Keweenaw Financial Corporation and Subsidiary

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2 TABLE OF CONTENTS Boards of Directors... I Letter to Shareholders... II Financial Highlights... III Report of Independent Auditors... 1 Consolidated Balance Sheets... 3 Consolidated Statements of Income... 4 Consolidated Statements of Comprehensive Income... 5 Consolidated Statements of Changes in Stockholders Equity... 5 Consolidated Statements of Cash Flows... 6 Notes to Consolidated Financial Statements... 7 Superior National Bank & Trust Employees Date Monday, April 24, 2017 Meeting Time 10:30 a.m. ANNUAL MEETING Place Magnuson Hotel Franklin Square Inn, Houghton, MI SUPERIOR NATIONAL BANK & TRUST LOCATIONS

3 Board of Directors Keweenaw Financial Corporation Neil J. Ahola Owner & Manager, Memorial Chapel & Plowe Funeral Homes James D. Fenton President & Chief Financial Officer, McGann Building Supply Michael R. Hauswirth Chief Executive Officer, Aspirus Keweenaw & Aspirus Ontonagon Hospitals Susan J. LaFernier Assistant Secretary, Keweenaw Bay Indian Community Tribal Council Comptroller, Keweenaw Bay Indian Community Accounting Department Michael S. Mikkola Commercial Account Executive, Grand River Insurance Almor D. Penegor President, John & Arthur Penegor, Inc. J. David Vlahos President & Chief Executive Officer, Superior National Bank & Trust Company Daniel J. Wisti President & Attorney, Daniel J. Wisti P.C. BOARDS OF DIRECTORS Board of Directors Superior Natonal Bank & Trust Company Neil J. Ahola James D. Fenton Michael R. Hauswirth Susan J. LaFernier Michael S. Mikkola Almor D. Penegor J. David Vlahos Daniel J. Wisti I

4 To our Shareholders, Keweenaw Financial Corporation and Subsidiary We are pleased to report that net income for 2016 was $5,389,668, up from $3,612,496 in Net income for 2015 was unusually low as a result of a one-time pension expense. Deposits grew 3%, ending the year at $502,649,080 up from $487,812,212 in Even though deposits grew, our interest expense declined due to an increase in demand and savings accounts as well as a decrease in certificate of deposit accounts. Total assets grew by 2%, ending the year at $592,016,263 compared to $579,915,987 at December 31, The continued progress of our loan portfolio is also encouraging. Total loans grew by 7%, increasing from $267,318,103 to $287,355,074, primarily driven by strong commercial real estate and consumer loan growth. Credit quality continues to improve as delinquencies over 30 days decreased from 1.92% of total loans in 2015 to 1.72% of total loans in Nonaccrual loans also decreased in 2016, ending the year at 0.43% of total loans compared to 0.91% of total loans in Loan growth remains an area of emphasis across our organization. A major achievement from the past year was the transition of the Bank s core software to a new provider. With the new software came an upgrade to our e-banking platform, which we named MySNB for individual customers and SNBPro for business customers. The new software includes enhanced security features and allows the Bank to provide some new and exciting e-banking and mobile banking services which you will see rolled out in the upcoming year. Strengthening our foundation and positioning the Bank for growth has been the focus for the past several years. In 2016, we continued that effort by improving loan quality, enhancing technology, investing in people, and realigning departments to better reflect our size and to help comply with increasing regulatory requirements. Our efforts to sustain growth and build on our strong foundation will continue in We will focus on utilizing technology to improve efficiencies and developing our staff to provide a superior customer experience every time. We are committed to providing a competitive return for you, our valued shareholders. Thank you for your continued support. Best regards, LETTER TO SHAREHOLDERS J. David Vlahos President II

5 FINANCIAL HIGHLIGHTS % Change For the year Net income $ 5,389,668 $ 3,612, % Cash dividends 1,661,651 1,618, % Return on average assets 0.92% 0.62% 48.4% Return on average equity 7.72% 5.21% 48.2% At year end Assets $592,016,263 $579,915, % Deposits 502,649, ,812, % Loans, net 282,469, ,541, % Stockholders equity 69,005,104 70,648, % Equity to assets ratio 11.66% 12.18% -4.3% Per share data Net income $ $ % Cash dividends % Book value % Book value, excluding accumulated other comprehensive income % HISTORICAL STOCK COMPARISON $4.00 $3.50 Per Share Cash Dividend Year End Stock Price $3.88 $200 $3.00 $ $175 $2.50 $2.84 $2.00 $150 $1.50 $1.00 $125 $0.50 $ $100 III

