,950 ____________ 1,262,168 10,532 21,494 - 634 8,562 13,256 ____________ 1,316,646 20 13,346 41,092 115,258 1,370 ____________ 171,086 ____________ $ 1,487,732 ____________ ____________ ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 21 ALERUS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 2015, 2014 AND 2013 (dollars in thousands, except share and per share amounts) Interest Income Loans and leases, including fees Investment securities Taxable Exempt from federal income taxes Other Total interest income Interest Expense Deposits Short term borrowings Other borrowed funds Subordinated notes payable Total interest expense Net Interest Income Provision for credit losses Net interest income, after provision for credit losses Non-Interest Income Retirement services Wealth management Mortgage banking Service charges on deposit accounts Net gain (loss) on investment securities Other Total non-interest income Non-Interest Expense Salaries Employee benefits Net occupancy expense Furniture and equipment expense Intangible amortization expense Other Total non-interest expenses Income before income tax expense Income tax expense Net Income Less preferred stock dividends Net Income Applicable to Common Stock Per Share Information Earnings per common share Diluted earnings per common share Dividends declared per common share Average common shares outstanding Diluted average common shares outstanding 2015 2014 2013 $ 51,731 $ 47,876 $ 43,750 3,496 808 293 ______________________ 56,328 2,758 18 562 120 ______________________ 3,458 ______________________ 52,870 4,200 ______________________ 48,670 51,059 11,418 24,630 1,611 (17) 4,554 ______________________ 93,255 59,122 12,804 5,203 5,018 4,361 31,626 ______________________ 118,134 ______________________ 23,791 7,289 ______________________ 16,502 ______________________ 200 ______________________ $ 16,302 ______________________ ______________________ 1.22 $ 1.17 $ $ 0.42 13,412,586 13,947,136 5,483 817 218 ______________________ 54,394 2,673 22 621 - ______________________ 3,316 ______________________ 51,078 (400) ______________________ 51,478 41,058 11,119 18,435 1,626 2,179 3,989 ______________________ 78,406 48,839 11,580 4,424 4,658 4,196 26,418 ______________________ 100,115 ______________________ 29,769 9,538 ______________________ 20,231 ______________________ 200 ______________________ $ 20,031 ______________________ ______________________ $ $ $ 1.51 1.44 0.38 13,289,714 13,877,344 5,905 707 148 ________________________ 50,510 3,101 30 581 - ________________________ 3,712 ________________________ 46,798 1,200 ________________________ 45,598 36,003 10,313 27,177 1,639 (70) 4,207 ________________________ 79,269 49,203 10,621 3,791 4,687 3,321 21,290 ________________________ 92,913 ________________________ 31,954 11,684 ________________________ 20,270 ________________________ 200 ________________________ $ 20,070 ________________________ ________________________ $ $ $ 1.52 1.46 0.34 13,205,604 13,762,044 22 ALERUS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY YEARS ENDED DECEMBER 31, 2015, 2014 AND 2013 (dollars in thousands, except share and per share amounts) Balance, December 31, 2012 Net income Other comprehensive loss Cash dividend declared preferred – 1.0% Cash dividend declared common ($1.02 per share) Issued 8,279 shares under director’s retainer plan Redemption of 4,901 shares of common stock Income tax benefit equity related items Stock-based compensation expense Vesting of 31,338 shares of restricted stock Balance, December 31, 2013 Net income Other comprehensive income Issued 5,877 shares under director’s retainer plan Stock dividend 3 for 1 Cash dividend declared preferred – 1.0% Cash dividend declared common ($.38 per share) Income tax benefit equity related items Stock-based compensation expense Vesting of 28,872 shares of restricted stock Balance, December 31, 2014 Net income Other comprehensive loss Repurchase of stock Issued 16,326 shares under director’s retainer plan Cash dividend declared preferred – 1.0% Cash dividend declared common ($.42 per share) Income tax benefit equity related items Stock-based compensation expense Vesting of 72,540 shares of restricted stock Balance, December 31, 2015 Preferred Stock $ 20 Common Stock $ 4,382 Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income Total $ 37,403 $ 94,623 $ 4,854 $141,282 - - - - - - - - - - - - 8 (5) - - - - - - 286 (34) 267 935 20,270 - (200) (4,689) - (164) - - - ______________________ 20 31 ______________________ 4,416 (31) ___________________ 38,826 - ___________________ 109,840 - - - - - - - - - - 6 8,895 - - - - - - 309 386 - - 539 1,061 20,231 - - (9,281) (200) (5,332) - - - (4,645) - - - - - - 20,270 (4,645) (200) (4,689) 294 (203) 267 935 - __________________________ 209 - 1,161 - ___________________ 153,311 20,231 1,161 - - - - - - 315 - (200) (5,332) 539 1,061 - ______________________ 20 29 ______________________ 13,346 (29) ___________________ 41,092 - ___________________ 115,258 - __________________________ 1,370 - ___________________ 171,086 - - - - - - - - - - (1) 16 - - - - - - (26) 299 - - 606 719 16,502 - - - (200) (5,859) - - - (321) - - - - - - 16,502 (321) (27) 315 (200) (5,859) 606 719 - ______________________ $ 20 ______________________ ______________________ 73 ______________________ $ 13,434 ______________________ ______________________ (73) ___________________ $ 42,617 ___________________ ___________________ - ___________________ $ 125,701 ___________________ ___________________ - __________________________ $ 1,049 __________________________ __________________________ - ___________________ $182,821 ___________________ ___________________ ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 23 ALERUS FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2015, 2014 AND 2013 (dollars in thousands) Cash Flows From Operating Activities Net income Adjustments to reconcile net income to net cash Deferred income taxes Provision for credit losses Provision for foreclosed asset losses Depreciation and amortization Compensation related stock plans Investment security premium amortization Increase in value of bank-owned life insurance Realized loss (gain) on forward sale derivatives Realized loss (gain) on rate lock commitments Realized loss (gain) on sale of premises and equipment Realized loss (gain) on sale of foreclosed assets Realized loss (gain) on sale of investment securities Realized loss (gain) on servicing rights Net change in: Securities held for trading Mortgages held for sale Accrued interest receivable Other assets Accrued interest payable Accrued taxes and expenses Other liabilities Net cash provided by operating activities Cash Flows From Investing Activities Proceeds from maturities of securities held to maturity Purchases of securities held to maturity Proceeds from sales of securities available for sale Proceeds from maturities of securities available for sale Purchases of securities available for sale Net (increase) decrease in loans and leases Proceeds from business combinations Purchases of bank premises and equipment Proceeds from sales of bank premises and equipment Proceeds from sales of foreclosed assets Net cash used by investing activities Cash Flows From Financing Activities Net increase (decrease) in deposits Net increase (decrease) in short-term borrowings Repayments of notes payable Proceeds from issuance of subordinated debt Cash dividends paid on preferred stock Cash dividends paid on common stock Tax benefits on stock plans Repurchase of common stock Net cash provided (used) by financing activities Net Change in Cash and Due From Banks Cash and due from banks at beginning of year Cash and Due From Banks Supplemental Cashflow Disclosures Loan collateral transferred to foreclosed assets Unrealized gain/(loss) on securities available for sale Interest paid for the period Income tax payments net of refunds received Acquisitions Noncash assets acquired Liabilities assumed Net noncash asset acquired Cash & cash equivalents acquired 24 2015 2014 2013 $ 16,502 $ 20,231 $ 20,270 581 4,200 53 8,727 1,034 636 (824) (186) 139 - 540 - (1,178) 13 (13,600) (56) (2,867) 78 (54) 10,015 ______________________ 23,753 - - - 40,096 (27,490) (38,723) (4,314) (3,906) - 2,126 ______________________ (32,211) 195,853 (10,532) (125) 49,375 (200) (5,859) 606 (27) ______________________ 229,091 ______________________ 220,633 45,526 ______________________ $ 266,159 ______________________ ______________________ $ 2015 684 (321) 3,381 10,165 4,572 (258) ______________________ 4,314 - (1,726) (400) - 8,160 1,376 1,372 (821) 91 (104) 163 546 (2,130) (1,045) (59) (4,788) 667 (6,548) (95) 2,756 3,187 ______________________ 20,833 - - 85,549 21,516 (18,391) (88,094) (10,843) (2,101) 3 3,341 ______________________ (9,020) (36,359) 2,657 (136) - (200) (5,332) 539 - ______________________ (38,831) ______________________ (27,018) 72,544 ______________________ $ 45,526 ______________________ ______________________ 2014 $ 1,499 1,161 3,394 11,257 127,650 (116,807) ______________________ 10,843 17,690 (974) 1,200 - 7,465 1,229 1,783 (832) 173 (133) (5) 299 (56) (2,214) (156) 47,178 (523) (1,405) (169) (2,944) (12,317) ________________________ 57,869 2,515 (11,318) 3,623 39,279 (56,328) (144,621) (1,882) (3,818) 21 6,351 ________________________ (166,178) 66,854 (4,729) (126) - (200) (4,689) 267 (203) ________________________ 57,174 ________________________ (51,135) 123,679 ________________________ $ 72,544 ________________________ ________________________ $ 2013 1,371 (4,645) 3,881 15,128 1,882 - ________________________ 1,882 - CliftonLarsonAllen LL P CLAconnect.com I N DEPEN DENT AU DITORS’ REPORT Board of Directors and Audit Committee Alerus Financial Corporation and Subsidiaries Grand Forks, North Dakota We have audited, in accordance with the auditing standards generally accepted in the United States of America, the consolidated financial statements of Alerus Financial Corporation and Subsidiaries, which comprise the consolidated balance sheets as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows for years then ended, and the related notes to the consolidated financial statements (not presented herein); and in our report dated March 4, 2016, we expressed an unqualified opinion on those consolidated financial statements. Other Matters Prior Period Consolidated Financial Statements The consolidated financial statements of Alerus Financial Corporation and Subsidiaries for the year ended December 31, 2013 were audited by other auditors whose report, dated February 18, 2014, expressed an unqualified opinion on those statements. Opinion In our opinion, the information set forth in the accompanying consolidated balance sheets, statements of income, changes in stockholders’ equity and cash flows are fairly stated, in all material respects, in relation to the consolidated financial statements from which they were derived. CliftonLarsonAllen LLP Minneapolis, Minnesota March 18, 2016 ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 25 (This page has been left blank intentionally.) 26 (This page has been left blank intentionally.) ALERUS FINANCIAL CORPORATION 2015 ANNUAL FINANCIAL REPORT 27