6 FINANCIAL HIGHLIGHTS $600M Total Assets $6.0M Net Income $590M $580M $592,016,263 $5.5M $5.0M $5,470,779 $5, $570M $4.5M $560M $550M $550,448,042 $4.0M $3.5M $300M Total Net Loans $510M Total Deposits $290M $280M $270M $285,516,579 $282,469,510 $500M $490M $480M $502,649,080 $260M $250M $470M $460M $476,341, IV

7 ANDREWS HOOPER PAVLIK PLC 5300 GRATIOT ROAD SAGINAW, MI p: f: Report of Independent Auditors Board of Directors and Stockholders Keweenaw Financial Corporation Hancock, Michigan We have audited the accompanying consolidated financial statements of Keweenaw Financial Corporation and Subsidiary, which comprise the consolidated balance sheets as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders equity, and cash flows for the years then ended, and the related notes to the financial statements. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. ANN ARBOR AUBURN HILLS BAY CITY GRAND RAPIDS GREATER LANSING MIDLAND OWOSSO SAGINAW 1 1

8 We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Keweenaw Financial Corporation and Subsidiary as of December 31, 2016 and 2015, and the results of their operations and cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Saginaw, Michigan March 1,

9 CONSOLIDATED BALANCE SHEETS December December Assets Cash and cash equivalents: Cash and due from banks $ 21,189,455 $ 18,428,140 Federal funds sold 487,677 9,049,821 Total cash and cash equivalents 21,677,132 27,477,961 Interest-bearing time deposits in other financial institutions 6,110,132 6,942,856 Investment securities available for sale 262,042, ,167,908 Federal Reserve and Federal Home Loan Bank stock 1,534,750 1,534,750 Loans held for sale 562, ,426 Loans, less allowance for loan losses of $4,885,564 in 2016 and $4,776,538 in ,469, ,541,565 Bank premises and equipment, net 6,921,081 6,119,738 Accrued interest receivable 2,599,670 2,312,289 Other assets 8,099,163 7,280,494 Total assets $592,016,263 $579,915,987 Liabilities and stockholders equity Liabilities: Deposits: Demand $ 80,941,148 $ 66,309,741 NOW 73,585,296 68,154,019 Money market 20,497,118 18,494,547 Savings 173,214, ,589,863 Time 154,411, ,264,042 Total deposits 502,649, ,812,212 Repurchase agreements 15,478,265 17,233,784 Accrued interest payable and other liabilities 4,883,814 4,221,270 Total liabilities 523,011, ,267,266 Stockholders equity: Preferred stock: no par value; 50,000 shares authorized; none issued or outstanding in 2016 and 2015 Common stock: no par value; 500,000 shares authorized; 422,556 and 431,648 shares issued and outstanding in 2016 and 2015, respectively 3,252,516 4,843,616 Retained earnings 68,406,384 64,678,367 Accumulated other comprehensive income (loss) (2,653,796) 1,126,738 Total stockholders equity 69,005,104 70,648,721 Total liabilities and stockholders equity $592,016,263 $579,915,987 See accompanying notes. 3

10 CONSOLIDATED STATEMENTS OF INCOME Year Ended December Interest income: Loans, including fees $ 15,012,533 $ 15,272,206 Securities: U.S. Treasury securities 99, ,696 U.S. Government agencies 3,120,692 3,277,255 Obligations of states and political subdivisions 2,531,486 2,089,063 Other securities 667, ,918 Other interest income 207, ,312 21,638,337 21,626,450 Interest expense: Deposits and borrowed funds 2,667,628 2,953,325 2,667,628 2,953,325 Net interest income 18,970,709 18,673,125 Provision for loan losses 1,213,000 1,414,000 Net interest income after provision for loan losses 17,757,709 17,259,125 Noninterest income: Trust fees 1,224,828 1,203,231 Service charges on deposit accounts 930,351 1,009,695 Other service charges and fees 848, ,265 Net gain on sale of investment securities 18, ,161 Net gain on sale of loans 163, ,211 Other 73, ,420 3,258,279 3,612,983 Noninterest expenses: Salaries and wages 5,669,473 4,953,760 Pensions and other employee benefits 2,200,034 5,065,861 Occupancy expenses, net 2,397,251 2,160,268 Postage and supplies 214, ,705 FDIC and general insurance 441, ,143 Legal and professional 430, ,454 Directors fees 145, ,425 Regulatory exam fees 156, ,602 Marketing 133, ,806 Net cost of operations of other real estate - including writedowns and losses on sales 808,786 1,300,484 Other operating expenses 1,318,659 1,024,948 13,917,313 16,321,456 Income before income tax expense 7,098,675 4,550,652 Income tax expense 1,709, ,156 Net income $ 5,389,668 $ 3,612,496 Net income per share of common stock $ $ 8.37 See accompanying notes. 4

11 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Year Ended December Net income $ 5,389,668 $ 3,612,496 Other comprehensive income (loss), net of tax: Unrealized holding gains (losses) arising during the period (3,768,607) 612,221 Reclassification adjustment for net gains included in net income (11,927) (80,626) Total other comprehensive income (loss) (3,780,534) 531,595 Total comprehensive income $ 1,609,134 $ 4,144,091 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY Years Ended December 31, 2016 and 2015 Common Stock Number of Shares Assigned Value Retained Earnings Accumulated Other Comprehensive Income (Loss) Total Stockholders Equity Balance at January 1, ,648 $ 4,843,616 $ 62,684,551 $ 595,143 $ 68,123,310 Net income for ,612,496 3,612,496 Other comprehensive income 531, ,595 Cash dividends paid ($3.75 per share) (1,618,680) (1,618,680) Balance at December 31, ,648 4,843,616 64,678,367 1,126,738 70,648,721 Net income for ,389,668 5,389,668 Other comprehensive loss (3,780,534) (3,780,534) Common stock repurchases (9,092) (1,591,100) (1,591,100) Cash dividends paid ($3.88 per share) (1,661,651) (1,661,651) Balance at December 31, ,556 $ 3,252,516 $ 68,406,384 $ (2,653,796) $ 69,005,104 See accompanying notes. 5

12 CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December Cash flows from operating activities Net income $ 5,389,668 $ 3,612,496 Adjustments to reconcile net income to net cash from operating activities: Depreciation 443, ,158 Amortization 1,483,035 1,379,009 Deferred taxes (benefit) (15,000) (1,150,000) Valuation writedowns of other real estate 481, ,617 Net gain on sale of other real estate (104,901) (92,195) Gain on sale of other repossessed assets (19,869) Loss on disposal of fixed assets 16,150 Accretion of investment securities discount (457,569) (293,396) Realized investment security gains (18,071) (122,161) Gain on sale of loans (163,519) (227,221) Proceeds from sale of mortgage loans held for sale 8,035,996 12,910,072 Origination of mortgage loans held for sale (7,896,051) (12,771,834) Provision for loan and overdraft losses 1,213,000 1,414,000 Net change in: Accrued interest receivable and other assets (562,331) (1,847,214) Accrued interest payable and other liabilities 699,330 2,603,765 Net cash from operating activities 8,524,264 6,564,096 Cash flows from investing activities Decrease (increase) in interest-bearing time deposits in other financial institutions 832,724 (3,429,482) Repurchases of Federal Reserve and Federal Home Loan Bank stock 332,700 Activity in investment securities available for sale: Purchases (88,270,424) (61,029,539) Maturities, prepayments, calls, and sales 84,660,030 57,681,150 Loan originations and payments, net (20,578,666) 9,670,591 Proceeds from sales of other real estate 480,156 Proceeds from sales of other repossessed assets 19,869 2,650,920 Additions to Bank premises and equipment, net (1,297,380) (237,650) Net cash from investing activities (24,153,691) 5,638,690 Cash flows from financing activities Net change in demand, NOW, money market, and savings deposits 28,689,637 4,966,093 Net change in time deposits (13,852,769) (10,718,953) Net change in repurchase agreements (1,755,519) 1,415,124 Repurchase of common stock (1,591,100) Cash dividends (1,661,651) (1,618,680) Net cash from financing activities 9,828,598 (5,956,416) Net change in cash and cash equivalents (5,800,829) 6,246,370 Cash and cash equivalents at beginning of year 27,477,961 21,231,591 Cash and cash equivalents at end of year $ 21,677,132 $ 27,477,961 Supplemental cash flow information Transfer of loans to other real estate owned $ 1,063,781 $ 3,957,277 Loans originated from sale of other real estate owned 1,626, ,960 Income taxes paid 1,647,500 2,313,472 Interest paid 2,730,451 2,989,299 See accompanying notes. 6

13 1. Summary of Significant Accounting Policies and Nature of Operations The accounting policies followed by Keweenaw Financial Corporation (Corporation) and its wholly owned subsidiary and the methods of applying these policies, which materially affect the determination of financial position, results of operations, and cash flows are summarized below. Nature of Operations The Corporation provides a variety of financial and trust services to individuals and corporate customers through Superior National Bank & Trust Company (Bank) and its branches located in Houghton, Baraga, and Keweenaw Counties in the State of Michigan. The Bank provides a wide range of traditional banking products and services, including automated teller machines, online banking, telephone banking, and automated bill-paying services, to both individual and corporate customers. The accounting and reporting policies of the Corporation conform to accounting principles generally accepted in the United States of America (U.S. GAAP) and to general practices within the banking and mortgage banking industries. Principles of Consolidation The consolidated financial statements include the accounts of Keweenaw Financial Corporation and its wholly owned subsidiary, Superior National Bank & Trust Company. All material intercompany transactions and balances have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. The significant estimates incorporated into the Corporation s consolidated financial statements, which are susceptible to change in the near term, include the adequacy of the allowance for loan losses, the fair value of financial instruments, impaired loans, investments, deferred tax assets, and other real estate. Accordingly, actual results could differ from those estimates. Labor Subject to Collective Bargaining Agreements Approximately 45% of the Bank s employees are subject to a collective bargaining agreement, which expires on October 6,

14 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Cash Flow Reporting For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined to include cash on hand, demand deposits in other institutions, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, interest-bearing time deposits, and repurchase agreement transactions. Cash and Cash Equivalents The Corporation maintains deposit accounts with other financial institutions, which generally exceed federally insured limits or are uninsured. Interest-Bearing Time Deposits in Other Financial Institutions Interest-bearing time deposits in other financial institutions are certificates of deposit which mature in the years ending 2017 through 2026 and are carried at cost. Fair Value Measurements Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Corporation uses various methods including market, income, and cost approaches. Based on these approaches, the Corporation often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable inputs. The Corporation utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on the observability of the inputs used in the valuation techniques, the Corporation is required to provide the following information according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value will be classified and disclosed in one of the following three categories: Level 1 Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. Level 2 Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. 8

15 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Fair Value Measurements (continued) Level 3 Significant unobservable inputs that reflect a company s own assumptions about the assumptions that market participants would use in pricing an asset or liability. In determining the appropriate levels, the Corporation performs a detailed analysis of the assets and liabilities. At each reporting period, all assets and liabilities for which the fair value measurement is based on significant unobservable inputs are classified as Level 3. For the years ended December 31, 2016 and 2015, the application of valuation techniques applied to similar assets and liabilities has been consistent. Investment Securities Management determines the appropriate classification of securities at the time of purchase. Securities classified as available for sale are reported at fair value, with unrealized gains and losses, net of related deferred income taxes, included in other comprehensive income. Unrealized gains and losses on investment securities available for sale are based on the difference between book value and fair value of each security. Securities available for sale consist of those securities that management intends to use as part of its asset and liability management strategy which might be sold prior to maturity due to changes in interest rates, prepayment risks, and yields in addition to the availability of alternative investments, liquidity needs, or other factors. Other securities, such as Federal Reserve and Federal Home Loan Bank stock, are carried at cost. Fair value is based on quoted market prices, when available, or market prices provided by recognized broker dealers. If listed prices or quotes are not available, fair value is based upon externally developed models that use unobservable inputs due to the limited market activity of the instrument. Interest income on securities includes amortization of purchase premium or accretion of discount. The amortized cost amount is acquisition cost adjusted for amortization of premiums and accretions of discounts. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments. Realized gains and losses on dispositions are based on the net proceeds and the adjusted book value of the securities sold, using the specific identification method. Securities are written down to fair value when a decline in fair value is other than temporary. 9

16 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Investment Securities (continued) The entire amount of impairment is recognized through earnings for debt securities with unrealized losses that management intends to sell or will more likely than not be required to sell before an anticipated recovery in fair value. Otherwise, declines in the fair value of securities below their cost that are other than temporary are split into two components as follows: (1) other-than-temporary impairment (OTTI) related to credit loss, which must be recognized in the statements of income; and (2) OTTI related to other factors, which is recognized in other comprehensive income. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost; (2) the financial condition and near term prospects of the issuer; and (3) the Corporation s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. For equity securities, the entire amount of OTTI is recognized through earnings. Federal Reserve Bank Stock The Bank is a member of its regional Federal Reserve Bank (FRB). FRB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. Federal Home Loan Bank Stock The Bank is a member of the Federal Home Loan Bank (FHLB) System and is required to invest in capital stock of the FHLB of Indianapolis. The amount of the required investment is determined and adjusted by the FHLB. Loans Held for Sale Loans held for sale are reported at the lower of cost or market value in the aggregate, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Mortgage loans held for sale are generally sold without servicing rights retained. Loans The Bank s loan portfolio includes residential real estate, commercial real estate, commercial, and consumer segments and classes. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. 10

17 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Loans (continued) Interest income is reported on the simple interest method on the daily balance of the principal amount outstanding and includes amortization of net deferred loan fees and costs over the loan term. Accrual of interest is generally discontinued on (1) commercial loans 90 days past due as to either principal or interest, (2) real estate mortgage loans which are past due 90 days or more and on which collateral is inadequate to cover principal and interest, and (3) any loans, which management believes, after considering economic and business conditions and collection efforts, that the borrower s financial condition is such that collection is doubtful. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income at the time the loan is assigned nonaccrual status. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. For impaired loans not classified as nonaccrual, interest income continues to be accrued over the term of the loan based on the principal amount outstanding. Loans classified as troubled debt restructurings (TDRs) are accounted for in generally the same manner as all other loans. If the loan is in accrual status at the time of the restructuring, the borrower has the ability to make the payments under the restructured terms, and the restructuring does not forgive principal, the loan remains on an accrual basis under the new terms. If there is a forgiveness of debt or partial charge-off, the loan will generally be placed on nonaccrual status with any accrued interest reversed against interest income. If a loan is in nonaccrual status at the time of a restructuring or subsequently becomes nonaccrual, it will remain in nonaccrual status until the borrower has demonstrated the ability to make the payments under the restructured terms by making a minimum of six months of payments. If the borrower makes the six months of payments without becoming past due 30 days or more, it will be returned to accrual status. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses, and decreased by charge-offs less recoveries. The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management s periodic review of the collectability of the loans in light of historical loss experience, the nature and volume of the loan portfolio, information about specific borrower s ability to repay, estimated collateral values, prevailing local and national economic conditions, and other factors. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. 11

18 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Allowance for Loan Losses (continued) Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management s judgment, should be charged off. Loan losses are charged against the allowance when management believes the collectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans and other real estate. Such agencies may require the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is possible that the estimated losses on loans and other real estate may change in the near term. However, the amount of the change cannot be estimated. The allowance consists of general, allocated, and unallocated components as further described below: General Component The general component of the allowance for loan losses is based on historical loss experience adjusted for qualitative factors stratified by the following loan segments: commercial, residential real estate, commercial real estate, and consumer installment loans. Management uses a rolling average of historical losses based on a time frame appropriate to capture relevant loss data for each loan segment. This historical loss factor is adjusted for the following qualitative factors: levels and trends in delinquencies; trends in volume and terms of loans; effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and staff; and national and local economic trends and conditions. The qualitative factors are determined based on the various risk characteristics of each loan segment. Risk characteristics relevant to each portfolio segment are as follows: Residential Real Estate Loans Loans in this segment are collateralized by residential real estate and repayment is dependent on the credit quality of the borrower and the value of the underlying collateral. Changes in business conditions, including unemployment rates and housing prices, and the local real estate market can affect the credit quality of this segment. Commercial Real Estate Loans Loans in this segment are collateralized by commercial real estate and repayment is dependent on the income-generating capacity of the business, the credit quality of the borrower, and the value of the underlying collateral. The underlying cash flows generated by the properties are adversely impacted by a downturn in the economy. Changes in business conditions and cash flows, and the value of the underlying collateral can affect the credit quality of this segment. Commercial Loans Loans in this segment are generally collateralized by the assets of the business. Repayment is dependent on the income-generating capacity of the business. Changes in business conditions, a weakened economy, and resulting decreased consumer spending, will affect the credit quality of this segment. 12

19 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Allowance for Loan Losses (continued) Consumer Installment Loans Loans in this segment are generally collateralized by vehicles, other personal property, or are unsecured. Repayment is dependent on the credit quality of the borrower and their intent to repay and the value of the underlying collateral, if any. Changes in business conditions, unemployment rates, and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate the borrowers capacity to repay their obligations may be deteriorating. Allocated Component The allocated component relates to loans that are classified as impaired. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. An allowance is established when the discounted cash flows (or collateral value) of the impaired loan are lower than the carrying value of the loan. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual residential real estate and consumer installment loans for impairment, unless such loans are subject to a troubled debt restructuring, collateral repossession, bankruptcy, or management has concerns about the borrower s ability to repay or concerns about the value of the underlying collateral. The Bank may agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a TDR. All TDRs are classified as impaired loans. Unallocated Component An unallocated component is maintained to cover uncertainties that could affect management s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio. 13

20 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Transfers of Financial Assets Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Corporation, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. If the transfer does not meet the conditions for sale accounting, the transfer is accounted for as secured borrowings with a pledge of collateral. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Additions and major replacements or improvements that extend useful lives are capitalized. Maintenance, repairs, and minor improvements are charged to expense as incurred. Depreciation is computed using the straight-line method over estimated useful lives for book purposes and is charged to operations. Depreciation is generally computed for tax purposes using an accelerated method. Deferred income taxes are provided on such differences. Gains and losses on premises and equipment disposed of are included in other operating income. Depreciation expense for 2016 includes $36,786 of accretion related to the recognition of a service provider credit for future expenses. Other Real Estate Other real estate acquired through, or in lieu of, loan foreclosure is initially recorded at fair market value less estimated selling costs at the date of foreclosure establishing a new cost basis. At the date of acquisition or physical possession, and the following 90 days, losses are charged to the allowance for loan losses. Costs of significant property improvements are capitalized, whereas costs relating to holding the property are expensed. After acquisition, valuations are periodically performed by management, and any subsequent writedowns are recorded as a charge to operations, if necessary, to reduce the carrying value of a property. Bank-Owned Life Insurance The Corporation purchased life insurance policies on certain key executives. Bank-owned life insurance is recorded at its cash surrender value, and is included in other assets on the consolidated balance sheets. 14

21 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Long-Term Assets Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. Repurchase Agreements All repurchase agreement liabilities represent amounts advanced by various customers and are secured by securities owned, as they are not covered by general deposit insurance. Pension and Profit Sharing Plans Bank contributions to the plans are charged to current operations. Income Taxes Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the federal income tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. The Corporation records interest and penalties related to tax positions as interest expense or other expense, respectively, in the consolidated statements of income. Common Stock Repurchases In 2016, the Corporation was authorized under the Keweenaw Financial Corporation Stock Repurchase Plan of 2016 to repurchase up to 37,000 of its outstanding shares of common stock upon privately negotiated terms, conditions, and prices. In 2016, the Corporation repurchased 9,092 shares of common stock for a total cost of $1,591,100. In January 2017, the Corporation s Board of Directors approved to continue with the Stock Repurchase Plan for Earnings Per Common Share Earnings per share are computed based on the weighted average number of shares of common stock outstanding. The weighted average number of shares of common stock outstanding was 428,332 shares as of December 31, 2016, and 431,648 shares as of December 31,

22 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Off-Balance-Sheet Financial Instruments In the ordinary course of business, the Bank has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commitments under credit arrangements, and letters of credit. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded in the financial statements when they become payable. Fair Values of Financial Instruments Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. Comprehensive Income Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes the net change in unrealized gains and losses on securities available for sale, net of tax, which are also recognized as separate components of equity. Other comprehensive income (loss) also includes a reclassification adjustment for gains included in net income. Restrictions on Cash Cash on hand or on deposit with the Federal Reserve Bank of $5,008,000 at December 31, 2016 and $3,570,000 at December 31, 2015, was required to meet regulatory reserve requirements. Dividend Restriction Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Corporation or by the Corporation to shareholders. Loss Contingencies Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the consolidated financial statements. 16

23 1. Summary of Significant Accounting Policies and Nature of Operations (continued) Reclassifications Certain prior year amounts have been reclassified to conform to the current year s presentation. Subsequent Events Subsequent events were evaluated through March 1, 2017, which is the date the financial statements were available to be issued. 2. Investment Securities The amortized cost and fair values of investment securities available for sale and the related gross unrealized gains and losses recognized in accumulated other comprehensive income at December 31, were as follows: 2016 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value U.S. Government and federal agencies $ 61,374,661 $ 698,853 $ (520,046) $ 61,553,468 Corporate debt 24,734, ,652 (185,821) 24,805,091 Mortgage-backed securities 69,225, ,245 (1,308,317) 68,167,242 State and local governments 110,729, ,045 (3,764,513) 107,517,024 $ 266,063,727 $1,757,795 $(5,778,697) $ 262,042, Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value U.S. Government and federal agencies $ 86,141,401 $ 1,207,140 $ (327,525) $ 87,021,016 Corporate debt 26,640, ,196 (180,045) 26,783,265 Mortgage-backed securities 66,628, ,878 (633,098) 66,366,266 State and local governments 84,050,727 1,215,369 (268,735) 84,997,361 $263,460,728 $3,116,583 $(1,409,403) $265,167,908 17

24 2. Investment Securities (continued) The amortized cost and fair values of investment securities available for sale by contractual maturity at December 31, 2016 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately. Amortized Cost Fair Value Due in one year or less $ 9,170,747 $ 9,233,905 Due in one through five years 71,579,923 72,333,578 Due after five years through ten years 65,090,999 64,083,746 Due after ten years 50,996,744 48,224,354 Mortgage-backed securities 69,225,314 68,167,242 $ 266,063,727 $ 262,042,825 Securities with unrealized losses not recognized in income at December 31, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows: 2016 Fair Value Less Than Twelve Months Unrealized Losses Fair Value Over Twelve Months Total Total Unrealized Losses Fair Value Unrealized Losses U.S. Government and federal agencies $ 32,178,314 $ 520,046 $ $ $ 32,178,314 $ 520,046 Corporate debt 5,191, , ,100 2,900 6,188, ,821 Mortgage-backed securities 45,866,321 1,153,684 5,789, ,633 51,655,565 1,308,317 State and local governments 75,060,514 3,764,513 75,060,514 3,764,513 $158,296,424 $5,621,164 $6,786,344 $157,533 $165,082,768 $5,778,697 18

25 2. Investment Securities (continued) 2015 Fair Value Less Than Twelve Months Unrealized Losses Fair Value Over Twelve Months Total Total Unrealized Losses Fair Value Unrealized Losses U.S. Government and federal agencies $ 29,030,377 $ 138,181 $ 8,917,388 $ 189,344 $ 37,947,765 $ 327,525 Corporate debt 13,614, ,111 1,080,025 24,934 14,695, ,045 Mortgage-backed securities 34,911, ,983 9,477, ,115 44,389, ,098 State and local governments 19,191, ,465 7,283, ,270 26,475, ,735 $96,748,934 $864,740 $26,758,882 $544,663 $123,507,816 $ 1,409,403 At December 31, 2016, 190 debt securities had unrealized losses with aggregate depreciation of approximately 3.4% from the Bank s amortized cost basis, and 25 of the 190 securities were issued by a federal agency. Unrealized losses on obligations of U.S. Government and federal agencies, corporate debt, state and local governments, and mortgage-backed securities were not recognized into income because the securities were not deemed to be of low investment grade, management has the intent and ability to hold for the foreseeable future, and the decline in fair value is due to general economic conditions. Proceeds from sales and maturities of investment securities available for sale during 2016 were $84,660,030. Net gains on those sales and maturities totaled $18,071. Proceeds from sales and maturities of investment securities available for sale during 2015 were $57,681,150. Net gains on those sales and maturities totaled $122,161. Investment securities with a book value of $35,800,759 at December 31, 2016, and investment securities with a book value of $31,059,268 at December 31, 2015, were pledged as collateral to secure repurchase agreements, public deposits, and for other purposes required by law. 19

26 3. Loans and Allowance for Loan Losses Loan segments at December 31 were as follows: Commercial $ 32,488,315 $ 31,515,731 Commercial real estate 94,118,079 78,505,911 Residential real estate 120,802, ,365,572 Consumer installment 39,946,211 36,930, ,355, ,318,103 Allowance for loan losses (4,885,564) (4,776,538) Net loans $ 282,469,510 $ 262,541,565 Changes in the allowance for loan losses by loan segment for the year ended December 31, 2016 were as follows: Commercial Commercial Real Estate Residential Real Estate Consumer Installment Unallocated Total Balance at beginning of year $ 459,596 $ 2,035,780 $ 1,147,201 $ 246,111 $ 887,850 $ 4,776,538 Provision charged to operations 594, , , ,331 (96,267) 1,213,000 Loans charged off (715,387) (137,114) (197,710) (180,019) (1,230,230) Recoveries 5,325 31,339 9,319 80, ,256 Balance at end of year $344,299 $2,102,924 $1,343,062 $303,696 $791,583 $4,885,564 20

27 3. Loans and Allowance for Loan Losses (continued) The following table presents the balance of loans by loan segment based on impairment method at December 31, 2016: Allowance for loan losses: Ending allowance balance attributable to loans: Commercial Commercial Real Estate Residential Real Estate Consumer Installment Unallocated Total Individually evaluated for impairment $ 151,721 $ 1,123,971 $ 416,295 $ 2,226 $ $ 1,694,213 Collectively evaluated for impairment 192, , , ,470 2,399,768 Unallocated to specific loan segments 791, ,583 Ending allowance balance $ 344,299 $ 2,102,924 $ 1,343,062 $ 303,696 $ 791,583 $ 4,885,564 Loans: Individually evaluated for impairment $ 1,752,342 $ 15,130,347 $ 5,231,243 $ 172,991 $ $ 22,286,923 Collectively evaluated for impairment 30,735,973 78,987, ,571,226 39,773, ,068,151 Ending loan balance $32,488,315 $94,118,079 $120,802,469 $39,946,211 $ $287,355,074 21

28 3. Loans and Allowance for Loan Losses Changes in the allowance for loan losses by loan segment for the year ended December 31, 2015 were as follows: Commercial Commercial Real Estate Residential Real Estate Consumer Installment Unallocated Total Balance at beginning of year $ 535,282 $ 1,952,401 $ 1,095,573 $ 216,659 $ 930,607 $ 4,730,522 Provision charged to operations (586,702) 1,193, , ,892 (42,757) 1,414,000 Loans charged off (243,652) (1,120,684) (564,731) (349,325) (2,278,392) Recoveries 754,668 10,447 7, , ,408 Balance at end of year $459,596 $2,035,780 $1,147,201 $246,111 $887,850 $4,776,538 The following table presents the balance of loans by loan segment based on impairment method at December 31, 2015: Allowance for loan losses: Ending allowance balance attributable to loans: Commercial Commercial Real Estate Residential Real Estate Consumer Installment Unallocated Total Individually evaluated for impairment $ 294,638 $ 866,176 $ 380,187 $ 44,289 $ $ 1,585,290 Collectively evaluated for impairment 164,958 1,169, , ,822 2,303,398 Unallocated to specific loan segments 887, ,850 Ending allowance balance $459,596 $2,035,780 $1,147,201 $246,111 $887,850 $4,776,538 22

29 3. Loans and Allowance for Loan Losses (continued) Loans: Commercial Commercial Real Estate Residential Real Estate Consumer Installment Unallocated Total Individually evaluated for impairment $ 2,588,254 $ 10,858,720 $ 3,843,863 $ 164,006 $ $ 17,454,843 Collectively evaluated for impairment 28,927,477 67,647, ,521,709 36,766, ,863,260 Ending loan balance $31,515,731 $78,505,911 $120,365,572 $36,930,889 $ $267,318,103 The following table presents impaired loans individually evaluated for impairment by loan segment at December 31, The table below does not include those impaired loans collectively evaluated for impairment: Impaired loans without a valuation allowance: Unpaid Principal Balance Recorded Investment Related Allowance Average Record Investment Interest Income Recognized Commercial $ 1,387,912 $ 1,383,979 $ $ 1,567,486 $ 111,792 Commercial real estate 8,448,707 8,068,939 8,610, ,729 Residential real estate 2,244,202 2,244,202 2,295, ,709 Consumer installment 98,414 98, ,459 7,536 Total impaired loans without a valuation allowance $12,179,235 $11,795,534 $ $12,592,419 $ 1,015,766 Impaired loans with a valuation allowance: Commercial $ 370,765 $ 368,363 $ 151,721 $ 366,901 $ 19,191 Commercial real estate 7,198,808 7,061,408 1,123,971 7,226, ,751 Residential real estate 2,989,054 2,987, ,295 3,020, ,202 Consumer installment 74,577 74,577 2,226 81,908 4,282 Total impaired loans with a valuation allowance $10,633,204 $10,491,389 $ 1,694,213 $10,695,375 $ 578,426 Total impaired loans $22,812,439 $22,286,923 $ 1,694,213 $23,287,794 $ 1,594,192 23